When it comes to pensions, what’s actually under the hood matters

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At a high level, a pension sounds great: save a percentage of your earnings throughout your working years and then retire with a “salary” for the rest of your life. Pool your retirement savings together with other workers and everyone can spread out the risks and costs. But does that really describe most pensions?

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Not unlike cars, what’s actually under the hood matters a lot when it comes to pensions. The types of investments in a pension can widely vary in their diversification, management styles, costs, expected performance and more.

Some pensions, such as those that have a wide array of sophisticated global assets, might be closer to turbo-charged engines. Others, like those with high-cost, basic public stock and bond portfolios, might be more like four-cylinder commuter cars. (I’m sure there’s a joke to be made about the Germans making both great pensions and automobiles, but I can’t quite zero in on it.)

Recently, I’ve even seen a new national group employer pension plan that markets itself like a “defined-benefit group pension.” However, unlike a typical group pension, the investment risk appears to be shouldered by the investors themselves; quite a difference that wouldn’t be readily apparent to the layperson.

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All of this is to say that some pensions certainly provide excellent value, but this is not an intrinsic feature of pensions themselves. Let’s break down the basics of common pension plans to help you know where to begin when assessing your own retirement savings.

Most people likely know pensions as being employer sponsored — a group pension plan (GPP). A GPP can be either defined benefit (DB) or defined contribution (DC). There are also group registered retirement savings plans (GRSPs) that are not pensions, but similar enough to warrant discussion. And then there are individual pensions for business owners or incorporated professionals.

With DB plans, an employee can expect to get a fixed amount of retirement income, usually indexed, often to inflation (consumer price index), for their entire retirement. This is especially great when longevity runs in the family since it makes it impossible to outlive one’s savings. The only exception would be if the pension fails for some reason. This is historically rare in Canada, but it does happen, as was the case for 17,000 Sears Canada Inc. employees when the company went bankrupt and closed in 2018.

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Employee contributions to a DB plan are based on an annual percentage of earned income, to a legislated maximum, and the employer matches these contributions. This can result in a lot of savings over an entire career. The future retirement benefit to be paid is defined in advance of retirement by the pension formula, usually a percentage of the employee’s average annual earnings over a measurement period (for example, “highest-earning consecutive five years”), and based on how many years total they were employed and actively contributing to the plan.

For all employees, all the pension funds are managed together in a pool, usually by an institutional pension manager following specific regulations around pension management. The investment risk is borne by the employer. The investments have an actuarial prescribed growth rate that they are required to grow by. If the pension pool is not meeting the rate, then the employer is required to make up the shortfall.

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High-profile examples of DB plans include the Canadian Pension Plan and the Ontario Teachers’ Pension Plan.

DC plans, meanwhile, focus more on the amount of annual savings going into them, not the resulting retirement income. The retirement benefit is not known in advance with DC plans. Like an RRSP, one can forecast the expected future value of the plan by estimating annual contributions, years invested and rate of return, but these are forecasts, not guarantees.

Like DB plans, DC pension contributions are based on an employee’s annual earned income, to a legislated maximum, and the employer matches contributions made. For those who haven’t yet realized, pension matching is the potential key benefit here.

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Say you put nine per cent of your income into a pension and your employer matches it, that can be a significant savings rate. Then again, if an employer simply paid nine per cent more in salary to their employees who then invested it themselves in their RRSP, along with their original nine per cent, there might not be any real advantage.

Employers typically hire an institutional manager to manage the DC plan investments. The funds might all be invested in a common way for all employees, though the employee will only see their respective holdings. Sometimes, the employee may even get some input on their DC investments, such as which “risk level” to set the investments at (conservative, moderate, aggressive). In my experience, the details of the underlying portfolio can be fairly opaque and materially vary in management fees, asset diversification and performance.

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At retirement, my observation as a planner is that the value of the DC plan is most commonly rolled over into some form of locked-in retirement income fund (LRIF), since annuities, the other option, have suffered from low interest rates. Assuming the LRIF option is taken, the amount of income that can be withdrawn from a LRIF will have a legislated minimum and maximum each year depending on where the plan is registered.

The risk of a DC plan is borne by the employee both in their working years and in retirement. The funds are simply a pool of investments, so whatever they grow into is what the employee can draw upon in retirement. If the investments perform below or above expectations, then the employee may need to adjust their retirement plans accordingly.

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A GRSP is a regular RRSP but offered through an employer. GRSPs are usually centrally managed with similar investment options to a DC plan. The employer may offer some contribution matching each year, though commonly (but not always), it is less than what is offered through GPPs (for example, if the employee contributes six per cent to the plan, the employer will contribute three per cent). The total contributions are still subject to the employee’s personal RRSP contribution limit — the lower of 18 per cent of earned income or the annual limit ($29,210 in 2022).

As an aside, it’s worth noting that in lieu of administering GRSPs themselves, employers may simply offer RRSP-matching to an employee’s own RRSP. This could potentially be desirable or detrimental since it gives the employee the ability to control their own investments. This would be a positive if the employee can select more suitable investments for their individual situation than are available from the group plan. But it would be a negative if the investor is not suitably savvy or makes poor investment choices.

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GRSPs seem common for mid-cap companies still in the growth phase. The bulk of my friends in technology companies seem to be offered these.

Finally, there is the individual pension plan (IPP). As the name implies, it is not a group pension, but an individual pension that exists for those who are contractors or self-employed. An IPP is a type of DB plan where the investments are managed by a corporation solely for one individual. It typically replaces an RRSP since it will have more allowable lifetime contributions. The individual represents both the employer and employee sides of the plan, so they make both required contributions each year.

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As with group plans, if the investments do not grow at the prescribed rate (7.5 per cent for IPPs), then the individual, a.k.a. the employer, will need to top up the plan. This means that an IPP holder bears the risk for investment performance. This can actually be desirable for high-income earners looking to shelter more funds for retirement; they can house the bulk of their lower-yielding fixed-income assets in an IPP where they are unlikely to earn the prescribed growth rate, thus forcing more funds from elsewhere into the IPP under its top-up requirement.

At retirement, the IPP can pay out a DB plan income, be converted to a LRIF or used to purchase a life annuity.

This is a very brief description of pensions and some of the facets of each type of plan. It is not intended to be exhaustive, nor should it be construed as advice on how to proceed with one’s own retirement savings. For a thorough and personalized analysis, please strongly consider reviewing your options with a qualified certified financial planner.

Chris Warner, FCSI CIM CFP PFP, is a wealth adviser at Nicola Wealth.

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