Employer Pension Plans
About 40 percent of workers in Canada are covered by an employer pension plan. Formally called Registered Pension Plans (RPPs), these plans are registered with Canada Customs and Revenue Agency and the appropriate federal or provincial regulatory authorities. Once an employer sets up a plan, it must comply with tax and pension standards rules.
If you are in a contributory plan, your employer deducts from your pay cheque any contributions you are required to pay, and reports the total on your T4 tax slip each year. Your annual contribution is tax-deductible.
There are two principal types of employer pension plans - defined benefit plans and defined contribution plans. The type of plan you belong to is important, because it affects the pension you will receive when you retire.
In a defined benefit plan, you’re promised a monthly pension income that is determined (or “defined”) by a formula, such as a combination of your earnings, job classification and the length of time you worked for the employer. It is generally the employer’s responsibility to ensure that sufficient funds are available to pay your pension when you retire. The employer assumes the risk of investing all contributions wisely to guarantee the future value of your pension.
In a defined contribution plan (or money purchase plan), the amount of the pension you receive is not set in advance. Instead, you and your employer contribute a set (or “defined”) amount to the plan, usually determined as a percentage of earnings. An account is set up in your name and the contributions are invested by your employer. Some plans give you a choice of how you want the contributions invested. Your pension will be based on the funds that have accumulated in your account when you retire.
You qualify by participating in your employer pension plan
Most large employers offer pension plans to their employees. Sometimes a number of employers in an industry will participate in a plan together, often in collaboration with a union. You are usually asked to join within two years of starting continuous employment. Plans can be mandatory or optional.
How much income to expect. Depends on normal retirement age.
Most pension plans specify a “normal” retirement age. This is the age when you can retire with a full pension, typically 65. Under many plans, the normal retirement age is based on your years of service with the company or a combination of your age and years of service.
You may be entitled to take early retirement up to ten years or more before normal retirement age. If so, your pension will normally be reduced because your retirement as late as the end of the year in which you turn 69, which may result in an increased pension to reflect the fact that you did not start receiving it at 65.
Defined benefit pension amount depends on your plan’s benefit formula
With a defined benefit pension plan, the benefit amount is usually calculated based on your plan’s benefit rate, your years of service and a measure of your earnings. The formula your plan uses is described in your pension plan booklet. For example, you may receive a pension of up to two percent of your earnings for each year of service. This percentage is important because it determines the amount of your pension. Under the tax rules, defined benefit plans may provide a pension benefit of up to two percent of earnings per year of service (up to a maximum amount).
There are four types of defined-benefit plan
- Career Average Pension Plans. These plans bases an employee’s pension benefits on average earnings over their careers. The employee earns “units” during each year of employment based on a fixed percentage of annual income (usually between 1 and 2%). AT retirement, the value of the pension benefit is simply the sum of these pension units times the pensionable earnings
- Final-Earnings Pension Plans. These plans bases the member’s pension benefit on the final average earnings, typically the last three of five years of service.
- Best-Earnings Plans. These plans, the pension benefits are based on an average of the best years of pensionable earnings, typically a consecutive period of three or five years.
- Flat-Benefit Pension Plans. These plans provides a specific amount of benefit for each year of pensionable service. So, the longer an employee works with a participating employer the greater is the pension payment.
Overall then, best-earnings and final-earnings plans provide better pension benefits to employers than flat-benefit or career-average plans, simply because they relate more closely to the typically higher earnings an individual can expect to earn later in their employment career.
Some pension plans are integrated with CPP or QPP
Defined benefit pensions sometimes take into account the pension you receive from CPP/QPP. If so, it’s called an “integrated” plan because the promised level of benefits is provided in combination with the CPP/QPP. If you retire early, the pension your plan provides will likely be reduced once you are 65 and are receiving CPP/QPP benefits. It’s a good idea to find out now if your pension plan is integrated and how this will affect your monthly pension income throughout your retirement.
