Defined contribution pension plan

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Retirement planning
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A defined contribution pension plan (DCPP or DC plan ) is one type of a Registered Pension Plan. A DCPP has no pre-determined payout at retirement, it is based on the assets in the plan at the time your retire. The investment risk is borne by the beneficiary not the plan. They are also known as money purchase plans,[1] reflecting the individual's contribution.

How a DCPP operates is typically company specific. Generally they involved a fixed contribution amount or percentage of salary that are deposited into an account in your name. The amount can either be contributed by the employer, the employee, or some combination of both based on the setup of the specific plan. These contributions are tax deductible, and the assets grow on a tax-deferred basis.

In a DCPP, you are responsible for the investment choices for the contributions, from a selection of options available for your plan. The funds in a DCPP cannot be withdrawn before the owner retires. The "cost" of a DCPP can be readily calculated but the benefit is ultimately unknown as it depends on the investment returns of the plan.

Over one million Canadians are covered by a defined contribution pension plan (DCPP).[2]

Origins

Defined contribution pension plans are nearly contemporary with defined benefit pension plans (DB plans), dating back to more than a century ago. They were first given legislative expression with the Government Annuity Act of 1908, which allowed for individual savings accumulated over a lifetime of labour to be converted into life annuities.

How DC plans work

DCPPs fall under the same regulations and legislation[3] as DB plans, even though their structure is quite different. Under a DB plan, the sponsor assumes liability for the payout, the investments, the service providers and along the way, the plan's solvency.

In a DCPP, the sponsor employer contracts with a plan administrator to provide the investment options; normally a limited menu negotiated at low cost; as well as the record-keeping for individual plan members. Because of their experience in offering group benefits, life insurers like Manulife, Sun Life and Great-West Life (including its London Life and Canada Life subsidiaries) dominate the DC pension space.[4]

While DCPPs follow DB regulations, they are quite similar in how they work to Group RRSPs.

Some 75% of DC plans are mandatory[5] and the rest are voluntary. One example of a voluntary contributory DC Plan is the Saskatchewan Pension Plan, which states on its website that it is[6]

"a fully funded, participatory money purchase or defined contribution pension plan. It is designed to provide supplementary income to individuals with little or no access to private pensions or other retirement savings arrangements or as part of a larger investment portfolio."

Matching contributions

Many company defined contribution plans top up employee contributions with matching funds, often up to between 3% and 6% of earnings. This gives the employee the incentive to join and contribute to their plan. Yet employers are paying out just 40% to 50% of available matching funds, according to industry estimates.[7]

CAPSA guidelines

DC plans are expected to follow voluntary guidelines from the Canadian Association of Pension Supervisory Authorities (CAPSA), including:

Investing in your DC plan

You will be making investment choices in a DC plan, typically from a menu of funds. From this you will build a portfolio. The plan will provide information and decision-making tools, which will help you come up with an asset allocation. There might an automatically suggested fund choice or a default option.

Educate yourself

In a survey of over 2000 DC plan members in the US, 68% said that they did not really understand the investment options they had selected.[8] Plan members are urged to educate themselves about investing so that they become comfortable making their own decisions about asset allocation and fund choices, or at least confirm that the default options or automated fund choices are appropriate for them. Articles that may help include:

Target date funds

The default investment option in almost half of DC plans consists of target date funds.[5] You pick your approximate retirement date and the fund automatically adjusts it's asset allocation as retirement approaches, lowering the proportion of equities and increasing the proportion of fixed income investments. Sunlife, a big provider, notes that target date funds "can be particularly appealing to less sophisticated or engaged investors looking for a streamlined portfolio choice."[9] If the target date fund corresponding to your approximate retirement date is too aggressive, or too conservative, to your taste, you can choose one with a different date.[10]

Balanced funds

Another popular one-fund solution is a balanced fund[9], which typically contains a fixed percentage of equities and fixed income investments. In DC parlance, balanced funds are sometimes known as "target risk" or "asset allocation" funds and range from very conservative to very aggressive.[11]

Although target date funds, with their asset allocations that change with time (a.k.a. "glide path"), appear more sophisticated, some studies suggest that you might do as well with the constant allocation of a balanced fund.[12] This is especially true if the balanced fund is significantly cheaper to own than the target date fund. However, sequence of return risk justifies the declining equity allocation of target date funds.

Simple index portfolio

If you want more control, and perhaps lower fees, consider building a simple index portfolio in your DC plan. Exchange-traded funds (ETFs) will probably not be available[13], but index funds may well be, and should be among the least expensive options in the menu. They might even be cheaper than equivalent plain-vanilla index funds available to the general public.

