WEALTH Matters — SUMMER 2009

how pension plans work

A Pension Plan is an investment portfolio that provides retirement income to one or more ‘members’ of the plan. The contribution rates, investment policy, and benefit rates are outlined in a booklet that is given to plan members when they enroll in the plan or when significant changes are made to the plan. Most pension plans are ‘Registered Pension Plans’ (RPPs) which allow you to claim your contributions as tax deductions, and accumulate investment income and growth without paying any income tax (like a RRSP) and instead pay tax only on the income you receive from the plan. A major advantage of an RPP over an RRSP is that your employer must fund at least 50% of the cost of the pension in an RPP, but most often will fund 0% of your RRSP contributions. So an RPP usually means you’re getting significant extra value on top of your salary.

There are two main types of pension plans, and the type you have will affect how you do your retirement planning.

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upcoming changes to canada pension plan

how pension plans work

how safe is my pension?

investment fraud

Defined Benefit (DB) Plans – the amount of income you will get at retirement is guaranteed by a formula usually based on how many years you have been in the plan, and your income during some or all of the years you were in the plan. The investment performance of the plan will not affect your pension amount (except in rare cases – see the article on the next page ‘How Safe is my Pension?’). The investments are managed by an insurance company or pension fund manager, and your employer is responsible for ensuring that enough money is put into the plan to cover the cost of the promised pensions.

Defined Contribution (DC) Plans – the amount of income you get at retirement is not guaranteed. Instead, the plan defines how much you contribute to the plan each year, and usually lets you choose how your contributions will be invested. The amount of retirement income you get will be based on the value of the investments in your plan account when you retire. You can use the plan balance to buy an Annuity that will pay you a guaranteed income for life, or transfer the balance to a Life Income Fund (LIF) which may provide more flexibility in the timing and amount of your income.

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In almost every way, a DC plan is the same as a RRSP in that you need to manage the asset allocation and investment vehicles inside the plan to ensure it controls your investment risk while earning enough to provide for your income needs. The biggest issue with these plans is that most members will not coordinate the investment management of the pension plan assets with the rest of their investments. Therefore, they may be missing opportunities to tax-optimize their holdings, and manage risk across their various plans. We have written extensively on these topics. Please ask us for copies of these articles or check our website to learn more.

A DB plan presents completely different planning challenges. You may wonder how a guaranteed retirement income could be a planning ‘challenge’. The problem is that the formula which determines the pension income amount is usually based on an average of your earnings over a number of years, and therefore the dollar amount of the pension won’t be known until you actually retire.

For example, a typical DB formula is ‘2% of your annual earnings multiplied by the average of your last 5 years of salary’. This is done to ensure the pension amount is meaningful even if inflation pushes up the cost of living and salaries before you retire. Other plans may use an average of all of your years of earnings, and would have less inflation protection before retirement.




Survivor Benefit

A problem that faces many people nearing retirement is their desire to ‘slow down’ at work in the years before retirement. If this means shifting out of a high-stress senior management position into something less intense, it often means taking a pay cut. If you have a DB plan based on your final years of earnings, a pay cut in the last few years could significantly reduce your pension amount. You may be better off to retire a few years early, take a higher pension, and take that lower-paying job on a contract instead.

We would be glad to review your pension plan booklet and statement with you to help you understand your choices and how they will affect your future income, tax, and estate planning. 



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