The Design and Administration of Employer-Sponsored Pension and Retirement Plans

by | Karen Reed

Three main forces influence the design of employer-sponsored pension and retirement plans in Canada:

1. Minimum standards required by legislation
2. Maximum benefit provisions permitted by the Income Tax Act and Canada Revenue Agency (CRA) guidelines
3. Plan sponsor objectives and the impact of employee demands through union negotiations.

This article identifies points to consider when designing and administering a plan in the current legislative framework and explores the general principles underlying the design of a pension plan.

Plan Types

Two primary types of pension and retirement plans are available in the workplace:

1. Defined contribution (DC) or money purchase plans. Employees are required or given the option to contribute to the plan. They typically choose how much they will contribute, within certain limits. Employers may also contribute and, depending on the plan, may be required by statute to contribute. If an employer does contribute, their contribution amount is set in advance (though it may depend on the employee’s contribution rate). The retirement benefit is what can be provided for by the accumulated contributions and investment earnings on these contributions.
2. Defined benefit (DB) plans. The benefit provided by a DB plan is based on a formula set out in a pension plan document. The employer’s contribution is determined by an actuary who calculates what is required to provide the promised benefits, taking into consideration any required employee contributions. While no law prohibits voluntary employee contributions, most DB plans do not offer this option. Instead, employees can use government savings programs for personal retirement savings. Suppose a DB plan permits voluntary contributions from the employee. In that case, the money can be used either to buy additional pension under the plan or transferred out of the plan to provide a retirement income amount via a money purchase arrangement.

Some DB plans—target benefit plans—have a benefit that is subject to adjustments depending on the ongoing contributions to the plan and the plan’s overall financial position. These plans are most commonly found in multi-employer pension plans (MEPPs) or negotiated contribution plans, where contributions are bargained under a collective agreement and do not vary based on the plan's financial position; as such, a targeted benefit is determined.

Some plans utilize elements of both DC and DB plan design. Benefits from “hybrid” plans follow one type of plan design (e.g., DC) but are subject to a minimum benefit under the other type of plan design (e.g., DB formula). “Combination” plans have a DC benefit in addition to a DB pension benefit.

Eligibility Rules and Employee Participation

Once a plan sponsor chooses the type of plan to offer, the next question is who is eligible and when. A plan may be offered only to salaried employees or hourly union workers. Eligibility requirements must comply with all human rights legislation; for example, a plan cannot discriminate by gender.

Workers may be eligible for plan participation as soon as they are hired or after fulfilling predetermined service requirements. A collective bargaining agreement with a union and pension legislation may govern the timing.

Special eligibility rules may apply to part-time employees. The plan's rules may require an employee to work a minimum number of hours per year or earn a minimum income. Again, in these situations, pension legislation may affect the minimum requirements.

Plans may be optional, compulsory or a combination of the two (e.g., optional for the first five years of service and mandatory thereafter). Some Canadian jurisdictions mandate that workers join a plan if one is available. Whether to make a plan optional, where permitted, or compulsory is extremely important because it affects the funding needed to support the plan, employee well-being, etc. Employers that provide optional plans often end up with employees who choose not to enroll. When these employees reach retirement age, they may be forced to continue working because they have no pension and, therefore, not enough income to retire. An employer may end up paying higher wages to workers with declining productivity at a time when it would like to bring younger workers into the organization. This is one reason a pension plan can play an important role in human resources and business planning; this concept is illustrated again in the Early Retirement section that follows.

Defined Benefit Formulas

When determining a pension plan’s benefit amount, it is easiest to consider what will be paid when a participant experiences specific life events. A logical starting point is an individual’s expected retirement date, defined in the pension plan document as the standard retirement date. In Canada, this date is frequently a worker’s 65th birthday or the first of the month coincident with or following their 65th birthday.