The following table is an example of a simple index portfolio built with "FPX Balanced" allocations, using four index funds offered in the DC plan of the University of Northern British Columbia:

FPX Balanced Four-index funds Portfolio
Asset Class ETF Amount
Domestic stocks BlackRock S&P/TSX Composite Index Segregated Fund 25%
International stocks BlackRock EAFE Equity Index Segregated Fund 15%
US stocks BlackRock U.S. Equity Index Segregated Fund 10%
Domestic bonds BlackRock Universe Bond Index Segregated Fund 50%
FPX Balanced Four-index funds.png

This example has a before-tax weighted average management fee of 0.24% (March 2015).[14]

Leaving your plan before retirement

Most DC plans require you to transfer your money out of the plan when you leave your employer. In Ontario for example, you will typically have three options:[15]

  1. Transfer to an individual locked-in retirement account (LIRA)
  2. Transfer to an insurance company to buy a deferred annuity
  3. Transfer to another pension plan, if they will accept the transfer

Options at retirement

Typically, a DC plan does not directly pay a pension after retirement. Instead, members typically have two options to obtain an income:[16][17][18]

  1. Transfer their funds to a Life Income Fund (LIF), which is similar to a Registered Retirement Income Fund (RRIF), but with both minimum and maximum annual withdrawals
  2. Purchase a annuity from an insurance company, which guarantees an income for life

In Saskatchewan, no new LIFs are allowed, but retirees can open a prescribed RRIF (pRRIF).[19]

When choosing between a LIF (or pRRIF) and a life annuity, retirees can consider the following aspects:[19]

  • What are your goals?
  • Are you permanently retired?
  • How much risk are you willing to bear?
  • How long will you live?
  • What do you expect annuity rates to be?
  • What's your complication threshold?

Since the purchase of an annuity is an irreversible decision, retirees are urged to consult a qualified and conflict-free professional before making the decision.

Problems

The Association of Canadian Pension Management outlines the challenges DC plans face:[20]

"Can a retirement savings plan make a significant contribution to a reasonable retirement income? Will retirement savings plan sponsors and members contribute enough? Will members invest these contributions appropriately? Should investment advice be provided to members? Who will provide investment advice to members? How will retired members manage mortality or longevity risk – the risk that they could outlive their money? Do members understand the risks and costs that they bear? What can be done to help them manage these risks and reduce these costs?"

See also

References

  1. ^ Registered Pension Plans Glossary, viewed February 7, 2014.
  2. ^ Statistics Canada, Registered pension plan (RPP) members, by area of employment, sector, type of plan and contributory status, viewed February 18, 2017
  3. ^ Income Tax Act, subsection 147.1(1), viewed February 7, 2014.
  4. ^ Benefits Canada, 2015 CAP Suppliers Report: Provinces hold the keys to CPP expansion, December 17, 2015, viewed February 13, 2017
  5. ^ a b Benefits Canada, DC plans need better design and raised contribution rates: report, February 19, 2016, viewed February 13, 2017
  6. ^ Saskatchewan Pension Plan, viewed Feb. 6, 2012.
  7. ^ Canadians losing out on as much as $3-billion in ‘free money’ defined-contribution pensions | Financial Post, viewed December 18, 2014.
  8. ^ Benefits Canada, DC pension plan members want to take risks, but lack knowledge, March 6, 2020, viewed March 14, 2020.
  9. ^ a b Benefits Canada, Pension column: Greater simplicity for DC plans, November 20, 2014, viewed February 13, 2017
  10. ^ Canadian Couch Potato, Are Target Date Funds Right For You?, Aril 18, 2016, viewed February 13, 2017
  11. ^ getsmarteraboutmoney.ca, Workplace pensions and savings plans -- Investing your contributions, viewed February 14, 2017
  12. ^ Graham Westmacott, Should my portfolio be on a glide path?, November 2016, viewed February 16, 2017
  13. ^ Benefits Canada, Can ETFs work in defined contribution plans?, March 18, 2015, viewed February 16, 2017
  14. ^ UNBC Pension Plan, April 22, 2015, viewed February 17, 2017
  15. ^ getsmarteraboutmoney.ca, Leaving your DC pension plan before retirement, viewed February 15, 2017
  16. ^ Retraite Québec, Income from a defined contribution plan, viewed February 15, 2017
  17. ^ getsmarteraboutmoney.ca, Your DC pension options at retirement, viewed February 15, 2017
  18. ^ Robb Engen, Defined Contribution Plan, February 23, 2011, viewed February 15, 2017
  19. ^ a b Government of Saskatchewan, Financial and Consumer Affairs Authority, Retirement Options, June 2016, viewed February 16, 2017
  20. ^ Association of Canadian Pension Management, Delivering the Potential of DC Retirement Savings Plans, May 2008, p. 3.

Further reading

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