Defined Benefit vs Defined Contribution Pensions

Defined Benefit vs. Defined Contribution Pension Plans

A defined benefit plan is funded and managed by an employer. A defined contribution plan is managed and funded by employees and boosted by employer contributions.

At the end of 2022, about 37% of Canadians had a workplace pension plan, according to the most recently available data from Statistics Canada.

A pension plan is a registered plan through which a person’s employer helps them save for retirement. Pensions vary from company to company, but the main differences are between defined benefit vs. defined contribution plans.

Here’s what you need to know about both of these options.

What is a defined benefit plan?

A defined benefit plan allows you to continue receiving income from your employer, even after you retire. Defined benefit is the most traditional type of employer-sponsored pension plan. The plan is based on a specific formula that allows you to know exactly how much you will receive every year during your retirement. While the formula varies depending on the employer, it is based on:

Your years of service (how long you have worked for the company).
Your average annual salary (this could be an average of your top-five earnings years, or an average over the course of your employment.).
An agreed-upon percentage multiplier.

Let’s say, for example, that you spent 25 years working for a company, your average annual income was $50,000, and your agreed-upon pension rate was 2%. That would mean you will receive $25,000 per year upon retirement (25 x $50,000 x 0.02 = 25,000).

With a defined benefit pension, both the employer and employee usually contribute to the plan. These contributions are pooled into a fund, which your employer must properly invest to ensure it has enough money to provide the agreed-upon annual pension payouts to employees in retirement.

A defined benefit plan is usually the most lucrative option for the employee, and it’s less stressful than other types of plans because you don’t have to make any investment decisions. However, that often means it is costlier and riskier for the employer, so these types of pension plans are not as common as they used to be.

Pros of a defined benefit plan

You know how much your pension income will be based on your employer’s formula, which makes it easier to plan for retirement.
You cannot outlive your pension, and there are often also survivor benefits.
Early retirement is an option, although it might mean reduced pension income.
Employer takes on the investment risk.
Allows you to take advantage of income splitting with a spouse to optimize your taxes.
May include a cost of living adjustment that takes inflation into consideration.
May include group health benefits during retirement.

Cons of a defined benefit plan

If things go wrong for the employer (e.g., the company goes bankrupt), your pension could be affected.
You cannot cash out your pension before retirement, though you may be able to transfer its commuted value to a locked-in RRSP.
There may not be inflation protection or survivor benefits.
Encourages you to work until a specific date, which may be later than you may want to retire, to get your full pension.

What is a defined contribution plan?

With a defined contribution plan, the employee contributes a specific amount of their paycheque to their pension. This is usually a percentage, but it could be a fixed dollar amount. The employer then matches that contribution up to a certain predetermined extent defined in your pension documents or employee contract.

For example, let’s say your employer matches 50% of contributions, up to an annual maximum of $10,000, and you earn $60,000 a year and contribute 5% of each paycheck to your plan. Here’s what that would look like:

Your contributions: $60,000 x 0.05 = $3,000

Your employer’s contributions: $3,000 x 0.5 = $1,500

Between you and your employer, $4,500 is contributed to your pension. If you could manage to contribute more from each paycheck, you’d benefit from additional employer contributions, since they’ll match up to $10,000 per year.

It’s then up to you as the employee to invest all these contributions for your retirement. The employer plays no role in managing pension money, other than offering access to an array of investments (usually mutual funds) through a specific financial services provider.

This means you take on all responsibility for risk and growth. It also means that you know how much you (and your employer) are contributing, but not how much you will end up with when it comes time to retire.

Pros of a defined contribution pension plan

You get to manage your investments yourself (though some people may consider this a con).
Matching employer contributions (which are part of your employment compensation, though some people view them as free money).
Withdrawals of retirement income are more flexible.
Easy to understand how much you have.
You may be able to cash out or move your pension before retirement, depending on your plan rules.

Cons of a defined contribution pension plan

You don’t know what your pension income will be at retirement, since it depends on how your investments perform.
You take on the risk and responsibility of managing your pension investments.
No protection against inflation.
You may outlive your pension.

Defined benefit vs. defined contribution: Which to choose?

Generally, employers offer either a defined benefit or a defined contribution pension plan. You typically aren’t able to choose one or the other, especially since defined benefit plans are becoming less common in Canada.

However, if you get the option to choose, weigh the above pros and cons to decide.

Remember that the rules surrounding these benefits will vary by company and plan, so be sure to read the fine print. Ask your company’s pension plan administrator if you have questions.

Alternatively, your company may offer another option such as a pooled registered pension plan (PRPP), which is similar to a defined contribution plan except that employer contributions are not mandatory. Other employers may offer group registered retirement savings plans, which are individual RRSPs that you contribute to through paycheque deductions.

Defined contribution plans are sometimes called group RRSPs, but there are differences between the two plans. Details of group RRSPs vary between companies.