Defined Benefit Pension Plans
Let’s talk about DBPP’s.
The first thing anyone is going to ask and the most important question you will have when you work for an employer who has a DBPP is, what are you going to be paid in retirement?
That answer depends on a lot of things actually and it’s impossible to know unless we look at a specific individual and a specific pension plan, but there are basically three different ways this can be calculated:
1. Final Average Earnings
This is probably the best one as it will take the highest average of your last 5-years of employment (usually 5 years) where you are likely making the most money, so let’s look at an example calculation.
2% (this is the highest percentage, some are lower) * Average salary (last 5 years) * years of employment
So, let’s look at someone who made $100,000 in their last 5 years and worked for 30 years.
2% * $100,000 * 30 = $60,000/year
2. Career Average Earnings
Same thing as the Final Average, but uses your career average earnings to make the calculation, which will likely be lower.
3. Flat Rate
I see this a lot with unions, and it’s a very simple calculation. It just says that your pension will go up by “x” dollars per month for every year that you work.
So it might say, your pension goes up by $50/month for every year you work. So, if you worked for 30 years, your pension would be:
$50 * 30 = $1,500/month
When are you eligible for your full pension?
That’s the calculations that they can use to figure out how much your maximum pension will be, but then you need to know how to be eligible to collect your full pension for life and that can be decided in a couple of different ways.
Some employers might say that if you reach age “x” you are entitled to your full pension, or they could have a qualification factor, which is often 85.
That means that you need to reach the number of 85 by adding up your age and your years worked.
So, if you are 60 and have worked for 25 years
60 + 25 = 85, (therefore you are entitled to an unreduced pension).
But, if you are 60 and have worked for 19 years
60 + 19 = 79
That means you need to work for 3 more years to get your full pension.
63 + 22 = 85
You could retire early if you want, but you won’t be entitled to your full pension.
Now, there are great things about DBPPs and there are some things that aren’t so perfect.
One important thing to know, is whether or not your pension is indexed to inflation. This means, does it increase as you age? If it doesn’t, that means you won’t be able to buy as much with each dollar as you age.
If it is a flat benefit that pays $2,000/month at the age of 60, well $2,000/month won’t be able to buy a hell of a lot when you’re 90.
There is also a good thing and a bad thing about the investments in the plan. As far as you’re concerned as an individual, it doesn’t matter what happens in the stock market or how the investments within the pension plan are performing, because if they perform poorly, it is up to your employer to fund the shortfall.
The pension plan is managed by a professional manager who can buy tons of cool stuff, because pension plans have a crazy amount of money, like the example of when the Ontario Teachers owned The Maple Leafs and Raptors. Or think about the movie, “The Other Guys,” when the guy was going to invest in that shady hedge fund. Some pensions do really well, while others don’t, but it doesn’t really matter to you as long as you work for a stable employer.
And then there is a super weird mathematician called an Actuary who calculates whether or not the plan is in good order. This guy also calculates the cash value your pension is worth, so you might get a statement that shows how much cash you would get if you quit today. This isn’t based on what you’ve put in, but on what the Actuary calculates.
On a side note. If you love math. Hate talking to people. And think the idea of sitting in a room by yourself and looking at numbers is a good idea, you should look into becoming an actuary. It’s a great job, but you’ll never meet an actuary, because they don’t know how to speak to people.
Why this can be risky for you
So, it’s kind of good that you don’t have control and that it appears that your employer is taking all of this risk on your behalf, but that is also what can become the biggest risk. Most employers don’t offer DBPPs, because they are super expensive and risky for them and become a huge liability on the books. So, if they no longer become profitable, your pension is now in jeopardy, because if they can’t pull it together, they could go bankrupt and now that guaranteed pension you thought you had, will never be paid out to you, because you are basically the last creditor who is going to be paid in a long list of debts.
This is also a reason why a lot of employers might be asking their employees to switch to a Defined Contribution Pension Plan. If they ask that, I might take the offer even if it doesn’t look as good, because at least that money will be yours and I assume they might not be in as good of financial shape as you might think.
Pension Income is Fully-Taxable
All pensionable income will be fully taxable in retirement.
Decisions You Need to Make
Now, there really isn’t much to think about with regard to your pension plan, except when you either switch jobs, get laid-off, or retire.
This is the moment when you are going to really want to talk to a CFP about your options as they might seem simple, but they definitely aren’t.
Quit or get Laid-Off
If this happens, you have to make a choice as to whether or not you want to move this money into a LIRA, maybe some into your RRSP and maybe take a taxable portion as cash, or just keep it in the plan.
There are so many factors to consider when doing this calculation, that you’re just going to want to talk to someone who gives you and actual comparison of your options and the pros and cons of each option. Otherwise, you’re probably just meeting with someone who says they are obviously happy to manage your huge lump-sum of cash without knowing which option is actually best for you. It’s in your best interest that you move it to accounts with us, but that doesn’t mean it’s the right decision for you.
This is also a huge decision based on your personal situation as there will be a number of options available to you and a lot of them depend on whether or not you are single. These can include:
Joint equal pension: If you die, your partner gets the full amount for life
Joint reducible: If you die, your spouse gets a reduced amount for life
Full Single Pension with Guarantees: This will pay you for life regardless, but let’s say for example you had a child and chose the single-life with no guarantee and your sister, who also had a child chose the single-life with a 10-year guarantee
She would make less than you per month, but if you both passed away on the first anniversary of your pension, your payments would stop, but her beneficiaries would now be paid that amount for the next 9-years.
In the end, the choices you have to make are very dependant on what your exact situation looks like and it’s not a one-size fits all solution.
Another thing that people with DBPPs need to understand is that although you are in a really good position, that doesn’t mean that you shouldn’t work with a financial planner to ensure you’re set up the way you want to be. It’s usually pretty simple planning and you don’t often have to save much, or anything, but to just assume everything is fine can be a mistake.
If you have any specific questions, feel free to email me at email@example.com