Pension Plans: What is the difference between DCPP and DBPP?
Most Canadian employers offer one of two types of pension plans: defined contribution, or defined benefits. However, there are other decisions you need to consider when choosing your pension plan. Understanding the different kinds of pension plans and the decisions you’ll need to make will greatly help with your retirement planning.
Defined Contribution Pension Plan (DCPP)
The first type of pension plan is referred to as a defined contribution pension plan, or a DCPP. If you have a goal of retiring with a fixed monthly income in mind, this plan may not be for you. The income you’ll receive at retirement is not predetermined based on your salary at your workplace, but will be based on the assets in your individual retirement plan when you retire.
In a DCPP, your company will make a contribution based on a formula, which may or may not require you to match the contributions. What this usually means is that you’d contribute (on average) 3 – 5% of your salary, which would then be matched by your employer. This retirement plan is popular because it offers choice and flexibility. Under a DCPP, you can determine your own investments, which means you can create a portfolio suited to your timeframe and tolerance for risk. Remember that your contributions to your DCPP are tax deductible, so don’t forget to include them on your annual income taxes.
It’s also useful to check how much your employer is willing to match into your plan. Most employers will provide a limit – for example, they’d match 50% of your annual contributions up until $4,000. If you’re only contributing $1,000 annually to the plan, then you’re missing out on a potential $1,500 of annual additional free money to be added to your pension plan.
Defined Benefit Pension Plan (DBPP)
A defined-benefit pension plan, or DBPP, is vastly different from the DCPP. Defined benefit plans promise to provide you with a guaranteed income at retirement, which is predetermined based on your years of service and earnings. For these plans, your company manages the assets, so you have no active involvement in managing your retirement portfolio. These plans are common in Canada with government jobs, hospitals, and teachers.
DBPPs vary greatly between employers. You should read your pension statement to determine how much you should expect at different retirement ages. Beyond providing a predetermined monthly retirement income, DBPPs include a penalty for early retirement. While the retirement age is usually 65, many plans will let you retire as early as 55 – but for a price. That price can be as much as 6% of your monthly income for each year that you begin your pension early.
Other aspects to consider when choosing your pension plan include single vs. joint pensions, guarantees, and coordinating or integrating your plan.
Single vs. Joint Pension Plans
Canadian pension legislation stipulates that your spouse has rights to your pension. Because of this, most pension options default to a joint pension with a survivorship. Survivorship means that if you die before your spouse, your spouse will continue to receive a percentage of your pension, usually 100%, 75%, or 50%, depending on your plan. Joint pension with survivor rights will pay a lower monthly income than single life options, although some pensions will allow the spouse to waive their rights to the pension to pursue a single life option.
If your spouse is reliant on your income, choosing a joint pension will allow you to continue to provide for them after your death. If you and your spouse are roughly within the same income range with equally good pensions, however, a joint pension may not be required. Additionally, if you are in poor health, then pursuing a joint pension that will be paid out to your spouse after your death will be beneficial.
Another decision you will have to make with your pension is your guarantee period. A guarantee period ensures that the pension is paid out for a certain number of years. For example, if you have a 10 year guarantee, then that implies that even if you were to die tomorrow, your pension would be paid out to your beneficiary or spouse for the full ten years.
Guarantee options are best decided by life expectancy. If you are in poor health, then it is ideal to choose the longest guarantee possible, as it’ll ensure that you’re providing for your loved ones for the longest period of time. If you expect to live a long life, then a guarantee may not be necessary.
Coordination or Integration on Pension Plan Decisions
Depending on which pension plan you fall under, you may be able to coordinate your pension with the Canada Pension Plan (CPP) and Old Age Security (OAS). What this means is that if you wanted to retire prior to age 65, you would receive a higher pension until you turned 65, at which time your monthly pension payment would decrease. The drop in pension would be offset by the new income from CPP and OAS provided at 65. However, you should remember that the calculation is theoretical – your pension plan won’t be in conversation with CPP or OAS to determine the exact amount for which you would be eligible.
Choosing your pension options at retirement is a serious decision. Once you’ve decided on your options, you cannot reverse them. While this is a good start to your decision-making process, always talk to a financial professional to get the best pension for your needs.
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If anything on this blog interests you further, please do not hesitate to reach out to me via email at [email protected] I’d love to talk about my financial services and advice in Vancouver, British Columbia’s lower mainland, and Canada in general.
- Brad Blair, CFP, CIM, FCSI, CHS.