The benefit payable at the typical retirement date under a DC plan is the amount that can be provided under a retirement income vehicle by accumulated employee and employer contributions and any investment earnings. In a DB plan, the pension amount at the typical retirement date depends on the formula specified by the plan document. There are four major types of DB formulas:

1. Final average earning
2. Best average earnings
3. Career average earnings
4. Flat benefit.

Final Average Earnings

A final average earnings formula expresses the benefit as a percentage of average earnings near retirement, multiplied by years of service. The average period may be as short as three years or as long as ten years. Averaging avoids the risk of recognizing only one year that may not be representative of the employee’s earnings level. A typical formula is average earnings over the last five years before retirement, multiplied by X% per year of covered employment (generally, X is limited to 2%). This approach automatically scales the benefit over a member’s working lifetime based on any increases in earnings—These increases reflect cost-of-living adjustments and job promotions.

Best Average Earnings

A best average earnings formula—slightly more sophisticated than a final average formula—is useful in cases where the earnings of long-service individuals decline as they near retirement and their capacity to work reduces. The pension is based on the period during which employees were at peak earnings. Be aware that when earnings include incentive pay or bonuses, there may be an unexpected result—providing benefits reflecting peak economic times versus the worker’s typical pay. The difference in the benefits paid may be significant.

Career Average Earnings

Plans using a career average earnings formula calculate retirement income by using a percentage of an employee’s compensation over the entire period of covered service. For example, an employee who retires after 30 years of service might receive an annual pension of 2% of total earnings in those 30 years. A risk for the retiree with this formula is that inflation will significantly reduce the value of a pension earned from the early years of service. To help protect a retiree from the effects of inflation, career average plans frequently update benefits, so the benefits earned early in a member’s career are increased in line with the individual's actual earnings or an index such as the Consumer Price Index.

Flat Benefit Plan

The flat benefit formula is the easiest to understand and communicate. An employee receives a flat dollar amount per month in retirement for each year of covered employment. For example, an employee might receive $20 a month per year of service—This would provide a monthly pension of $600 (starting on their expected retirement date) for a person retiring after 30 years of service. The flat dollar amount is typically increased from time to time as a means of reflecting inflation. Some plans adjust benefits upwards only for future service but, more frequently, past and future years of service are treated uniformly. A flat benefit plan is most common under a collective bargaining agreement (i.e., employer-sponsored pension plans covering union employees).

Early Retirement

What happens if someone wants to retire before reaching the standard retirement age? Plans typically require a minimum age before an employee can draw a pension from the plan, generally age 55 or within ten years of the standard retirement date.

Defined Benefit Plans

Under a DB plan, the most common early retirement approach is to use the standard retirement age formula but reduce the pension by some factor to allow for the earlier commencement of the pension. The factor might be one-half of a percent for each month the person retires before the standard retirement date. Alternatively, a pension may be the actuarial equivalent of what would have been paid at the standard retirement. This means the lower early retirement pension, adjusted for a more extended payment period, has the same value as the pension that would have been payable at standard retirement (based on expected lifetime). A formula-based reduction is more easily understood by plan members, making them better able to plan for retirement. The plan can have a reduction formula that approximates the actuarial equivalent basis with minimal impact on the plan's funding.

Sometimes, an employer or union wants to encourage early retirement by using financial incentives within a DB plan—This is not practical with a DC plan. One incentive used is to waive the early retirement reduction or provide a subsidized reduction in benefits if specific age and/or service criteria are met; for example, a worker is at least age 60 and has 30 years of service. In these scenarios, the retiree receives the benefit calculated for the average retirement age or a slightly lower amount if the entire early retirement reduction is not waived. Note that the criteria for early retirement do not have to involve both age and service. Some plans provide unreduced early retirement after 30 years of service with no age requirement. Others specify an age the worker must reach, such as 60 or 62.

Another inducement to early retirement is an open window policy that gives employees a limited time to take advantage of special early retirement rules. Consider an employer that announces that employees over age 55 with 20 years of service may retire with no pension reduction if the employees retire within the next 12 months. The plan reverts to its standard rules at the end of this “window.”

Another early retirement incentive is a bridge benefit. Traditionally, the Canada Pension Plan/Québec Pension Plan (CPP/QPP) and Old Age Security (OAS) were only payable once the member reached age 65. Today, CPP/QPP payments may begin as early as age 60, but the monthly benefit amount is reduced if started before age 65.

