Everything You Need To Know About A Defined Contribution Pension Plan

A pension is a regular payment to a person that is intended to allow them to subsist without working. This usually takes the form of a retirement pension, though it can also describe disability pension/benefits. In Canada, every member of the working population over 18 years old has to contribute to the Canada Pension Plan (CPP). With an increasing cost of living, longer life expectancies, and increased expectations for the standard of living during retirement, however, many individuals opt to contribute to additional pension plans (see ‘Types of Pensions’). Most employers now offer some form of pension or retirement savings plans for their staff.

One of the two main types of optional pension plans available is the defined contribution plan. This type of plan, also known as a money purchase pension plan, means an individual contributes a specified amount of money on a regular (usually monthly) basis. Despite this being a scheme you join as part of your employment; each individual will actually have their own investment account in their name. Contributions to these plans are not taxed; however, the benefits are upon receipt. In a defined contribution plan, employers may also contribute to the employees investment account (often matching the employees contribution up to a defined amount), which is most often invested, for example in the stock market, by an employer arranged board of trustees, though some plans allow individuals to make their own investment decisions, choosing from a number of investment plans available. Since the amount received by an individual is essentially the account balance they have upon retirement, there is no reduction for early retirement, other than the fact that less money will likely have been accrued at this time. When an individual retires, all the contributions they have made plus the interest they have earnt through investment of those contributions, is used to provide a pension. This means the amount received each month during retirement is non-defined until retirement.

The amount each individual will receive is therefore directly linked to the amount they contribute throughout their working life, along with the success of the investments made with those contributions. There are government limits on how much can be contributed to the defined contribution plan. These limits change annually (usually increase in line with inflation) and in 2006 were approximately $44,000 in the United States, which includes employer and employee contributions. The employee-only limit in 2006 was $15,000.

Although the balance of an individuals account must be used to provide an income stream during their retirement, pension legislation does allow for some variation in the way this money is managed upon retirement. There are three main forms for the defined contribution plan:

-Life Annuity
-Registered Retirement Income Fund
-Variable Benefit.

Life Annuity

The most common form of the defined contribution plan is the life annuity, which means that upon retirement an individuals combined contributions along with the profit they have made through investment, are paid to a life insurance company that then guarantees they will pay the individual a fixed (defined) amount of money on a regular basis for the rest of their lifetime i.e. you purchase an annuity. Annuity rates (i.e., long-term interest rates) when an individual purchases their pension (at retirement) will be a factor in the amount received.

Registered Retirement Income Fund & Variable Benefit

One of the alternatives to the life annuity is the Registered Retirement Income Fund (RRIF) which allows an individual to actively manage their own account balance upon retirement (rather than leaving all decisions to a life insurance company), allowing them to set the level of income they would like to receive, as well as continue to use the money to take advantage of investment opportunities, and provide flexibility for tax purposes. Another alternative to the life annuity is a Variable Benefit plan, which is similar to the RRIF. The administrator of an individual’s pension plan should be able to describe whether this is an option and what the benefits would be.

In the majority of cases, an individual will sign a form on commencemnt of employment allowing their employer to automatically deduct these contributions from their salary, and will receive pension plan documents that informs them of their account balance at set periods of time.

Disadvantages

The individual is relying on investment decisions to result in monetary gain, rather than loss (which is a possibility). This is a risk that is not present with a defined benefit plan, where the employer is the one taking the investment risk. This means an individual cannot predict the benefits they will receive with absolute certainty.

If an annuity is not purchased, an individual runs the risk that they will outlive their retirement funding.

Advantages

Although the individual is bearing the investment risk, the up side of this is that they also receive any investment benefits, which could well exceed the benefits they would have received making the same contributions under a defined benefit plan.
Most defined contribution plans, where an individual has chosen to manage the fund themselves (the RRIF or Variable Benefit option), include some tax benefits as long as the indivdual commits to not withdraw any funds before they are a certain age (typically 59.5 years old in the U.S.).

Defined contribution pension plans are typically considered more prtable than defined benefit plans due to the less arduous administration involved and the greater ease with which the value of the individuals contributions can be assessed (essentially the balance of their invetsment account).

Defined contribution plans are now the most common type of pension plan in the private sector in many countries. Defined contribution plans in the United States include Individual Retirement Accounts (IRAs) and 401(k) plans, where an individual is reponsible for making at least some of the investment decisions involved. The other major type of private pension plan is the defined benefit plan. Some employers also offer a combination of the defined benefit and defined contribution plan, known as hybrid or combination plans, which have become increasingly popular.