Defined Benefit Pension vs Defined Contribution Pension

With retirement being a hot topic in personal finance, I get a lot of questions regarding the differences between a defined benefit pension plan and a defined contribution pension plan.  Even though both have similar names, they have vast differences as to what it means for the retiree.

Defined Benefit Pension (DBP)

A defined benefit pension (gold-plated) is just as it sounds. The payout, when it comes time to collect, is fixed to a certain formula.  The formula is typically a combination of years of service multiplied by a percentage of your average salary over the last several years of service.

A typical government defined benefit plan will offer 60%-70% of the employees average salary over the last several years of service once they reach the 30 to 35 years of service mark. So for example, my wife is on a defined benefit plan with the government.  When she is in her early-mid 50’s, she will have accumulated over 30 years of service at which point she’ll be entitled to around a pension of around 66% of her working pay.  If she reaches the 35 years of service milestone, she will receive around 70% of her working pay during retirement.

The Advantages

  • Retirement income is independent of market performance and usually adjusted for inflation.
  • Retirement income is relatively high (up to 70%) for the amount of contribution the employee makes.
  • The higher income years prior to retirement really works to the employees advantage.

The Downside

  • Defined benefit pensions are extremely expensive on the employer which is why most companies are, or have switched, to a defined contribution plan instead.  The biggest risk with having a non-government defined benefit plan is that there’s the possibility of the pension not being funded properly.
  • Another disadvantage is that some DBP’s only allow a portion of the pension to be transferred to a spouse if the beneficiary passes away.  Whereas an RRSP is more flexible where all assets can be transferred.

Defined Contribution Pension (DCP)

Instead of the benefit being fixed, a defined contribution pension plan has a fixed contribution usually based as a percentage of the employees salary (usually employer matched).   The benefit is dependent on how the portfolio performs with no guarantees as to how much income you’ll receive during retirement.

For the astute investor, a defined contribution plan has the benefit of total control over the money/portfolio.  The investor can choose various funds and asset allocation within the plan.

Advantages:

  • Watch your money/portfolio grow, what you see is what you get.
  • Control over your money and investments within the plan.

The Downside:

  • Retirement income is entirely dependent on how the portfolio/market performs over the vested period.
  • Even an employee who has no interested in finances needs to be involved with the portfolio.

Final Thoughts

Typically speaking, an employee doesn’t have a choice as to whether to to enroll in a defined benefit plan or a defined contribution plan.  It’s usually one or the other depending on the company.  Defined contribution plans are becoming more popular as they are much less risk to the company and arguably the employee as well.

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FT

FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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Pension Tension
5 years ago

I have just started at a new company that offers both DC and DB pensions. I am 40 years old. I need to make a decision as to which plan to enter.

If I don’t anticipate that I will be at the company for more than 5 to 10 years, is it correct that the DC would be a better option?

What if I enter the DB plan and then leave the company in 10 years, what typically happens with the pension? Does a set amount move into a LIRA like with the DC?

paul
6 years ago

What are your thoughts on buying back service, under defined benefit plan?

Johnny Cash
8 years ago

What does the rule of age 55 and 10 years of continuous pensionable service (DB) mean in Ontario?

whiskey tango
8 years ago

i have a nice DCP with matching at work. but my investment choices are limited and in my opinion very expensive due to management fees. Is it possible occasionally transfer money out of an RPP into a self directed LIRA without quitting my job and ending the RPP?

Ed Rempel
11 years ago

Hi Cannon,

No. The pension administrators have a “CPP offset formula” that they use to estimate your CPP during the time you were in that pension plan.

Most pensions offer you a choice when you retire of taking a flat pension or an integrated pension (if you retire before age 65). For example, if you retire at 55, you may have a choice of taking $25,000/year flat for life, or taking $30,000/year from age 55-64 and then it drops to $20,000/year from then on as your CPP of $10,000 kicks in.

If you take the flat pension, then your income will actually be higher at age 65. This may make sense if you are still working part time, for example.

Many people take the integrated pension to give themselves more travel/spending money the first few years. Then they also elect to take CPP early at age 60. Their pension will then drop by about $10,000 at age 65, but OAS still kicks in at about $6,000, so their income drop at 65 is not much.

Ed

cannon_fodder
11 years ago

Ed,

So, do you have to annually submit any documentation to the ‘trustee’ administering your DBP detailing how much CPP you received? Or do they simply ask for a statement of contributions to coordinate the benefits?

Ed Rempel
11 years ago

Hi Cannon & FT,

Yes, most public sector DBP’s are integrated with the CPP. The actual pension is benefit you calculate from the formula less an estimate for CPP.

For example, if your formula is 2%/year x the average of your best 5 years x 30 years in the pension, you would expect to get 60% of the your salary for the 3rd year before retirement. However, that is what you would get from BOTH your pension and CPP.

Ed

cannon_fodder
11 years ago

If I understand correctly, many public sector DBP’s coordinate with the CPP so that you can’t “double dip”, i.e. receive the CPP without a commensurate reduction in your DBP payments.

Is that correct?

Houska
11 years ago

There’s discussion of whether DB or DC is more risky for the retiree. The answer is that it depends since there are two types of risk.

One is the risk of uncertain investment performance (let’s call it market risk), leading to uncertain level and duration of payout for retirement. This is a continuous risk – you expect it to vary with a bell curve like shape (possibly with fatter tails). In a DC scheme, the retiree bears all of this risk. In a DB scheme, the employer bears the bulk of this risk, though as mentioned above, if the whole plan gets too much out of whack, contributions may need to be adjusted.

The second is the catastrophic risk of an event wiping out (or significantly devaluing) the pension. This is a form of counterparty risk. In a DC plan with reasonable asset allocation, this is only the risk of a complete financial system failure – possible, but unlikely, and its impact is somewhat under the control over the retiree by what they do. In a DB plan, the retiree is significantly exposed to the risk of collapse of his/her employer and devaluation of the pension.

So in DC, recipient has lots of market risk but minimal counterparty risk. Employer has none of either, so prefers it. In DB, employer bears the bulk of the market risk, but recipient has a ton of counterparty risk – financial health of the employer.