Under a Defined Contribution Pension Plan, the contributions of plan members and plan sponsors are invested towards the funding of a retirement income. The maximum combined contribution is the lesser of 18% of earned income to the maximum contribution limit. Typically, the contribution going into the plan is known, while the final benefit is not known. The employer’s contributions are a tax deductible expense and are not a taxable benefit to the plan member.
The amount of gross retirement income which a plan member will receive is based on:
- Future salary or wage levels and the resulting contributions made
- Investment selection
- Investment return
- Annuity and/or interest rates at the time the plan member retires
Employer contributions are credited to the account of the employee, but are kept separate from employee contributions for investment purposes. The employer’s contributions generally “vest” with the employee after a period of time (two years in many provinces). In other words, after a certain period of time, the employee obtains the right to the employer’s contribution. Employers can allow employees to make the investment decisions for the employer contributions, or the decision may be left to the employer. Employees usually make the investment decisions for their own contributions. The investment options available to the employee are generally determined by the employer.
There is a considerable choice of investment options. These typically include:
- Guaranteed investment funds
- Canadian bond funds
- Canadian balanced funds
- Canadian equity funds
- International and/or global equity funds
- Segregated funds
At retirement, the plan member has the option of purchasing a Life Annuity, a Life Income Fund (LIF), or a Locked-In Retirement Income Fund (LRIF). The life annuity can be purchased with a guarantee period (e.g. payments for the life of the plan member with payments guaranteed for a minimum of 15 years) or on a joint and last survivor basis which provides benefits for both the life of the plan member and his or her spouse. In the later case, the payments can be set to continue at the same level after the plan member’s death or they can be reduced after the death. If a joint and last survivor option is not chosen, both the plan member and spouse must sign a “Spouse’s Waiver of Rights Under a Pension Plan” form.
A LIF is very similar to a RRIF (Registered Retirement Income Fund). A LIF has some advantages over a life annuity. In particular, it allows for more flexible payment schedules and control over investment choices. A LIF must be converted to a life annuity by age 80.
An LRIF is similar to a LIF but has greater flexibility in withdrawing funds as it is subject to a different maximum payout formula. With an LRIF, there is no mandatory conversion to a life annuity.
Advantages of a Defined Contribution Pension Plan:
- Employee contributions by payroll deduction
- Easy to understand and communicate
- Employees can participate in investment decisions
- Actuarial calculations of funding not required
- Few problems with pensions surplus or over funding
- Contributions are tax deductible to the employer
- Contributions are not taxable to the plan member
- Employer costs are easier to predict (as compared to a Defined Benefit Pension Plan)
Disadvantages of a Defined Contribution Pension Plan:
- Benefit is not guaranteed
- Investment time is a crucial factor in determining benefit for older employees
- Benefit of older employees may be lower than under a Defined Benefit Pension Plan