If you are one of the nearly 6 million Canadians with membership in a Registered Pension Plan, the expected benefits from it will likely make up the vast majority of your retirement income. Which is why it is essential to understand the type of plan you are in and what your options will be when you eventually leave the workforce.
There are two main types of Registered Pension Plans – Defined Benefit and Defined Contribution.
Members of Defined Benefit plans generally pay a certain percentage of their income into the plan and, upon retirement, receive a set monthly allowance for the rest of their life. The amount is usually based on a formula that takes into account average earnings and years of service. Each particular Defined Benefit plan will also have its own unique characteristics:
- What are the age and years of service requirements for Normal, Early and Early Reduced pension benefits?
- Is the plan indexed for inflation?
- Is there a bridge benefit if you retire prior to age 65?
- Does your pension decrease at age 65 due to CPP integration?
- What happens if you pass away while receiving pension? What about prior to retirement?
Members of Defined Contribution plans also contribute a certain percentage of their income each year and the company normally matches it. When you retire the total amount is rolled into a registered plan which you control. You are not guaranteed a certain benefit amount in retirement and you must make all the investment decisions yourselves. On the other hand, you have control over the performance of your plan and enjoy far greater flexibility with regard to your retirement income.
There are also some key questions that need to be answered if you are in a Defined Contribution plan:
- How much do you need to contribute? What about your employer?
- What are the retirement eligibility requirements?
- What are your investment options?
In most cases the type of plan, Defined Benefit or Defined Contribution, is dictated by your employer and you do not get to choose. However, under certain circumstances Defined Benefit plans will offer a Commuted Value transfer at the time of retirement, allowing you to either opt for the original monthly allowance with its guarantees and predictability or to transfer a lump-sum value to a Locked-In Retirement Account (LIRA) or Prescribed Retirement Income Fund (PRIF). The amount available for transfer is based on actuarial calculations and the end result is comparable to moving from a Defined Benefit to a Defined Contribution plan.
The first step in making this crucial decision is to have your financial advisor determine what rate of return you need to generate in the LIRA or PRIF in order to match, or exceed, the monthly benefits of the Defined Benefit plan. Once that is established you can move on and examine some of the other factors that need to be considered.
Sticking with the Defined Benefit plan provides:
- A guaranteed monthly allowance even if you survive beyond regular life expectancy.
- No investment risk.
- Income that is eligible for pension splitting with a spouse or common-law partner. PRIF income is only eligible after age 65.
Transferring the Commuted Value offers:
- Unlimited access to lump-sum withdrawals.
- Full control of your investment portfolio.
- The entire account balance to be left to your named beneficiaries upon death. Most Defined Benefit plans include only a return of premiums prior to retirement and a 5 or 10 year guarantee during retirement.
In addition, you need to consider the other aspects of your financial situation such as age, investment horizon and personal risk tolerance. If your pension is going to be your primary source of retirement income you may be more comfortable with the guaranteed retirement income stream of the monthly allowance. On the other hand, if you expect to have additional sources of retirement income you will be in a better position to withstand market volatility and would likely benefit from the flexibility of a PRIF.
So, as you can see, this can be a complex decision to make. Do yourself – and your future – a favour by taking the time to consult with an experienced Financial Advisor. It’s never too early to start planning your retirement.