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Published November 15, 2021

Defined Benefit vs. Defined Contribution Pension Plans

The main differences between a defined benefit and defined contribution pension plan are who funds it, who manages it, and whether or not it pays out a predetermined amount.

At the end of 2019, about 37% of Canadians were active members in a workplace pension plan, according to the most recently available data from Statistics Canada. This rate has been slowly declining. In 2009, around 39% of Canadians were covered by a pension, and in 1999 it was 40.8%.

A registered pension plan is a financial tool 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 will vary 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 your top-five earnings years, or over the course of your employment, etc.).
  • An agreed-upon percentage multiplier.

Let’s say, for example, that you spent 25 years working for a company. During that time, your average annual income was $50,000, and your agreed-upon pension rate was 2%. That would mean your pension would pay $25,000/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.

» MORE: What to know about Registered Retirement Income Funds (RRIFs)

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 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.
  • There may not be inflation protection or survivor benefits.
  • Encourages employees to work longer than they may want to, so they get their full pension.

What is a defined contribution plan?

With a defined contribution plan, sometimes referred to as a group RRSP,  the employee contributes a specific amount of their paycheque (usually a percentage, but it could be a fixed dollar amount) into their pension, and the employer matches that contribution up to a certain extent. For example, if you decided to contribute 10% of your paycheck, your employer might match a portion of that contribution, up to a maximum of $10,000.

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 monies, 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. This also means that you know how much you are contributing, but not how much you will end up with when it comes time to retire.

» MORE: What to know about Registered Retirement Savings Plans (RRSPs)

Pros of defined contribution pension

  • You get to manage your investments yourself (some may consider this a con).
  • Matching employer contributions (i.e., free money).
  • Withdrawals of retirement income are more flexible.
  • Easy to understand how much you have.
  • You may be able to cash out your pension before retirement, if it is below a certain amount.

Cons of defined contribution pension

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

Defined benefit vs. defined contribution: Which to choose?

It’s rare to be able to between types of pension plans, 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 before you decide. Remember that the rules and regulations surrounding these benefits will vary company by company, so be sure to read the fine print and ask 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. Group registered retirement savings plans, which are individual RRSPs that you contribute to through paycheque deduction, can also be sponsored by your employer.

About the Author

Hannah Logan

Hannah Logan is a writer and blogger who specializes in personal finance and travel. You can follow her personal travel blog EatSleepBreatheTravel.com or find her on Instagram @hannahlogan21.

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