Pension Plans: The
Nuts and Bolts
A PENSION PLAN IS A FORMAL arrangement
between a participant and a sponsor to provide post-retirement income. There are many
kinds of pension plans but the most common way that they are classified is on the basis of
the level of benefit promised to their members.
All pension plans operate in the same way.
Contributions are paid into a fund that is invested and becomes the source of payments to
beneficiaries. Over the life of the plan, the contributions, together with the income that
they generate, must be suP ficient to cover benefits paid and any expenses incurred by the
If the plan explicitly defines the
contributions that are to be made by the sponsor and the members participating in the
plan, it is called a "defined contribution" plan. Contributions can be defined
in relation to a participants annual earnings, for example, and the sponsors
contribution can be
a function of its profitability for the year. With such a
plan a separate account is maintained for each participant and all contributions whether
made by the participant or the sponsor on his behalf are credited to his account.
Investment income and gains are credited to the account and investment losses reduce it.
When the participant retires, the money accumulated in his account is used to purchase a
pension. Because of this feature, these plans are often called "money purchase"
plans. Under these plans the cpntributions are explicitly defined but the benefits are
not. They will be calculated when the participant is ready to purchase a pension. The
sponsor has discharged his obligation by maintaining funds in an available account until
such time as they will be required. But when that date is reached, the benefits to be
enjoyed are whatever pension can be purchased by contributions and investment returns.
The second type of pension plan is the "defined
benefit" plan. With such a plan, the pension benefit to be enjoyed at retirement is
explicitly determined according to a set formula laid out in the plans bylaws.
For example, the plan may call for a monthly pension
equal to 2% of the panicipants average career earnings, multiplied by his years of
service. The sponsor is therefore promising to provide benefits at some predetermined
level and it is his responsibility to ensure that contributions made into the plan will be
sufficient to pay out these benefits when the time comes. Participants may contribute at a
fixed level, but the balance of money required, whatever it may ultimately turn out to be,
must be made up by the sponsor.
Today, it is very uncommon for an employee to remain with
one employer throughout his entire working life. Therefore, all pension plans have
provisions that recognize the realities of vesting and portability.
A fundamental distinction must be made between membership
in a pension plan and actual receipt of pension benefits at retirement. The divergence
between the two represents lost retirement income or "slip-page".
Vesting is defined as the employees right to all or
part of the employer contributions paid on his behalf upon termination of employment
before retirement. An employee may work in a company for several years, all the while
contributing to the company pension plan. However, due to any of a number of situations
that may arise, he may leave the company.
If he leaves the company without satisfying certain aspects
of the particular pension plan, he will not qualify for pension benefits upon retirement.
He will be entitled to a refund of his contributions (plus interest) for the money that he
has paid into the plan but will forego all contributions made by the employer on his
behalf during his years of employment with the company. These monies are usually
transferable to a "locked-in RRSP" and can only be withdrawn upon reaching a
certain age, usually 60 or 65.
In Canada, the most common standard for
many years has been the "45 and 10" rule which stipulates that a person must
satisfy both an age and a service requirement to be entitled to a vested pension upon
retirement. Under this rule, a person must have attained age 45 and have worked
with the same employer for at least ten years to qualify for a deferred benefit.
Unless vesting requirements are satisfied -
usually laid out in terms of age and/or years of service - a person will not be
entitled to a pension if he changes employment prior to retirement.
Coupled with vesting is the issue of
portability or the preservation of pension entitlements for terminating employees. If a
person changes employment several times during his working life and thereby never has the
continuity of service necessary to satisfy vesting requirements, it will be impossible for
him to benefit from the contributions made on his behalf by his employers.
Portability allows the transfer of either
pension contributions or benefits under a defined benefit plan from the pension fund of
one employer to the fund of another in respect of an employee whose employment is
terminated with the first and who finds employment with the second.
Unfortunately, while transferability
arrangements are relatively common in the public sector, their existence in the private
sector are rare. This is because while portability in theory can be arranged between
different employer-sponsored pension plans, the differences existing among plans means
that they do not "blend together" in a manner that easily allows such transfers
to take place. Resolving this problem would require a central pension agency under public
or private sector control to facilitate and regulate such transfers.