(Also known as a "DB Pension Plan")
In a defined benefit plan, you know in advance how much your pension will be at retirement.
The cost of a defined benefit plan is met by contributions made by your employer You may also be required to make contributions.
Each year you will be given a pension statement. It will show an annual pension amount that you will receive on retirement.
For example, your statement might show that you have accrued $9,000 of pension. This means that you would receive $9,000 each year for the rest of your life. That would be $750 each month.
The amount of your pension might be based on your years of service (flat benefit) or your annual salary and your years of service. Your annual salary will change through the years. The salary used to calculate your pension is chosen in one of two ways:
- career average
- final average
Career Average Pension Plan
In a career average plan, your pension is calculated by multiplying your annualized salary (before deductions) each year by the percentage defined in the pension plan and your service during the year. Annualized salary means the salary you would earn if you worked the whole year.
For example:
In 2013, Sue earned $30,000 and worked a full year. The defined benefit percentage in her career average pension plan is 1.5 per cent.
Sue's earned pension for 2013: $30,000 x 1.5 per cent x 1 = $450.
In 2014, Sue earned $32,000 and worked a full year.
Sue's earned pension for 2014: $32,000 x 1.5 per cent x 1 = $480.
Sue's total pension at the end of 2014 = $450 + $480 = $930.
In 2015, Sue only worked half of the year, her annualized salary was $34,000.
Sue's earned pension for 2015: $34,000 x 1.5 per cent x .5 = $255.
Sue's total pension at the end of 2015 = $450 + $480 + $255 = $1,185.
A final average pension plan will usually pay a higher pension than a career average plan. However, career average plans can be amended from time to time to increase pension benefits. They can provide what is called a base year upgrade. This means that earnings for a particular year (the base year) are used to calculate pension benefits for all of your service up to that point. The effect is similar to that of a final average plan.
Final Average Pension Plan
In a final average plan, your pension is calculated by using the average of the salaries you have received over a defined number of years (usually 3 years). This average is then multiplied by the percentage defined in the pension plan and your total service.
Using Sue as our example again:
| Year | Annualized Salary | Service |
|---|
| 2013 | $30,000 | 1.0 |
| 2014 | $32,000 | 1.0 |
| 2015 | $34,000 | 0.5 |
| Average Salary/Total Service | $32,000 | 2.5 |
Sue's total pension at the end of 2004 = $32,000 x 1.5 per cent x 2.5 = $1,200.
A final average pension plan will pay a higher pension than a career average plan. In general, your salary is higher in your last three years of employment. This means your pension is based upon a higher rate of earnings than a career average plan.
Benefits of final average plans:
- your accrued pension will keep pace with inflation because it is based on your most current earnings.
- you can easily calculate your pension, because it will be a percentage of your pre-retirement income. Example: Sue has worked 30 years. Her pension formula is 1.5 per cent of final average earnings. She can quickly work out that her pension will be 45 per cent (30 x 1.5 per cent) of her average earnings over that last three years.
Flat Benefit Pension Plan
In a flat benefit plan, your pension is calculated by multiplying a defined dollar amount by your total service.
For example:
When he retires, Sam has 25 years of service. His pension plan provides a flat benefit of $480 per year of service.
Sam's total pension at retirement = $480 x 25 = $12,000.
Therefore, Sam will receive $12,000 per year ($1,000 per month) each year until his death.