what is a pension

What Is a Pension? all you need to know

In this post, I’ll explain what a pension is, how it works, its benefits, and the different plans that are available.

What is a Pension?

A pension is a payment plan for income when you are retired. It is made from an investment fund that either the individual and or the employer contribute to during their working career

Not all employers offer pension plans. But for those that do the two main types of pension plans are ‘defined benefit pension plans’ and ‘defined contribution pension plans’. Which I’ll explain in detail in this post

How does a Pension work?

A pension is basically a guarantee from your employer to pay you a certain amount of monthly income when you retire for the rest of your life.

It’s hard to save enough money on your own for retirement. But this type of employer benefit can help you meet your retirement goals

So how does it work basically?

Based on the number of years that you worked there, your age, salary, and other factors your employer is determining what benefit you’re going to get.

Let me give you an example:

Let’s say I make $50,000 a year from my job and I’m getting ready to retire. I’ve been there for a long time. My employer based on their pension agreement has said we’re going to pay you a pension when you retire.

We’re going to pay you $20,000 a year for the rest of your life.

So certainly it’s not what I was making but it’s a big component of my retirement income. When compared with my own savings and maybe some money from Social Security. That can help me live at the standard of living I’m used to in retirement

Now there are a lot of decisions to make with a pension

First, you have to decide when you are going to start collecting it. Sometimes there’s a ranger of Ages where you’re eligible to collect a pension. What if you collect it early? That’s good because you’re getting the money sooner but you’re usually getting a smaller benefit amount.

Second, what type of pension option you want to choose?

If I’m getting $20,000 a year on a pension for the rest of my life what happens if I pass away 2 weeks after I retire? Is all of that money wasted? Can any of that money go to my wife, my children, or other beneficiaries?

So sometimes there are a variety of pension options that you can choose from.

Third, what kind of pension plan is offered to you and which one you choose? (I’ll go into details just keep reading)

The benefits

There are several benefits to contributing to your Company’s pension plan:

First, if your company offers matching contribution by putting in an amount equal to what you can or a percentage of what you contribute, you’re essentially getting free money you would otherwise not receive

Second, your contributions are tax-deductible. Meaning you pay less income tax now and the funds remain exempt from tax until they are withdrawn.

Third, a company pension plan is a great way to supplement other forms of retirement savings and individual savings plans.

Understanding what your Company pension plan offers can help you determine how to make the most of all your retirement savings options.

A defined benefit pension

A defined benefit pension plan is a retirement Savings Plan offered through your employer.

In retirement, you have a defined amount that you will receive each and every year. This amount is often linked to inflation. As items become more expensive each year your pension income goes up by the rate of inflation.

The benefits

Another benefit of this type of pension plan is that it provides you income for as long as you live. If you live to age 150 you still receive the same amount of money.

Survivor benefits are also often available. If you pass away your surviving spouse will continue to receive a portion of the pension. Many plans have the Survivor pension set at 60 or 66%.

While others will allow you to choose the amount of survivor benefit you want. If you choose 100% Survivor option the ongoing pension you receive will be slightly lower but your Survivor won’t see a drop in their income when you pass away.

How is this benefit calculated?

This is different for each plan. But it’s a calculation based on the number of years of service within the plan and your employment income. The employment income used is often an average of your final five years of income or your highest-earning 5 years.

You may or may not contribute to the plan yourself but your employer certainly does. An actuary uses a bunch of estimates and assumptions to calculate how much you and your employer need to save each year in order to provide that benefit.

This is typically less than you would have to save yourself for the same amount of pension income. Because it pulls the risks across many retirees with different ages who will pass away at different times.

Ultimately your employer takes on all the risks. If there isn’t enough money in the pension plan to provide the benefit that has been promised to you your employer will have to make up the difference.

These plans also allow for early retirement if you meet certain thresholds, called the 85 factor.

If your years of service, in other words the number of years you’ve been enrolled in the pension plan, and your current age add up to 85 you can retire early with an unreduced pension.

For example:

Let’s say that you’re 55 years old. You started working and paying into the pension plan when you were 25.

So you have 30 years of service. Adding your age 55 and your years of service 30 would result in a total of 85. This means that you’d be able to retire at age 55 with an unreduced pension.

If you don’t meet this 85 Factor and want to retire at age 55 still you can but you won’t get the full pension promised to you.

The downsides

So you get a guaranteed amount of money for retirement for the rest of your life. You don’t have to take on any investment risks and often your monthly pension increases with inflation. It continues to provide your spouse with income even after you die.

So what’s the catch?

With anything there are trade-offs. One major drawback is that you don’t have control over your money. Although, some view this as a good thing, they’re professionals looking after your money.

Secondly, if you don’t live a long life your heirs may not get as much in your state as they would have if you had your savings outside of the pension plan.

Finally, if your employer goes bankrupt the benefit you receive could be significantly lower than what was promised.

Usually, the benefits outweigh the risks when it comes to Define Benefits Pensions. Unfortunately, these plans are declining as employers no longer want to take on the risk and expense.

A Defined Contribution Pension Plan

A defined contribution pension plan is aptly named since the employer benefits portion of this plan is related to the contributions. Each year the employer will contribute a specific dollar amount to the plan.

This is usually stated as a percentage of your salary. The employer contribution is often contingent on you making a contribution to the plan yourself but doesn’t have to be.

How does it work?

For example, your employer may match contributions up to 4% of your salary. If you contribute 3% your employer will contribute 3%. But if you contribute 5% your employer will only give you 4%.

This is often referred to as “free money”. For those who would already be saving for their future, their employer is topping that up for them.

SunLifeFinancial estimates that Canadians are leaving over three billion dollars on the table from not contributing to these matching programs.

Of course, there are many reasons why Canadians are using their money for other things aside from matching. But if it’s a result of lack of knowledge that’s something that needs to be addressed.

Unfortunately, with this type of plan, the employer is only responsible for providing a contribution to the plan. Once they’ve made that contribution the rest is up to you.

You’re given a list of options to invest in based on what the pension plan provider like SunLifeFinancial, Manulife, or Great-West Life is offering. It’s your responsibility to select the investment option that you’re comfortable with from a risk perspective.

The amount of money you receive at retirement will depend on how much you contributed to the plan and how well your investments have done.

These plans should really be called savings plans rather than pension plans.

A defined contribution plan is similar to an RRSP with employer contributions. However, your investment options are limited and there are additional government restrictions around withdrawing your money.

Now, you might be thinking this plan isn’t nearly as good as a defined benefit plan. All the risk is on you and in general, you’re right.

A defined contribution plan May provide some advantages over a defined benefit plan though.

First, the money saved in your plan won’t change aside from savings withdrawals and your investment returns if your employer goes bankrupt.

Second, you should have greater flexibility around withdrawing your income in retirement.

Third, you can receive a higher retirement income if you invest in a riskier manner and it works out for you. However, the opposite could be true If you outlive what your assets can provide, due to a long life or your Investments fall at the wrong time.

Forth, a lump sum is available to your heirs if you and your spouse pass away before spending the income.

Conclusion

Most individuals don’t have a choice whether they have a defined contribution or a defined benefit plan. Although it’s important to know which plan you have so that you can plan for your retirement accordingly.

In addition, depending on the plan you currently have and the plan at a potential employer this may be a consideration if you’re looking to switch jobs.

Thanks for your time

This was my approach to pensions. I hope you liked it and if you did then I recommend you to join my newsletter I post about money management and how to make money online.

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