Defined contribution pension amount depends on how much has been saved
In a defined contribution pension plan, your pension is based on the contributions and investment income that have accumulated in the plan by the time you retire. It will also depend on the type of retirement income plan you choose at that time. Under the tax rules, you and/or your employer may contribute 18 percent of your earnings (up to a maximum of $13,500 in 2001).
Not all private pensions are protected from inflation
Some plans provide full or partial indexation of benefits to inflation. Other plans provide discretionary increases from time to tome, to help keep up with inflation. Many plans do not provide indexing at all.
Pension income is taxable
Once you start receiving your pension, the income is taxable. This is because no tax was paid on the funds in the plan while you were making contributions.
What to do now
Review your company’s pension booklet
It’s a good time to read your pension booklet – it explains the terms of your employer pension plan. Find out what kind of plan you have and ask about the ages of normal and early retirement.
Review your pension statement
Take a look at your statement of benefits for your employer pension plan. Generally, if you are a member of a pension plan, you are entitled to one. This statement contains information such as your credited years or service, employee and employer contributions during the year, the pension benefit earned during the year, and your expected retirement date. Get to know your pension situation.
Planning to leave your company before you retire? What about your pension options?
You normally participate in an employer pension plan for two years before you have a right to receive benefits from it. At that time, your benefits are said to be “vested”; your contributions are locked in and can only be used to provide retirement income.
If you leave your employer before your benefits are vested, you are entitled to a refund of your contributions, plus interest.
If you leave after your pension is vested, you normally have three options:
- take a pension when you reach retirement age;
- transfer your pension funds to another pension plan if your new employer agrees; or
- transfer your pension funds to a registered retirement account. This could be a “locked-in retirement account” or a “locked-in RRSP”, depending on your original pension plan. At retirement, you will need to transfer you funds to a locked-in Registered Retirement Income Fund or a Life Income Fund, or use the funds to purchase an annuity.
Rules about vesting, locking in and withdrawing funds vary, depending on the legislation that governs your plan. Make sure that you fully understand the consequences of all decisions you make in relation to your pension savings.
Registered Retirement Savings Plans (RRSPs)
RRSPs are the most popular method of personal savings for retirement, especially if you do not participate in an employer pension plan. RRSPs are individual, personally managed savings plans. Like employer pension, savings in an RRSP receive tax assistance – contributions are tax deductible and investment income is not taxed as it is earned. The tax is paid when funds are withdrawn from these plans.
RRSP funds may be invested in a range of financial products and investment vehicles, including savings accounts, Canada Savings Bonds, term deposits, guaranteed investment certificates, and mutual funds. You can set up an RRSP through most financial institutions – banks, credit unions, trust companies, mutual fund companies, insurance companies, and investment dealers or brokerage firms. You may set up a regular RRSP or a self-directed one. A self-directed RRSP may hold a wider range of investment vehicles (such as individual stocks) and allows you to directly manage your investments. Check with your RRSP issuer and CCRA to find out what investments may be held in your RRSP. Detailed information about RRSP you will find in section RRSP
Group Registered Retirement Savings Plans (Group RRSPs)
Some employers offer a group RRSP. It’s similar to an individual RRSP except that your employer deducts the contribution from your pay cheque and deposits it into an RRSP for you.
Deferred Profit-Sharing Plans (DPSP)
A deferred profit-sharing plan is set up by an employer for employees. The employer makes contributions based on the company’s profits up to a specified maximum. Like employer pension plans and RRSPs, savings in a DPSP are tax-assisted. The contributions and investment income remain tax-sheltered until amounts are paid out of the plan. When you retire, you may receive a lump-sum payment, transfer the funds to an RRSP or Registered Retirement Income Fund, or use them to purchase an annuity.
* This section was written by Serguei Totrov using the CFP course 203, Financial Planning for Retirement (The Canadian Association of Insurance and Financial Advisors).