This is the second of a five-part commentary about an issue central to your financial wellbeing as you approach retirement age. It is an analysis of the sources of income necessary to support your retirement objectives.
Before continuing, we suggest you read part 1 of this series.
Types of Pension Plans
There are two types of pension plans, a defined benefit pension plan and a defined contribution pension plan.
As many of you know, not all companies offer pension plans. But if you are currently working for one that does, or if you have accumulated pension entitlements from a former employer, you need to understand the following distinctions and differences.
Broadly speaking, there are two fundamental pension plans to which company employees are eligible.
Defined Benefit Pension Plan
With a defined benefit pension plan (DB plan) an employee enjoys the security of knowing precisely what to expect at retirement.
A monthly retirement income stream is identified in advance, usually based on a formula involving your years of service and earnings.
It is up to the employer to contribute enough to the plan to ensure that sufficient funds are available in the future.
How much an employer must contribute will vary based on the changing market value of their investments. As a result, the investment risk is on the employer.
Funds for pension plan participants are pooled into one investment plan and controlled by a plan administrator.
The income that a retiree is eligible to receive is typically dependent on years of service and income – the average of your last five years’ earnings often being used as a guide.
Defined Contribution Pension Plan
In a defined contribution pension plan (DC plan), an employer determines how much will be contributed to the plan on a regular basis.
Investment of the funds is generally directed by the employees from a selection of investment options available within the plan, similar to a personal RRSP.
The amount a retiree is eligible to receive varies. The amount is based on contribution levels and the investment performance of the invested funds.
Whether your pension plan is a DB plan or a DC plan or a combination of both – which many plans are these days – it is an important part of your retirement investment strategy.
Knowing which type of plan you have and understanding how it works will help you determine how it can contribute to your retirement income.
The employer or the employer and the employee typically make contributions to both kinds of pension plan.
Contributions by both employer and employee are the most common arrangement.
Rules for contributions are specific to each plan and may include matching cash contributions, calculated in either dollar amounts or percentages.
Pension plan funds are held in trust. Those funds are separate from the company, and managed by an independent plan administrator.
Once in the plan, pension assets are not available to the company to draw on.
If you have any doubts or uncertainties about which plan you are enrolled in, and what your obligations and entitlements are with respect to that plan, consult your financial advisor. If you do not have a financial advisor, one of our partner credit unions (Coastal Community Credit Union, Interior Savings Credit Union, or FirstOntario Credit Union) would be happy to help.
Healthy, wealthy and wise is an expression with which we are all familiar. Retirement income planning is a fundamental building block of that crucial challenge as you prepare for one of the most critical of all life’s transitions. Getting informed, professional advice is both sensible and necessary.