Someone retiring at 60, for example, may want to live for five years on a corporate pension benefit alone before receiving unreduced government benefits.

To compensate for CPP/QPP benefits possibly not being taken until the age of 65 and OAS not starting until 65, some DB plans have bridge benefits that provide an additional benefit amount from the early retirement age to age 65. This benefit may be a flat dollar amount for each year of service or based on estimated full government benefits not yet being paid.

For downsizing purposes, the CRA permits plan sponsors to offer plan incentives for a limited period, including recognizing additional service, removing early retirement reductions, or adding bridge benefits. This is to help encourage older workers to retire and possibly help keep jobs for younger workers.

Whatever early retirement incentive is offered ends at the age when government benefits begin (i.e., age 65). The standard CPP/QPP pension payable at 65 can be started earlier but no sooner than age 60, although it will be reduced to reflect the longer paying period.

Defined Contribution Plans

Since the size of a DC plan benefit depends on how much money was contributed and the investment earnings on those contributions, DC benefit payments are usually less than if the individual had waited until normal retirement, barring any possible negative impact from changes in interest rates and investment losses. The three interrelated reasons for the lower DC benefit with early retirement are (1) fewer years to make contributions, (2) fewer years to earn investment income on these contributions before entering the decumulation phase and (3) the benefits will be paid out over a longer period.

Phased Retirement

Challenging economic conditions and increasing longevity are expected to motivate more workers to forgo early retirement. Many will also work past the average retirement age. Phased retirement may also become more popular.

In 2008, the Canadian tax authorities paved the way for phased retirement, which allows workers to draw up to 60% of their pension as early as age 60 (55 under certain situations) yet continue to work, contribute to a pension plan and earn pension credits. Prior to this change, plans prohibited a member from earning or accruing pension benefits while collecting a pension. Phased retirement provisions remain optional, but when incorporated into a plan, they allow workers to gradually transition to full retirement. This applies to both DB and DC plans. Plans that offer both DB and DC provisions can permit workers to receive a pension under the DB provision while contributing to the DC provision.

As of 2023, many plans still do not offer phased retirements. Several factors—including legislative action needed at the provincial level in some jurisdictions—have contributed to delayed implementation. If labour shortages become a concern, however, this option may be an attractive strategy for employers that want to keep their employees working longer.

Postponed Retirement

Most plans allow an individual to remain a member after the typical retirement age, though the benefit provisions differ. Sometimes, a worker continues to accrue pension service credits for DB plans and accumulates contributions and investment earnings for DC plans. In other cases, workers do not earn additional DB credits or accumulate further contributions under DC plans. In either case, the DB retirement benefit increases, or the pension provided by a DC balance is expected to increase (barring any adverse effects from interest rate changes and investment losses) because it will be paid for a shorter period than if the member had retired at the typical retirement age. Some plans allow employees to continue working and to start receiving a full DB pension or the funds under a DC plan at the usual retirement age without any further benefit accruals or contributions made to the plan on behalf of the member. Benefits must meet the minimum requirements of pension legislation and start no later than age 71. With the trend of delaying retirement, this feature will increasingly receive attention from individuals.

Disability Pensions

Pension plan sponsors have several options when a worker becomes disabled before retiring. When making a plan design decision, much depends on how the plan is integrated with group insurance programs. If an employer has a long-term disability (LTD) plan, it may not be necessary for the employee to be provided a pension benefit before the typical retirement age. In this case, the DB or DC plan may permit the employee to continue to earn pension benefits while disabled. In a DC plan, this means the employer may continue to contribute on the employee’s behalf at the level in effect prior to disability, including any amount representing employee-required contributions. For a DB plan that bases retirement benefits on earnings, the member may continue to accrue benefits based on earnings at the point of disability. When the disabled employee reaches age 65, insured LTD payments stop and the DB pension begins, based on the recipient’s years of service, including years of disability, or the DC plan account balance is used to provide a retirement income.

