Beware: your pension might not be sufficient

Deborah Leahy

May, 2011

We all want financial security when we retire, and many Canadians are counting on employer pension plans to provide that security. But there’s a growing possibility that your pension won’t provide the income you need.

There is a trend toward defined contribution pension plans. These are registered pension plans that specify the employee and employer contributions, but not the amount the employee will receive at retirement. Payout amounts from these plans are based on the returns earned by their investments. If the investments perform well, you could have more income than you expect; if they underperform, you could be left short.

Defined benefit pension plans are different from defined contribution plans. In a defined benefit plan, the employee knows, in advance, how much will be paid out at retirement, and contributions are based on the employee’s salary and length of service. Defined benefit plans were once the norm in Canada. However, most new pension plans are of the defined contribution type, and many existing defined benefit plans are being converted.

Members of defined contribution plans can usually choose how to invest their contributions. Participants are provided with tax-sheltered options ranging from conservative to higher growth. Their contributions are pooled with those of other plan members and invested by professionals.

Companies prefer defined contribution plans because employers aren’t required to pay fixed benefits when investments perform poorly, as is the case with defined benefit plans. This shifts risk from the employer to the employee. For example, those who choose a growth option that invests largely in equities could suffer if the stock market has a few down years immediately before they retire.

Even defined benefit plans have risks. Many of these plans are underfunded and could fail to meet obligations to employees. This can be because of poor investment returns or the employer’s inability to make contributions.

How can you protect yourself from the possibility of less pension income than you’ll need? The best strategy is to have other sources of income.

Registered retirement savings plans (RRSPs): If you belong to a pension plan, your yearly RRSP contribution room will be reduced by a pension adjustment. However, you may still be able to build considerable RRSP wealth before retirement. That wealth can provide additional income.

Tax-free savings accounts (TFSAs): Consider taking advantage of TFSAs, which can provide you with tax-free income during retirement. Every Canadian age 18 or older can contribute up to $5,000 per year.

Non-registered investments: If you have used your available RRSP and TFSA contribution room, consider holding your investments in a taxable investment account. Although your investment income is taxable, capital gains and dividends from certain Canadian companies may provide you with some tax advantages. Remember, however, that dividends can be increased, decreased or eliminated at any point without notice.

Consult with your financial adviser to determine whether your pension will provide the retirement income you need.

Deborah Leahy is an investment adviser with Edward Jones, specializing in assisting seniors.