Defined benefit pension plans can be an important part of retirement planning for many Canadians. As an aspiring or currently working financial advisor, you will meet people who belong to these plans. You might also encounter clients who are thinking about joining one or those who have left their employers and feel unsure about their options.
In this article, Wealth Professional Canada will discuss what a defined benefit pension plan is, how contributions and benefits work, and more. We’ve also included the latest defined benefit pension plan news at the bottom of this article. Feel free to check them out or share with your clients!
A defined benefit pension plan is an employer-sponsored pension that promises a set retirement income, usually for life. Instead of asking your clients to choose and manage investments inside the plan, the employer or pension administrator invests a pooled fund on behalf of all members.
The defining feature is the formula. The plan sets out how to calculate the pension, most often using:
The result is a promised pension amount, usually paid monthly once your client retires. Unlike a savings account that depends directly on investment returns, this pension is based on the formula.
Investment performance still matters behind the scenes for the health of the plan. However, your client’s benefit is not simply the market value of their own contributions.
Watch this video to learn more about defined benefit pension plans:
When discussing defined benefit pension plans with clients, it helps to connect it with why more Canadians are delaying retirement. Talking about how pension access shapes their sense of security might also help.
With most defined benefit pension plans, both your clients and their employer contribute. These contributions are held in trust for plan members. The employer is responsible for funding at least half of the pension benefits your clients earn and for addressing any funding shortfalls over time.
Some defined benefit pension plans also include inflation protection. In these plans, pension income for retirees can increase each year to match all or part of increases in the cost of living.
This indexing helps the pension keep its spending power as prices rise. Not every plan offers this, so your clients need to confirm details with a human resources contact or plan administrator.
It can also help to contrast defined benefit plans with defined contribution plans. In a defined contribution plan, contribution amounts are set, but the final retirement income depends on investment returns.
In a defined benefit pension plan, the benefit formula is set, and the employer carries much of the investment and funding risk.
Not all defined benefit pension plans are linked to a single employer. Some are sponsored by many employers within the same field. These are known as multi-employer pension plans and are common in industries where workers often move from project to project and employer to employer.
Take construction as an example. A worker might move from one contractor to another as projects start and ends. Instead of starting a new pension at each employer, that worker might belong to one multi-employer defined benefit pension plan that covers many employers in that sector.
A portion of their hourly wage goes into the plan while they work for participating employers. Service builds continuously, even though the employer changes.
Multi-employer plans can be structured in different ways. Some have straightforward formulas. They operate in much the same way as a single-employer defined benefit pension plan, with a known benefit formula and traditional funding responsibilities.
Others blend elements of defined benefit and defined contribution plans. These blended plans are often referred to as target benefit plans. In a target benefit plan, the plan sets out a target pension amount for members.
However, the pension that members receive can end up higher or lower than that target. The outcome depends on the investment performance of the pension fund and overall funding conditions.
Short answer: yes. From the point of view of a financial advisor, a defined benefit pension plan can be a good foundation for your clients’ retirement income. A reliable stream of income for life can reduce the pressure on personal savings and make retirement planning more straightforward.
Because the pension is based on a formula using salary and years of service, your clients can build estimates of their future income as they move through their career.
A final average or career average formula gives them a way to see how extra years of work add to their expected pension. This can support their decisions about when to retire and how much to save in other accounts.
Let’s look at three main benefits of these pension plans:
Here’s a more detailed discussion for each benefit:
Inflation protection, where available, is especially valuable. A pension that rises along with increases in the cost of living helps your clients maintain a stable standard of living across a long retirement.
Otherwise, they would be stuck watching flat payments buy less each year.
Employer contributions are another upside to these pension plans. As mentioned earlier, the employer must fund at least half of the pension benefits and address funding gaps over time.
As such, your clients receive support that they would find difficult to match through personal savings alone. They also benefit from the scale of a large, pooled fund and from professional investment management.
Multi-employer defined benefit pension plans provide further benefits for workers in sectors with frequent job changes. Your clients can move between employers and still build one continuous pension record in a single plan.
This is more rewarding than juggling several small pensions or losing ground every time they change jobs. To better understand the benefits offered by defined benefit pension plans, watch this:
Aspiring top Canadian financial advisors need to show clients how defined benefit pension plans can underpin long-term retirement income.
Despite their strengths, defined benefit pension plans also carry some disadvantages that you and your clients must know. Here are three of them:
Let’s further discuss each disadvantage below:
Pension assets are invested in markets, so they can fall during periods of weak returns or economic stress. A plan that was fully funded at one point can become underfunded if investments decline sharply.
Employers are allowed several years to restore full funding. If an employer goes bankrupt before this process is complete, the plan might remain underfunded. Members and retirees might also receive less than the full pension they were promised.
Your clients do not choose how assets in the pension fund are invested. For many people, this is a relief. However, for those who prefer to set their own asset allocation or who have strong views about investment style, it can feel limiting.
They must accept the investment strategy chosen by the plan administrator and governing body.
When your clients leave a defined benefit pension plan, their choices can be hard to compare. Each of these decisions involves trade-offs in terms of investment risk, income stability, fees, and flexibility:
Transferring the cash value out removes the pension guarantee and places the burden of investment and withdrawal decisions on your clients.
Defined benefit pension plans offer your clients a promised stream of retirement income tied to their earnings and years of service. Plus, they’re often backed by employer funding and, in some cases, inflation protection.
As a financial advisor, you can bring structure and confidence to your clients’ decisions around these plans. This includes explaining how the benefit formula works and how contributions from both your clients and employers build toward a future pension.
Now that you’ve learned how defined benefit pension plans work, you’ll understand how they interact with savings in other accounts. With this knowledge, you can support your clients when they face job changes, disability, or questions about benefits for their spouse or beneficiary. Finally, you can help them see how this kind of pension fits into their overall plan for their retirement income.
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