If no LTD insurance plan covers the employee, a DB pension plan may pay a disability benefit to a worker who becomes totally and permanently disabled. This benefit is usually based on the pension plan formula, recognizing service up to the date of disability, possibly including the projected service up to the typical retirement age, and without any early retirement reduction for starting the “disability” pension before expected retirement.

Some plans do not accommodate continued accruals for disabled members unless required under applicable workers’ compensation legislation, and some plans do not provide disability pensions.

Death Benefits

Another plan design issue is what to do upon the death of a plan participant. Two scenarios exist: (1) death before retirement and (2) death after retirement. In the case of death before retirement, the death benefit amount is relatively straightforward for a DC plan—The individual’s spouse, estate or beneficiary is paid the funds in the individual’s account. DB plans are more complex. However, in all plans, if the member has a spouse, the spouse is usually entitled to the death benefit unless a written waiver in a prescribed form was provided.

DB Plan Death Benefits Before Retirement

Several death benefits are available under DB plans for members who die before starting their pension. The options must comply with legislative standards. In most cases, the individual’s spouse, beneficiary or estate is entitled to receive the value of the deceased member’s accrued pension as if the member had terminated just before death. The commuted value of the pension earned may be paid as a lump sum or used to provide a pension to the spouse.

For a member who dies while still employed but was eligible for early retirement, some plans assume the deceased member retired the day before they died. This provides the spouse with the same benefits the spouse would have received had the member retired before dying.

DB Plan Death Benefits After Retirement

A DB pension plan document sets out a normal form that defines the standard death benefit when a plan member dies after retirement has begun. A normal form must be paid for the life of the individual with or without features such as those listed below. Plans typically allow members to opt for some variation of the normal form with different features more suited to the member's needs, usually provided on an actuarial equivalent or cost-neutral basis to the plan.

Optional pension features include:

• Guaranteed pension payments for a minimum period (e.g., five or ten years) regardless of whether the retired member lives this long—generally referred to as a life guarantee form
• A pension benefit that is reduced upon the death of a retired member’s spouse
• Continuation of a percentage of the pension benefit to the spouse following the retired member's death, referred to as a joint and last survivor form. The most common example is to continue the pension to the deceased retired member’s spouse at 60% of the pension amount paid while the retired member was alive. This 60% spousal option is a minimum legislative requirement when there is a spouse.

An actuary calculates the equivalent value of the pension form chosen, which could result in a lower monthly benefit than what would have been provided in the normal form. The lower amount results from the selected form, which is expected to increase the number of payments the plan will pay.

In the case of a DC plan, the form of pension is based on the type of annuity or retirement vehicle implemented with the DC funds. The form is also subject to specific legislative requirements that protect spouses.

Spousal Relationship Breakdowns

When there is a breakdown of a spousal relationship, the spouse of a pension plan member is usually entitled to a share of the pension earned during the relationship period—or to include a share of the pension as part of the equalization of family property. As might be expected, this calculation is relatively simple for a DC plan but can be extremely complicated for a DB plan. It is the plan sponsor’s responsibility to perform these calculations to the extent required by the various pension authorities in Canada. The methods vary significantly among the different jurisdictions, adding to the complexity of administering a pension plan with members in several provinces.

Termination

Working for the same employer or even in the same industry for an entire work life is increasingly rare. As a result, plans must also consider what to do with members whose employment is terminated before they are eligible for retirement.

Vesting

Most jurisdictions require immediate vesting. For a DC plan, this means employees are entitled to all their contributions to their pension plan plus their employer’s contributions, with any investment earnings on both. For a DB plan, employees are entitled to the pension earned and payable at retirement.

However, some DC and DB plans require members to work for a specified period or meet other service requirements before they are fully vested. Employees who are not fully vested have a right only to a return of their contributions with interest. They may lose some or all of the contributions an employer contributed on their behalf to a DC plan or pension earned under a DB plan.

Locking In

Vesting is often linked with locking in. While these events generally coincide, they are not the same. The government believes that money set aside for retirement should be used only in retirement. The precise rules concerning locking in vary from province to province. Generally, once individuals have participated in the plan for several years, they are not allowed to spend the money accumulating for their retirement until they retire. These funds become inaccessible within the plan, and the member must wait until a certain age to start receiving benefits, usually structured as a lifelong income stream.

