Author Topic: Pension: Defined Benefit vs Defined Contribution  (Read 3554 times)

SMC

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Pension: Defined Benefit vs Defined Contribution
« on: April 14, 2014, 10:21:13 AM »
Hi all, I just started a new job that offers employees 2 pension choices (I can only pick 1 and can't change), I'm having a tough time deciding so I figured I would post up here for some thoughts/advice.


Option 1 - Defined Benefit: Pretty similar to most DB pension plans, formula is: 1.6% x (avg of top 3 yrs salary) x (# yrs service) = annual payment.  Can take it at age 60 without any reductions, or at 55 with some scaling for taking it early.  Options if you leave the company before age 55 are to:
A) leave it alone and begin receiving it at age 55 or 60,
B) get paid out the lump-sum value and transfer it into a LIRA (locked in retirement account, basically an RSP that I can't touch or add $ to, could put into mutual funds), or
C) get paid out the lump-sum value and buy an annuity.

Since I'm hoping to retire in 10-15 years I would likely be taking the lump-sum value and putting it in a LIRA.  This is fine, my biggest concern is there is no formula for the lump-sum value I get paid out.  I have no idea what it would be, which makes it tough to factor into my FI plans.

The DB pension would use up about 2/3rds of my RRSP room.


Option 2 - Defined Contribution:  This one is pretty straightforward, company contributes 5% of my salary to a retirement account that I control.  Goes up to 7% after 7 years experience. I would likely be putting it into index funds.  I like this one because I can control where it goes, and because I always know what the value is which helps for FI calculations.

When I leave the company I would have to convert it to an LIRA or buy an annuity, (same as above).

The DC pension would use up about 1/3rd of my RRSP room.



Some background info:
  • both plans are 100% employer paid (yay!)
  • I'm 26 yrs old aiming for FI in 10-15 yrs, current stache about $70k
  • Current salary is about $90k, expecting annual raises of about 3-7%
  • I'm in Canada
  • I think both plans are taxed the same, only difference is the DB uses up more of my RRSP room
   

My thoughts are to go with the DB as I *think* the lump-sum payout will be pretty good when I quit the company, but I don't really know for sure.  Since the DB would be taking up quite a bit of RRSP room I could take the money I'm currently putting to my RRSP and use it to pay off my house, or contribute to a spousal RRSP for my partner.  The DC on the other hand might net me less money, but at least I'll be in control of it. 

Any feedback?

Thanks in advance!

zolotiyeruki

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Re: Pension: Defined Benefit vs Defined Contribution
« Reply #1 on: April 14, 2014, 11:10:02 AM »
I don't know how the DB plan is structured, but please consider the risk of placing both your employment and your eventual retirement eggs in the same basket.  If the company goes belly up, is the DB plan separated enough that you'd still receive what you're due?  What happens if you hate your job and want to go elsewhere?  What are the vesting conditions?

SMC

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Re: Pension: Defined Benefit vs Defined Contribution
« Reply #2 on: April 14, 2014, 11:24:23 AM »
There are no vesting conditions, it's 100% employer paid and there is no time period.  If I quit next week I would get paid out the lump-sum value of whatever has accumulated in the 2 weeks I've worked here.

Acadian

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Re: Pension: Defined Benefit vs Defined Contribution
« Reply #3 on: April 14, 2014, 04:02:31 PM »
I'm leaning towards the DB option. Some quick back of the enveloppe math shows that after 15 years of service you would have approx $21600/yr as a payout for life (at 60 yrs old, I ignored future raises). The DC would be approx. $4500/yr x 15 years = $67,500 added to your future LIRA (a bit higher since it goes up to 7% after 5 years service). That doesn't seem like much after 15 years of service ($123,000 even if it is making 8% interest).

Does you DB have COLA (cost of living adjustments)?

I am guessing that if you are planning to reach FIRE in 15 years (age 41) it will be because of investments/real estate outside of this pension. As a result, will it make a big difference in your plan? Could you leave the DB there until age 55 and take it as a pension?

