Defined pension plan vs. defined contribution plan: Are they enough?
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When it comes to planning for retirement, it’s crucial to understand the difference between various types of pension plans and how they could impact your future financial security.
Defined benefit (DB) plans offer a guaranteed payout in retirement, with the employer carrying the responsibility. In contrast, defined contribution (DC) plans shift the burden onto employees, who manage their contributions and investment choices.
But here's the thing: Relying solely on these "golden handcuff" plans may not be enough.
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Key takeaways
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- Defined benefit plans offer predictable retirement income, with employers assuming the investment risk, while defined contribution plans provide flexibility and investment control but shift the risk to employees
- Employers increasingly prefer defined contribution plans due to lower administrative costs and reduced financial risk, making them more attractive for workplace retirement solutions
- Effective retirement planning, including diversifying savings with additional accounts like RRSPs or TFSAs, is essential for achieving financial security and maintaining a desired standard of living in retirement
A defined benefit plan is like having a personal financial safety net waiting for you when you retire.
It’s an employer-sponsored retirement plan that guarantees a set amount of income during your retirement years. Basically, your paycheque in retirement is based on your salary and how long you worked for the company.
Unlike defined contribution plans, where you're at the mercy of how well your investments perform, DB plans shift all the investment risk to the employer.
That means, no matter what happens in the stock market, you’ll get a steady and predictable income. It’s like having your financial future on cruise control – a huge win for peace of mind when it comes to long-term planning.
How DB plans work
Here’s how DB plans work in plain English: They use a set formula to calculate your retirement income and it’s usually based on a few key things — your salary, how long you've been with the company and sometimes your age when you retire.
A typical formula might look something like this:
Retirement benefit = tears of service × average salary × multiplier (like 2%)
So, the longer you’ve worked and the more you’ve earned, the bigger your retirement paycheque will be.
Now, here’s the sweet part: Your employer foots the bill for this plan.
They’re responsible for making sure there’s enough money in the pot to cover your benefits, so you don’t have to worry about how the market is doing.
Even better, these payouts often get adjusted for inflation, so your buying power stays solid over time. It’s basically all about giving you a stable and predictable income after years of hard work, while your employer handles the tricky stuff, like investments.
Pros and cons of defined benefit plans
Pros
- Predictable income: The biggest win with a DB plan is knowing exactly what your retirement income will be. It’s like setting your financial cruise control for retirement – no surprises, just a steady paycheque, which is super comforting, especially when the markets are on a rollercoaster.
- No investment risk for you: Unlike other plans where you’re stressing about making the right investment choices, with a DB plan, your employer takes on all the risk. They’re the ones making sure your payout happens, no matter what.
- Rewards loyalty: The longer you stay with the company, the sweeter the deal. DB plans tend to give bigger payouts to long-term employees, so sticking around can seriously pay off, which makes it a pretty good motivator for employee loyalty.
Cons
- No control over investments: You don’t get a say in how the money is invested. Your employer, or whoever runs the plan, calls the shots, so, if you’re someone who likes being hands-on with your money, this could feel a little restrictive.
- Heavy lifting for employers: DB plans can be expensive for employers to maintain. If there’s ever a shortfall or a bad year for investments, it’s on them to make up the difference, which could be a strain on the company.
- Less flexibility: Unlike other retirement plans, DB plans are rigid. You don’t have a tonne of flexibility when it comes to how or when you take your payouts, and you can’t really move the money around easily if you want to manage your own investments.
A defined contribution plan is like a build-your-own retirement savings plan.
You, the employee, put in a portion of your income, and most of the time, your employer will chip in by matching part of that contribution.
The catch?
Your retirement payout isn’t guaranteed — what you end up with depends on how well your investments do over time.
So, unlike a defined benefit plan where the income is set in stone, with a DC plan, it’s all about how much you save and how smart your investments are.
