Defined benefit and defined contribution pensions are not the same promise

Two neighbours can both say they have a workplace pension and mean entirely different things. One has been promised an income for life, calculated from salary and years of work. The other has an account that the employer and employee paid into, and whatever it holds at retirement is what there is. Both are registered pension plans. They are not the same promise.

The difference decides who carries the investment risk, what the annual statement shows, what can happen when someone leaves the employer, and how the money becomes income. This file sets the two side by side and points to the files that follow each path further.

Two plans with the same name

OSFI, which supervises federally regulated pension plans, defines them by what they fix. A defined benefit plan defines the pension benefit to be provided, based on factors such as years of plan membership and earnings. A defined contribution plan defines the amount of employer and employee contributions to the pension fund. One fixes the output; the other fixes the input.

Some plans combine both, and some newer designs share risk between members and employers in other ways. But most Canadians with a workplace pension are in one of these two broad types, and the plan booklet says which.

A defined benefit plan promises an income

In a defined benefit plan the pension is set by a formula, commonly a percentage of earnings multiplied by years of service. The Financial Consumer Agency of Canada describes the result as a set amount that does not depend on how well the investments perform.

The employer’s contribution is what moves. OSFI explains that in a defined benefit plan the employer’s contribution is usually not fixed by the plan text; it is based on how much the promised benefits are predicted to cost, estimated by an actuary using assumptions about salaries, investment returns, retirement ages and life expectancy. If returns disappoint, the cost of keeping the promise rises.

Defined benefit plans often come with features that shape the monthly amount: a bridge benefit that ends at 65, a joint and survivor pension for couples, and sometimes indexation.

A defined contribution plan promises contributions

In a defined contribution plan, the employer and usually the employee pay a set amount, often a percentage of salary, into an account in the member’s name. The member typically chooses among the investment options the plan offers. The Financial Consumer Agency of Canada puts the consequence simply: the amount you get when you retire depends on how your plan is managed and how the investments perform.

There is no promised income at the end. There is an account balance, and the member decides, within the plan’s and the law’s rules, how to turn it into income.

Who carries the risk

The plainest way to see the difference is to ask who absorbs a bad decade in the markets, or a retiree who lives to 100.

An illustrative comparison

Take two members with the same hypothetical career: $60,000 a year for 25 years. One is in a defined benefit plan that pays 1.5% of salary per year of service. The other is in a defined contribution plan where combined contributions are 10% of salary.

The defined benefit member knows the income. The defined contribution member knows only that the balance depends on returns, and still has to decide how to turn it into income, for example by keeping it invested and drawing from it, or by buying an annuity; that choice is set out in how an annuity compares with keeping savings in a RRIF.

What each statement tells you

A defined benefit statement usually shows credited service, the earnings used in the formula and the annual pension earned to date, payable from the plan’s normal retirement age. It may show a second figure for the pension after a bridge ends. A defined contribution statement shows contributions made, investment returns and the current balance, along with the funds chosen.

Both types report a pension adjustment on the T4 slip each year. The Canada Revenue Agency explains that it is the assumed value of the benefits earned that year, and that it reduces the next year’s RRSP contribution room. For a defined contribution plan it is the total contributions; for a defined benefit plan it comes from a formula of nine times the benefit earned, less $600. In the example above, the defined benefit member’s pension adjustment would be $7,500 a year, and the defined contribution member’s $6,000.

What happens at retirement, or on leaving

A defined benefit member who leaves before retirement usually chooses between a deferred pension and a lump sum; see commuted value or monthly pension when you leave an employer. A defined contribution member’s account generally moves to a locked-in account, then to a life income fund or an annuity; see what a locked-in account turns into at retirement.

For tax purposes, life annuity payments from a pension plan qualify for pension splitting at any age, while income from a life income fund qualifies from 65. That difference is explained in why some retirees open a RRIF before they have to. And whichever plan someone has, CPP sits alongside it; the CPP increase that changed payments in January applies to CPP only, not to workplace pensions, which follow their own indexing rules, if any.

How to tell which one you have

The short version

A defined benefit plan promises an income and leaves the investment risk mainly with the employer. A defined contribution plan promises contributions and leaves the risk, and the choices, with the member. Knowing which one you have is the first step to reading the statement correctly and to knowing which decisions are still yours to make.

SOURCES ON FILE

1. OSFI — Glossary of pension plan terms — definitions of defined benefit and defined contribution plans.
2. Financial Consumer Agency of Canada — Employer pension plans — how each plan type pays out.
3. OSFI — Pension members’ guide — how employer contributions to defined benefit plans are set.
4. Canada Revenue Agency — Pension Adjustment Guide (T4084) — how the pension adjustment is calculated.

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