April 24, 2008
To get ready to retire it is important to think about how you will finance your retirement life. Knowing how much income you can expect once you retire is an essential part to any retirement plan.
One common source of retirement income is a pension plan. A pension plan is an arrangement between you and your employer or union to help provide you with income during your retirement years. Two common types of pensions are Defined Benefit Plans, Defined Contribution Plans. In addition, many employers offer Group RRSPs retirement plans. If you are unsure which plan you have, simply ask your employer to tell you.
Defined Benefit Plans
A defined benefit plan is one where your employer or plan provider guarantees that you will receive a specific amount of retirement income. The amount is often based on three factors: how long you are employed, your income, and often the best five years of your employment history. A pre-determined ratio predicts how much of your salary you will get as a pension.
Because it is a fixed amount of income, defined benefit plans make it easier for you to plan for retirement. Typically, only big companies and governments still offer defined benefit plans. One possible reason is that such plans place the responsibility on the employer to ensure its employees receive the fixed amount of retirement income. You should be aware that as a result more and more companies, big and small, are shifting that responsibility to the employee.
Even if you are fortunate enough to have a defined benefit plan, you still need to ask some questions. How is your plan protected if your employer goes out of business? It is possible that over time the pension fund can become under-funded and require an injection of money to make it viable. Where will this money come from? Do the payments under your plan remain at a certain level or rise with the cost of living? Does your plan affect payments from the Canadian Pension Plan? The answers to these questions can change your income projections for retirement.
Defined Contribution Plans
A defined contribution plan is one where your employer or plan provider guarantees to contribute a specific amount to your retirement plan. For employers, these plans have fewer liabilities for them, are easy to administer, and cost less than defined benefit plans. Under the defined contribution plan, the actual amount of retirement income you will receive is somewhat unknown. The income depends on how much money you and your employer put into the plan and how well it is invested. Often employees choose their own investments, which mean they bear the market risk. Generally, employees who leave the company can take their portion as well as the employer portion with them if they have a certain number of years with the company, usually 2 to 5 years.
Although group RRSPs are not pension plans, they are the most popular form of retirement benefit offered by employers. It is no different than contributing to a personal RRSP except it is done through your pay cheque, creating in effect, forced savings. For an employer, group RRSPs are the easiest plan to put in place and offer a lot of flexibility to employer and employee.
With defined contribution plans and group RRSPs, calculating your retirement income is a little trickier than with a defined benefit plan. You need to take more responsibility to make certain that you have the right advisor and investments in place to ensure you receive adequate retirement income. To do this, here are three basic steps to get you started:
- Know your yourself – understand your risk tolerance and set proper investment goals.
- Work with an advisor – choose an advisor wisely to ensure they can help you achieve your investment goals.
- Know your investments – understand the basic types of investments and the risks and benefits of each one before you make a purchase to ensure they match your investment profile and goals.
Make sure you thoroughly understand the type of pension you have so that you can accurately predict your retirement income and safely plan for your retirement years. Pass this information along to family and friends. Help them be prepared for retirement and gain peace of mind.
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