Flexibility and investment control - the perks of DC plans
One of the biggest perks of DC plans is the control you get. You’re in the driver’s seat when it comes to picking how your contributions get invested, tailoring your choices to your financial goals and risk tolerance.
Whether you want to go all-in on aggressive growth stocks or play it safer with bonds, it’s up to you. This can lead to serious growth if you pick wisely, especially when the market’s hot.
But with great power comes great responsibility — you’ve got to stay on top of your investments and make sure they’re still aligned with your retirement plans.
Pros and cons of defined contribution plans
Pros
- Investment control: You get to call the shots on where your money goes, tailoring your investment strategy to fit your goals.
- Growth potential: With the right picks (and a little employer matching), your savings could grow substantially thanks to tax-deferred growth and compounding.
- Portability: Switching jobs? No problem. You can usually take your savings with you when you leave, which is great if you’re job-hopping.
Cons
- Market risk: Your retirement outcome is at the mercy of the market. If your investments don’t perform, your retirement fund takes the hit.
- No guaranteed income: Unlike a DB plan, there’s no set amount of income waiting for you. This can make long-term planning a bit tricky.
- Active management: You’ve got to stay engaged and manage your investments, which can be a headache if you're not comfortable making financial decisions.
Who should consider a DC Plan?
A DC plan is perfect for people who want control over their retirement savings and are willing to take on a bit of risk. If you like the idea of managing your own investments and have a long time horizon to ride out market ups and downs, a DC plan could be a good fit.
Younger professionals, in particular, may love the growth potential. And if you’re someone who changes jobs often, the portability of a DC plan makes it easy to take your retirement savings with you wherever you go.
So if you want flexibility, control and the potential for big growth, a DC plan could be your ticket. Just keep in mind, it requires some effort and smart management to make sure you’re on track for a comfortable retirement.
When it comes to choosing between defined benefit and defined contribution plans, here’s a breakdown of how they stack up in terms of security, flexibility, risk, employer contributions and tax perks.
Summary of DB vs DC
DB vs DC in deeper detail
Are DB or DC plans enough? Can you shake the golden handcuffs?
When it comes to retirement planning, relying on a defined benefit or defined contribution plan alone may not cut it if you’ve got bigger financial goals in mind.
Sure, these plans can be the backbone of your strategy, but there are a few other things to factor in if you want to fully future-proof your retirement.
And let’s not forget the golden handcuffs dilemma — those perks that keep you tied to a job even when you’re itching to leave.
Related read: How much money do you need to retire in Canada?
Golden handcuffs: Is a LIRA your get-out-of-jail-free card?
Golden handcuffs — sounds fancy, right? But they can feel like a trap. These are the financial perks, like pension benefits, that make it hard to walk away from a job, even if you’ve long since checked out mentally.
But here’s where a (Locked-In Retirement Account (LIRA) could be your key to freedom.
A LIRA lets you transfer your pension benefits when you leave your job, giving you more control over your retirement savings without feeling locked into a gig that’s no longer doing it for you.
For example, if you leave your job with a DB plan, the money earned goes into aLIRA, allowing you to keep the money you contributed, to take with you when you go. The money, as the name suggests, is locked away until it’s time for you to retire, from whatever job you move on to.
So, if you’re dreaming of greener pastures, but your pension is holding you back, a LIRA might just be your best bet.
Risk: Is a defined benefit plan really enough?
A DB plan covering 70% of your salary sounds pretty sweet, right?
But before you settle into that cushy retirement chair, let’s take a reality check.
With inflation1creeping up and your future lifestyle goals in play, you may actually want to aim higher — think 80 to 90% salary replacement to keep your financial game strong.
- Inflation: Inflation will eat away at your purchasing power over time, a DB plan may not stretch as far as you’d think down the road.
- Lifestyle goals: Whether it’s spoiling the grandkids, travelling the world, or just keeping up with life’s little luxuries, shooting for 80 to 90% of your current salary could help you live your retirement dreams, stress-free.
