Pension plans
Pension plans can be highly desirable for an employee and can greatly assist in long term savings for their retirement. As an employee, pension plans and how they work can be complicated and it may be challenging to understand what this means for you and your savings. As an employer, it is important to understand what you offer employees and what you are responsible for. In this blog I would like to cover some of the basics of pension plans and what they mean for employees and employers.
There are primarily two different types of pension plans: Defined Contribution (DC) and Defined Benefit (DB) plans. Over the past decade, or more-so since the 2008 financial crisis, pension plans being offered have declined from employers in favor or more cost effective plans such as RRSP matching incentives. Of the pension plans being offered most are DC based plans.
DC plans involve an entity (employer) to contribute defined amounts into a fund on the employee’s behalf. The defined amounts are typically set out as terms of the employee’s contract, most commonly as a percentage of earnings. For example, the company agrees to contribute 2% of the employee’s salary for each year of service. Other incentives may be offered such as matching contributions where an employee can contribute a percentage of their own salary and the employer will match it. The contributions are transferred into a separate fund where the monies are invested using more long-term based investing techniques.
As the contributions are placed into an investment fund, the value of this fund and subsequently the amount the employee is entitled to are subject to market fluctuations (also known as investment risk). This risk of value fluctuation in the fund is borne by the employee where the organization is not responsible for the fund or its future value. Post employment the individual can decide how much they would like to withdraw each year to live off of, this amount is classified as income and will be subject to taxation.
DB plans are defined by way of the plan terms and are most commonly offered in unionized or government environments. For example, an employee would earn a future pension benefit of 2.5% of their salary for each year of employment served until death. Similar to DC plans the organization contributes the monies collected into a pension fund where the money is invested using long-term investment strategies and is ultimately subject to fluctuations in market value of fund assets.
However, the main difference between two types of plans is that under DB plans the amount defined in the plan (2.5% example above) is guaranteed to the employee regardless on fluctuations in market value. Therefore, DB plans represent a liability for the organization and would appear in the entity’s financial statements. In contrast to DC plans where the amount contributed by the employer is just an expense and would only appear on the organization’s profit & loss statement with no future liability associated with the fund.
In conclusion, from a risk perspective one or the other may be more beneficial depending on if you are an employee or employer. As an employee, it is more beneficial to contribute to a DB plan as the organization will bare any risk of changing fund balances and therefore ensuring the individual receives the full pension benefit they are entitled to. However, as an employer this could mean being on the hook for poor plan performance or poor economic conditions in addition to not knowing how long an employee will live for post employment, which are all additional risks for the organization. This is why most organizations who do offer a pension plan opt towards offering DC based plans as it eliminates any risk of future value fluctuations but still allows the organization to contribute to their employees retirement savings.
While pension plans assist in an individuals plan for retirement, it should not be the sole strategy for retirement income. Other options that should be considered include: RRSPs, TFSA, personal investments and savings.
