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Summer 2000

Introduction to Retirement Income
Pension Plans: The Nuts and Bolts
Show Me the Money
The Effects of Inflation on Pension Benefits
Sample Pension Statement

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 fund.

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 participant’s annual earnings, for example, and the sponsor’s 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 plan’s bylaws.

For example, the plan may call for a monthly pension equal to 2% of the panicipant’s 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 employee’s 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.

SUMMER 2000: Introduction to Retirement Income | Pension Plans: The Nuts and Bolts | Show Me the Money | The Effects of Inflation on Pension Benefits |Sample Pension Statement