Let’s break it down: If you’re making $80K now, and your DB plan promises 70% of that (so, $56K), it may cover your basics. But will it be enough for inflation, medical expenses, or those bucket list vacations? Aiming for $72K (90%) gives you more wiggle room to really enjoy your retirement, rather than just getting by.
Opening an RRSP or TFSA: Boost your retirement savings game
Even if you’ve got a solid DB or DC plan, opening up an RRSP or TFSA could seriously level up your retirement savings. These accounts come with killer tax advantages that let your money grow faster over time.
- RRSP: Your contributions are tax-deductible, and the growth isn’t taxed until you start pulling it out, making it a powerhouse for long-term savings
- TFSA: Everything grows tax-free, and you can withdraw whenever you want without worrying about the CRA taking a cut
If you’ve got some contribution room sitting there, why not max it out if you can? It’s an easy way to pad your retirement fund and give yourself a little extra security.
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Future-proofing your retirement
To make sure your retirement savings can handle whatever life throws at you — whether it’s market crashes or inflation spikes — you’ve got to adopt a strategy that’s built for the long haul. Here’s how you can future-proof your retirement:
- Diversify your strategy: Use your DB plan for that steady, guaranteed income, but mix in some DC plan investments to capture market growth. It’s all about balance.
- Robo-advisors vs. model ETF portfolios: Consider using robo-advisors or model ETF portfolios to manage your investments without the hassle. Robo-advisors are automated, low-cost and do all the heavy lifting for you. If you like a bit more control, model ETFs give you access to diversified, low-fee portfolios. Either way, these tools help manage risk and optimize returns without you having to constantly check in.
By diversifying and leveraging these smart tools, you’ll keep your retirement plan on track, no matter what the market decides to do. That way, you can enjoy your golden years without financial worry dragging you down.
Factor
Defined benefit plan
Defined contribution plan
RRSP/TFSA supplement
Income security
Guaranteed, predictable income
Income based on investment performance
Offers supplemental savings with tax advantages
Investment control
No employee control
Full employee control
Employee controls investment strategy
Risk
Employer assumes investment risk
Employee bears investment risk
Employee assumes investment risk, but with tax-free growth
Golden handcuffs solution
Use a LIRA to leave job and transfer benefits
Portable savings that follow the employee
Allows further flexibility in saving and withdrawing funds
Tax implications
Contributions grow tax-deferred, income taxed at retirement
Contributions grow tax-deferred, withdrawals taxed
RRSP tax-deductible, TFSA growth and withdrawals are tax-free
Supplementary benefits
Provides core retirement income
Provides flexibility and growth potential
RRSP/TFSA offer additional financial security in retirement
So while DB and DC plans lay the foundation for retirement, combining them with RRSPs, TFSAs and future-proof investment strategies can help ensure you maintain a comfortable lifestyle in retirement, no matter the economic landscape.
Final thoughts
At the end of the day, DB and DC plans are great starting points for building your retirement, but relying on them alone might leave you short of your goals.
Combining the steady income of a DB plan with the flexibility and growth potential of a DC plan gives you a solid foundation, but adding in some RRSPs, TFSAs or even a LIRA for extra freedom can really supercharge your retirement strategy.
Think of it this way: Diversifying your savings and investments, while taking advantage of tax benefits, is like adding extra layers of protection to future-proof your retirement. Whether it’s inflation, market volatility or just wanting a bit more spending power to enjoy life’s luxuries, a well-rounded approach ensures you're covered, no matter what.
Retirement is about living comfortably, and with a balanced strategy, you can do just that and on your terms.
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Noel Moffatt
Writer
Noel Moffatt is a Canadian fintech expert with a passion for simplifying personal finance. Based in St. John’s, NL, he draws on his background in finance, SEO, and writing to deliver clear explanations and actionable advice. Noel is dedicated to equipping readers with the knowledge and tools they need to make informed financial decisions, striving to make personal finance more accessible and understandable through his in-depth articles and reviews.
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