Dee

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Re: Pension: Defined Benefit vs Defined Contribution
« Reply #4 on: April 20, 2014, 06:23:50 PM »
On the other hand, in terms of mitigating risks / diversifying, I think there is something to be said for the DB which would be invested through a regulated pension entity. Yes, you give up control, but does handing over the reins to someone else for that portion of your investment result in s a different kind of risk than handling your entire portfolio yourself?

I have a DB plan (and wasn't given two options to choose from) so maybe I am talking myself into loving it, and only seeing the benefits thereof. Certainly, my employer's PR is to the effect that this is an outstanding benefit to which regular workers are not entitled (I'm a federal public servant).

In my case, my general FI plan is to work until I have enough of my own stash to see me through to the beginning of payments from my DB pension (and a DB pension that will pay out more than my yearly expenses).

Of course, the real benefit of the DB is it goes on until you die and you don't have to worry about outliving it -- in that sense, it mitigates one of the biggest risks of living off one's own stash.

Gin1984

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Re: Pension: Defined Benefit vs Defined Contribution
« Reply #5 on: April 20, 2014, 06:29:23 PM »
I've never known anyone who has regretted having a DB plan.

livraison

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Re: Pension: Defined Benefit vs Defined Contribution
« Reply #6 on: April 21, 2014, 06:12:59 AM »
What sort of indexing is there? Is the DB payment indexed to inflation once you start receiving it? Would it be indexed for the interim period between when you quit and when you start receiving it at age 60? If that's the case, you may want to consider not taking it as a lump payment when you quit. I've thought about this a bit and have tentatively settled on considering my (indexed) DB benefit as a way of diversifying risk in FI. I.e., my savings that will allow me to leave early will be exposed to market risk, while my DB pension will be exposed to political risk (in the case of gov't pensions) or risk of the company or pension plan failing (in the case of private pensions). You'd have to gauge the risks for yourself at the time you leave, but if the pension is indexed from the time you leave, it might be attractive to have that option for diversification.

On the other hand, if there's no indexing, I'd think that the probable devaluation over the 12-18 years of FIRE before you can start collecting the benefit would send you running to the lump sum payout.

rtrnow

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Re: Pension: Defined Benefit vs Defined Contribution
« Reply #7 on: April 21, 2014, 07:02:28 AM »
I had a similar choice when starting my job 10 years ago. In my case the lump payout was only my contributions if I had <10 years service, but the non-DB option let me keep the matching with immediate vesting. For me that was an easy choice, no DB for me. Even though I have now been there long enough to vest, I couldn't collect until I'm 60 and even after vesting the lump sum if I cash out is only my contributions with no match or ROI. In your shoes, I would understand the lump pension payout well before deciding but in general I would rather direct my on money.

Blackadder

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Re: Pension: Defined Benefit vs Defined Contribution
« Reply #8 on: April 21, 2014, 08:30:53 AM »
I haven't crunched the numbers of your situation, but here's my take on DB vs. DC.

The DB option pretends to be essentially risk-less. Of course, it really isn't -- the risks are the same as with DC (mostly investment risk and longevity). That's why the DB tries to compensate the risk by spreading it out over the participants. This works satisfactorily with longevity, not so much with investments. So, in a situation where investments perform badly, the DB organization is faced with two choices: (a) respect established benefits and pay them by making new participants pay more than they will get (essentially, the currently working employees will be paying part of the current pensioners' pension). Or (b) adjust (lower) the benefits. There is no option (c) when there's not enough money -- a DB pension cannot create money out of thin air. Something has to give. These hard boundaries makes these risks "hard" risks. This may cause some DB pensions to be invested too conservatively, sacrificing return for added confidence.
TLDR: DB doesn't necessarily invest your money better than DC. If DB sounds much better than DC in your situation, keep in might that the defined benefits may not be so fixed after all.

That's why I find DC pensions more "fair" (between generations) and more "honest". Of course, most of them don't mitigate the longevity risk.

Matte

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Re: Pension: Defined Benefit vs Defined Contribution
« Reply #9 on: April 21, 2014, 11:40:36 AM »
I would go with the dB.  At my company they pressured people to switch in the 90s but some stayed dB.  For most it made the difference between retiring in their 50s vs there 60s.  New employees  never got the chance.  As long as its a relatively safe company and pension fund I would go dB.