Defined benefit pensions 101

From underfunded plans to LIRA transfers, here are some issues to take into account

Do you belong to a company pension plan? If so, do you know what benefits you can expect to receive when you retire?

Typically, a defined benefit (DB) pension promises to replace a percentage of pre-retirement earnings.

If that is the type of plan you belong to, you likely receive a personalized statement each year telling you the monthly benefits you can receive when you retire.

A benefit rate of two per cent is designed to replace 70 per cent of earnings after 35 years of service. When you multiply two per cent times 35 years times $50,000 that would give you a pension benefit of $35,000 per year.

A DB plan is different from a defined contribution (DC) pension plan, which provides benefits based on the size of the pot of money you accumulate when you retire.

A DC pension is much like an RRSP. The size of a DC pension depends on an unknown future growth rate.

DC plan members accept the investment risks and look forward to being rewarded accordingly.

Because pension benefits are defined by a formula, a DB plan, in theory, should offer more certainty for the employee than a DC plan.

UNDERFUNDED DB PENSIONS

What happens to that DB promise to pay when an employer runs into financial trouble the way Sears has recently? It becomes harder to pay the promised DB pension benefits. Sears is just one of many DB pension plans that are underfunded. Low interest rates and longer life spans for retirees have made DB plans increasingly expensive for employers to fund.

A pension funding shortfall is little cause for worry if your employer is a government or a stable company with a good credit rating.

Even in a worst-case scenario, where there is a pension shortfall and your employer goes bankrupt, your risk is limited to the extent of the shortfall. If your pension is 80 per cent funded, for example, you would not lose more than the other 20 per cent.

The best-known recent example of the worst-case scenario occurred after Nortel went bankrupt

in 2009 with a large pension shortfall. Nortel’s pension benefits were cut back to 59 per cent of promised levels.

If you are a member of a DB pension, ask about your pension plan’s solvency ratio.

COMMUTED VALUE TRANSFER

What if you terminate employment before retiring and go work somewhere else?

Suppose you want your exemployer to transfer your DB pension as a lump sum to a Locked-In Retirement Account (LIRA), instead of waiting to collect your pension as a future stream of monthly DB payments at retirement age. When you ask for a quote on how much is available to transfer, don’t be surprised when your ex-employer holds back a percentage of the account value due to solvency deficiency. For example, let’s say the actuarial valuation indicates that the pension plan has a solvency ratio of 72 per cent. That means 28 per cent of the pension transfer value upon termination must be held back and paid out five years after the date of the termination payment.

If you transfer your pension savings to your own personal LIRA you’d become responsible for the investment decisions in the same way as you manage your RRSP investments.

You should ask yourself a key question: What is the break-even rate of return that your LIRA funds would have to generate until, say, age 95 to be able to match the cash flow that you could get from leaving your money in the DB pension plan? A low break-even rate would favour transferring the funds to your LIRA.

Terry McBride, a member of Advocis, works with Raymond James Ltd. The views of the author do not necessarily reflect those of Raymond James Ltd. Information is from sources believed reliable but cannot be guaranteed. This is provided for information only. We recommend that clients seek independent advice from a professional adviser on tax-related matters. Securities offered through Raymond James Ltd., member of the Canadian Investor Protection Fund. Insurance services offered through Raymond James Financial Planning Ltd., not a member of the Canadian Investor Protection Fund.