CI Direct Investing’s All-in-One Guide to Understanding Retirement Savings Options: Part 2
Welcome to part two of CI Direct Investing’s guide to retirement savings options. In part one, we learned about the types of retirement savings mandated by the Canadian government. Didn’t catch the first part? Go start there first!
Next up, we’ll look at the types of ways your employer can help you save for retirement:
Savings aided by your employer
During your working years you may contribute to a retirement plan through your employer. There are two main types of company-sponsored retirement benefits: Registered Pension Plans (RPPs) which are subject to their limits using the Money Purchase Limit and the Group RRSP which behave just like individual RRSP.
Registered Pension Plans
Defined Benefit Plans: provide a pension for life-based on the number of years you have contributed to the plan and your employment earnings. The formula varies from employer to employer, but it is usually something like this
2% * Annual salary = Monthly Benefit
The annual salary used depends on the employer, but it is most often one of the following:
1) Average salary
2) Average of highest 5 years of salary
3) Average of last 5 years of salary
Your benefit is guaranteed, regardless of the performance of the underlying pension fund investments. This is the best type of plan for employees and puts all the risk on the company as they have to make the pension payments even if the pension funds haven’t performed well.
The dark side of the Defined Benefit Pension Plan
Because the employer is on the hook for the payout of the pension regardless of market performance, the employer may choose to change the terms of the plan or cease to provide it all together. If this happens, your assets may be frozen until retirement and any future contributions will be made under the new rules or in the new plan.
If the company is insolvent, depending on the funding status of the plan at the time, your accrued value may be paid out to you at that time. If the plan is underfunded, you may not even get the total accrued value of the plan.
Defined Benefit plans are becoming less common each year for these reasons.
Defined Contribution Pension Plans
Defined Contribution Plans provides you with a pension based on not the amount of contributions you have made and the performance of the underlying pension fund investments.
This type of plan shares risk with employees, as the pension benefit is partly dependent on how much they contribute as well as the investment performance of the pension fund. Many companies – and some public pension plans – have been switching from Defined Benefit to Defined Contribution Pension Plans in recent years, and this trend will likely continue.
The DCPP plan contributions are usually a portion of your salary, often a specified percentage below and above Yearly Maximum Pensionable Earnings (YMPE). This is because they are designed to work in conjunction with your CPP, thus you save less on the portion of the salary on which you contribute to CPP.
The contributions to the plan are subject to Money Purchase Limit and reduce your ability to save inside the RRSP.
Group Retirement Savings Plans
Group RSP accounts are retirement savings plans that both the employee and employer can contribute to. They are easier to manage than a full pension plan, so many small and medium size companies elect to provide matching RSP contributions to a group RSP account instead. A common arrangement is for an employee to contribute a certain percentage of their earnings to the group RSP which is matched by the employer up to a certain annual maximum. This type of plan provides the most flexibility for the employee, who can choose how to invest the money, but the most risk, as well as the responsibility, lies with them to ensure the investments perform well enough to meet their retirement needs.
Deferred Profit Sharing Plan
Sometimes, rather than simply adding their contributions to the Group RRSP, employers contribute to a special account called Deferred Profit Sharing Plan (DPSP). DPSP is a little like DCPP, but the contributions are not tied into your salary, but into the profit of the company and at employers sole discretion, up to the 1/2 of money purchase limit, which is in turn restricted by your salary value. Employees cannot contribute to the DPSP, but oftentimes, employers couple DPSP with a Group RRSP and keep employer’s contributions in a DPSP and employees contribution in a DPSP.
DPSP’s are registered pension plan with the CRA and have to abide by the rules of RPPs.
Leaving a Pension Plan Before You Retire
If you decide to change jobs before you retire, your pension contributions will be converted to a Locked-In Retirement Account or a LIRA. LIRA behaves exactly the same way as a RRSP, but you cannot take money out or put more in. However, your savings grow on a tax-deferred basis, the same as they would in an RRSP.
If you change jobs while you have a group RRSP, your funds are simply transferred to an individual RRSP.
Can’t wait and want to get started on saving for retirement right away? Sign up for CI Direct Investing and create a financial plan with your dedicated financial advisor for free!