Understanding pension plans

Sept. 14, 2011 – “The way DB works is that members and employers make contributions to the plan each payday over the employee’s career. These contributions are then professionally invested.”

There are two major types of pension plans – defined benefit and defined contribution.
And though their names sound very similar, these are two very different vehicles for saving for retirement.
With defined benefit, what you get out of the plan is what’s defined in advance. There’s usually a formula that determines what your benefit will be. Typically, the DB pension will provide you a percentage of your earnings for every year you were in the plan. So at retirement, someone in a two per cent DB plan would, after 25 years of work, get a pension of about half of what they made at work.
If they made $50,000, the pension would be $25,000. And that $25,000 would be paid for life – they can never outlive their retirement payments/benefits.
The way DB works is that members and employers make contributions to the plan each payday over the employee’s career. These contributions are then professionally invested. At retirement, the member gets the benefit as per the formula. Usually, 80 cents of every pension dollar comes from investment returns, with the rest coming from contributions.

With defined contribution, all that’s known is how much money is put in.  Typically, a member has contributions deducted on payday that are matched by the employer. These contributions are then invested – but it’s up to the member to pick the investments, and change them as needed over their career. No professional investing is involved.

When the employee retires, he or she gets the total of the invested contributions at the moment in time when they retire. Usually, this money is then used to purchase a lifetime annuity – an insurance product that pays the member a pension for life.
You don’t know in advance what you’ll get. The typical DC plan in Canada accumulates $150,000 at the point of retirement. This provides only $7,500 per year in income. Timing is everything on picking a retirement date, too – if the markets are down, you might have to keep working until they are up again.
In Australia, DC plans are mandatory for all workers. The average Australian male has $130,000 at retirement, the average female just $45,000. They can then draw money out of the account to live on. By age 75, only 35 per cent of Australians have any DC money left. Most Australians outlive their retirement plan, and are forced to rely on government benefits.