Defined benefit vs defined contribution: two kinds of workplace pension

How a defined benefit plan works

A DB plan uses a formula to set your pension. A common structure multiplies a percentage by your years of service and by your average earnings over a set period, though formulas vary widely from plan to plan. The result is a lifetime monthly pension, often with options for a survivor benefit.

The employer — and sometimes members — contribute to a pooled fund, and the plan's sponsor is responsible for making sure the fund can pay the promised benefits. Some plans add cost-of-living increases (indexing), fully, partially or only when funding allows. Your plan booklet and annual statement explain your own formula and any indexing.

Some DB plans also pay a bridge benefit — a temporary extra amount until 65, meant to fill the gap before CPP and OAS — while others reduce the pension for early retirement. Both features can change the picture considerably in your early 60s.

How a defined contribution plan works

A DC plan works more like a group RRSP with an employer's name on it. You and your employer contribute a set amount or percentage of pay, the money is invested (often in options you choose), and the balance at retirement depends on contributions and returns.

At retirement, DC money is typically moved to a locked-in account, such as a life income fund, or used to buy an annuity. Locked-in accounts usually have both minimum and maximum yearly withdrawals, and the rules depend on the pension legislation that applies to your plan — federal or provincial. Confirm those rules with your plan administrator.

Hybrid designs exist too. Some plans combine a DB formula for part of your service with a DC account for the rest, and some target-benefit plans aim for a set pension but can adjust payments if funding falls short. If your plan is a hybrid, the booklet explains which parts work which way.

Farah and Kevin: a side-by-side example

Suppose Farah and Kevin both retire at 65 in Fredericton, both have a CPP estimate of $950 a month at 65, both receive the full OAS, and both have $50,000 in a TFSA. The planner uses an illustrative 4.5% return, 2% inflation and today's dollars.

Farah has a DB pension of $26,000 a year that isn't indexed, plus $80,000 in an RRSP. Kevin has a DC plan worth $450,000, which the planner treats like an RRSP for simplicity. With those inputs, the highest steady after-tax spending each plan supports to 95 is about $40,600 a year for Farah and about $38,000 for Kevin.

The table follows Farah at $40,000 a year of spending. Her pension's buying power falls each year — to about $23,549 in today's dollars at 70, $19,318 at 80 and $15,847 at 90 — so she draws more from her RRSP over time. Her RRSP is used up before 90, and her TFSA then covers the gap, with about $56,746 remaining at 90.

Kevin's DC drawdown

Kevin, spending $38,000 a year, draws about $24,374 a year from his DC savings in his late 60s. His balance falls to about $277,320 by 75 and about $84,634 by 85, and he leans on his TFSA from his late 80s. In this illustration he reaches 95 with very little left — about $1,097 after tax.

That's the nature of a DC plan: the balance has to last as long as Kevin does, and returns can be better or worse than the single rate used here. Our guide to sequence of returns risk explains why the order of good and bad years matters for someone drawing down a balance, and the Monte Carlo guide shows how a range of outcomes is tested.

Some DC members use part of their balance to buy an annuity, which moves some longevity and investment risk to an insurer — closer to how Farah's pension works. Our annuities guide explains the trade-offs.

Why indexing makes such a difference

Farah's pension is a fixed number of dollars, so with 2% inflation its real value shrinks every year. If the same $26,000 pension were fully indexed, the highest steady spending her plan supports to 95 would rise from about $40,600 to about $44,700 — roughly $4,100 more each year, in today's dollars.

That gap is why it's worth reading the indexing section of any DB plan booklet carefully. Partial indexing, indexing up to a cap, or indexing only when the plan's funding allows can each lead to very different results over a 30-year retirement. Our inflation guide explores this further.

Who carries which risks

The two designs divide risks differently between the plan and the member:

Tax rules and RRSP room

Membership in either kind of plan reduces your RRSP room. Each year, your employer reports a pension adjustment, which is subtracted from the room you would otherwise get — 18% of the prior year's earned income, up to the 2026 RRSP dollar limit of $33,810.

In retirement, income from a registered pension plan life annuity — including a DB pension — qualifies for pension income splitting with a spouse at any age, up to 50%. Income from RRIFs and similar accounts, including many locked-in income funds, generally qualifies from 65. The pension income splitting tool estimates the effect.

Members leaving a DB plan before retirement may be offered a lump-sum commuted value instead of a future pension. That's a significant decision with its own trade-offs, covered in our commuted value guide.

Questions to ask your plan administrator

Whichever kind of plan you have, a few questions can clarify what to expect:

Your plan's annual statement often answers several of the questions below, and the how much do I need tool shows how a pension estimate fits alongside your savings target.

• Is the plan DB, DC or a hybrid, and which pension legislation applies to it?
• For DB: what is the formula, the earliest unreduced retirement age, and the indexing policy?
• For DB: what survivor options are available, and how do they change the monthly amount?
• For DC: what happens to the balance at retirement, and what are the locked-in withdrawal limits?
• Are there bridge benefits or early retirement reductions that change the picture before 65?