How much pension a member of a superannuation plan – that is, an employer-sponsored plan – receives depends on the type of plan. The differences between the arrangements are sufficient to make a meaningful difference to how a pensioner lives considering the possible differences in the monthly pension payment.
Generally, there are two types of plans – defined contribution and defined benefit – and there are several arrangements in a defined benefit plan. Defined contribution plans are becoming more popular while defined benefit plans are getting less popular.
An employee can only participate in the type of plan being offered by the employer. A pension from a defined contribution plan, also called a money purchase plan, is based on the contributions of the employer and the employee to the fund plus the income that is earned on them.
When the invested contributions earn good investment returns, the pensioner is able to get a good pension, but low investment returns cause the pensioner to get a relatively smaller pension. In this case, it is the employee – who eventually becomes the pensioner – who bears the investment risk as there is no guarantee that the funds will consistently generate good returns.
It is the contribution rate of both the employer and employee that is defined, not the level of the monthly pension. The pension legislation provides, however, for the employee to make voluntary contributions, which, combined with the basic contributions of the employer and the employee, cannot exceed 20 per cent of the employee’s salary.
The contributions of the employer and the employee plus the income that they earn form the basis of the pension the retired person receives. This sum is calculated by a qualified actuary.
The defined benefit plan offers a greater level of certainty to the pensioner as the onus is on the employer to ensure that there is sufficient money to pay the defined benefit, so in this arrangement, it is both the contribution and benefit that are defined. There is a prescribed formula that states clearly how the annual pension is to be determined at retirement.
There are several options, including the career average salary plan, the modified career average salary plan, and the final salary plan. In the latter, pensionable salary may be based on final salary, average annual salary over the last three years, average annual salary over the last five years, or some other number of years, depending on what is provided for by the plan rules. The final salary plan generally yields the best pension.
In the defined benefit plan, the Plan Rules set the employee’s basic, or compulsory, contribution rate, and the employer is required to contribute what is needed to make it possible to pay the defined pension. There is, however, provision for the employee to make a prescribed level of voluntary contribution in some cases. These contributions and the income they generate are used to provide a pension benefit in addition to the defined pension benefit.
The maximum annual pension allowable at the normal retirement age is 75 per cent of final salary where pensionable service is 37.5 years or more, and some employers provide some protection against inflation through indexation. In such a case, the pension is indexed to inflation.
There is a significant tax benefit to people who are members of an approved pension arrangement: The portion of the employee’s pay that is deducted and contributed to the pension fund is not taxed. Neither is the income that those contributions earn in the pension fund.
This favourable tax treatment is very significant to the pensioner although the portion of the pension that exceeds the income tax threshold is taxed at the regular personal income tax rate of 25 per cent.
It is not mandatory for employers to provide a pension for employees. People whose employers do not make such a provision have the option of providing for the retirement years by participating in an approved retirement scheme, which provides for people like themselves and the self-employed. They may contribute up to 20 per cent of their income entirely by themselves.
In cases in which their employers opt to contribute, the combined amount should not exceed 20 per cent of the employee’s annual income. It is worth noting, though, that approved retirement schemes are defined contribution plans.
Notwithstanding any formal pension arrangement that is in place, the wise course is to amass additional funds for retirement. The more money there is in the retirement years, the better the chance for financial independence and for maintaining a lifestyle in line with that of the pre-retirement years.
Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. Email: [email protected]