Portability

Vesting, locking in and portability—transferring the value of a DB pension when moving to a new employer—were all major issues in the pension debate in Canada during the 1980s. As the rules governing all forms of retirement savings have been modified, the Registered Retirement Savings Plan (RRSP) has become one of the key vehicles in providing portability.

The commuted value—the current cash value—of a pension earned until a worker’s relationship with an employer terminates is calculated and can be transferred to an RRSP. Similarly, a DC account balance can be transferred to an RRSP. The RRSP is locked and, in many provinces, is referred to as a Locked-In Retirement Account (LIRA). At some later date, employees are permitted to use the monies in the LIRA to buy an annuity or an income-paying investment product such as a Life Income Fund (LIF). Occasionally, funds can be transferred directly from a pension plan to a LIF.

Life Income Funds

A LIF is an arrangement between an authorized financial institution and an individual who has locked in pension monies. Individuals with locked-in RRSPs or LIRAs may choose a LIF option. Upon termination, pension plans may also permit workers to transfer locked-in funds to a LIF, subject to an age limit and spousal consent. Spouses and former spouses of plan members entitled to a pension benefit may also purchase a LIF if the plan member has a LIF option.

A LIF is a locked-in version of a Registered Retirement Income Fund (RRIF). While the rules differ among jurisdictions, a LIF can usually be opened when the holder reaches age 55. Certain Canadian jurisdictions permit the cashing out or unlocking of a portion of the monies (e.g., 50%) when funds are transferred to a LIF. Saskatchewan allows locked-in funds to be transferred to a “prescribed RRIF” that is not locked, allowing 100% of funds to be cashable at any time.

Amounts in a LIF are subject to minimum and maximum withdrawals that vary by jurisdiction. The annual minimum withdrawal factors are prescribed for each age of the individual. Examples are 4% at age 65, 7.38% at 71, 7.85% at 75, 10.33% at 85, and 20% on and after age 94. In its 2015 budget, the federal government proposed reducing the minimum withdrawal rates for ages 71 to 94—for example, 5.28% at 71, 5.82% at 75, 8.51% at 85 and 18.79% at 94. There are still groups moving for the government to change the RRIF withdrawal rules given longevity concerns.

Even at higher ages, some provinces never allow more than 20% to be withdrawn in any one year unless the investment returns are greater, in which case the investment return can be withdrawn.

When LIFs were first introduced, it was generally required that the balance at a specified age be used to purchase a life annuity. All jurisdictions have since withdrawn this requirement. Now, an annuity can be purchased at any time or not at all.

Decumulation options for DC plan members to convert their balances into retirement income continue to develop. Effective for 2020, the tax rules were amended to permit advanced life deferred annuities (ALDAs) and variable payment life annuities (VPLAs).

An ALDA is a life annuity, the commencement of which may be deferred until the end of the year in which the annuitant reaches age 85. ALDAs are subject to a lifetime dollar limit of $150,000 from all qualifying plans and 25% of the value of the RPP. The lifetime ALDA dollar limit is indexed to inflation. An ALDA aims to reduce the risk of running out of income late in life.

VPLAs, available to DC and pooled registered pension plans, provide lifetime retirement income paid directly from the pension plan. The payments are based on pooled investment returns and mortality experience. Provincial pension legislation must be amended if VPLAs are to be used by DC pension plans.

Postretirement Indexing

Postretirement indexing refers to regular increases to pensions in pay to maintain the purchasing power of the member’s retirement income. The rate of increase is often related to a standard measure of inflation, like the Consumer Price Index (e.g., 75% of the Consumer Price Index year over year in September). Indexing is an expensive benefit to provide retirees and could mean that the base benefit accrual rates need to be lower during a member’s working lifetime to accommodate pension increases in retirement. Many plans, especially those not in the public sector, have eliminated any existing indexing provision or transitioned to providing conditional or ad hoc indexing so that pension increases do not need to be prefunded; increases are only granted if the plan is healthy enough to absorb the related cost.

