When you read your pension statement, does it seem like it’s in a foreign language? You’re not alone. Unless you work in pensions for a living, it can be next to impossible to make sense of even the most basic terms.
This article is the first in a series aimed at providing a better understanding of pensions. Although you don’t need to be an actuary to understand pensions, it’s a good idea to at least have a basic understanding. If you’re one of the millions of Canadians lucky enough to have a pension plan, here are a few confusing pension terms defined.
Probably the most common question when it comes to your pension is, “how much will I receive when I retire?”. If you have a defined benefit pension, the accrued pension is simply the amount you’ll receive at your normal retirement date. It’s calculated using the plan formula based on your years of credited service and pensionable earnings. If you decide to retire early, your pension is often reduced by a set percentage, such as three per cent per year.
If you have a defined benefit pension plan, the benefit formula is used to calculate your pension entitlement. Although formulas vary by plan, here’s an example of a basic formula:
Accrued Pension = Earnings X Credited Service X 1%
There are three common benefit formulas: final average earnings, career average earnings and flat dollar. Final average averages is the most generous, using the earnings in your final years of employment, career average takes the average of your earnings over your career (less generous), and flat dollar provides a pension based on a set dollar amount regardless of your earnings (it’s most common in employers with unions).
If you decide to leave your employer before retirement and you’re a vested member (meaning you’ve worked for the company long enough to qualify for a pension), one of the choices you’ll have is to receive the commuted value. The commuted value is a lump sum payment equal to your pension at retirement.
The time value of money plays a big role, as your age and the interest rate in effect have a bearing on how much you’ll receive. All things being equal, a younger employee will receive a lower commuted value because they have a longer time horizon to invest. Meanwhile, a lower interest will lead to a higher commuted value since you’ll require a larger amount to invest to achieve the same pension at retirement.
Similar to your earnings, your credited service helps determine your accrued pension at retirement. You start receiving credited service once you’re a member of the pension plan. It’s fairly common for employers to make you wait a couple years to join the company pension plan, although more generous employers allow you to join the plan immediately.
Joint and Survivor Pension
This form of pension helps protect your spouse if you pass away before him or her in retirement. By choosing this form of pension, you’ll receive a lower pension now in exchange for your spouse receiving a portion of your pension – often 60 per cent or 100 per cent – when you pass away. A spousal waiver must be signed by your spouse if you choose a less generous form of pension, such as life only or guarantee five, 10, or 15 years.
If you’re a member in a pension plan, it’s crucial to know your vesting date. Being vested means you’re entitled to a payout when you leave your employer. If you’re considering leaving your employer and you’ve only been there a short while, you might not have any entitlement. You can usually find your vesting date on your annual pension statement. Certain provinces like Quebec and Ontario have introduced immediate vesting – as long as you’re a member, you’ll receive a payout regardless of how long you’ve been enrolled in the plan.