Past Service Transfers

Many plans include a provision to accommodate a new member transferring in the value of a previously earned pension benefit in exchange for an additional pension in the current plan. A plan may have a reciprocal transfer agreement with one or multiple other plans for this purpose, where the basis on which the amount transferred and/or the pension calculated in the new plan is prescribed. Alternatively, the plan may determine a “buy back” methodology based on the accrual rate or the actuarial value of the transfer. This is becoming a more important plan design feature as employees are increasingly transient and unlikely to work for the same employer (or be a member of the same pension plan) for their entire career. The associated plan design must comply with jurisdictional pension legislation and provisions of the Income Tax Act and its regulations. Members are encouraged to understand what they are giving up and what they are getting, as plans have widely varying past service transfer provisions.

Integration

An essential and much-debated issue is how pensions can be integrated with government benefits (i.e., CPP/QPP and OAS). Integration can be where (1) contributions to the private employer plan and government plans are integrated and (2) the benefits paid by each are integrated.

Prior to 2011, it was relatively common to find private plans that blended reasonably well with government benefits. Because of changes to CPP in 2011 and QPP in 2012 as well as CPP enhancements in 2019, combined with the increase in the OAS benefits eligibility age in 2023, this is no longer true. Integrating benefits and/or contributions is extremely difficult now if a plan sponsor’s objective is to provide future retirees with income adequacy that includes government benefits (e.g., to provide an overall pension equal to 70% of preretirement income for a 35-year-old employee).

The need to incorporate benefit integration with government benefits as a plan design feature will diminish over time as government programs change and provide more options for pension start dates. Also, the employment framework is changing; members can continue working while collecting and contributing toward a government pension and, in some cases, a company pension.

Plan Administration

How a private pension or retirement plan is administered is driven by the features of the plan and the regulations where plan participants are located. Still, it is possible to identify certain commonalities in activities.

The plan administrator is the entity or body responsible for all aspects of managing plan affairs, including establishing and amending the plan. The administrator, for example, may be the employer (sometimes referred to as the “plan sponsor”) of a single-employer pension plan or a board of trustees for a multi-employer pension plan. By contrast, plan sponsors or participating employers are responsible for contributing to the plan. The following provides a sample of activities for which a pension plan administrator is responsible.

• Establish an office with the personnel, equipment and other resources required to perform plan operations. Just a small sampling of these activities includes hiring and retaining qualified individuals and entities to perform the work of the plan—coordinating professional development, maintaining office equipment and other furnishings, formulating and enforcing office policy, and assessing future needs of the plans.
• When applicable, collect contributions and other income. For example, the administrator arranges for the receipt and tracking of employer and employee contributions.
• Determine benefit eligibility and process benefit applications. The plan administrator establishes the process for enrolling employees and determines whether such persons meet the participation criteria established by the plan. The administrator also calculates or arranges for the calculation of benefits due to plan participants when life events occur, such as a disability, retirement or death. One of the most challenging duties of an administrator is the accurate calculation of benefits due when there is a spousal breakdown.
• Track and prepare reports regarding plan assets, income and expenses. A plan administrator oversees a plan's general financial accounts, including any individual member accounts under a DC plan. This information is essential to providing participants with the benefits promised by the plan.
• Retain and maintain plan data and records. The administrator maintains participants’ personal data, such as names, birth dates, contact information, date of eligibility, spousal status, beneficiary, etc. In addition to personal data, a record of how benefits were calculated and when they were paid is required. This includes plan documents and reports providing direction and supporting decisions made and processes established to calculate and settle member entitlements.
• Secure plan records and assets. Every plan should have a records retention policy specifying how long specific records should be maintained. The administrator is responsible for seeing that this policy is followed and for ensuring the safety of plan records and other property should there be a fire, flood, theft, etc. Spreading financial functions over several individuals and departments avoids monetary theft and fraud.
• Comply with applicable laws and regulations. Pension plans in Canada are presently undergoing substantial changes that require a plan administrator to keep current and, when necessary, seek the outside advice of benefits experts and legal counsel to ensure all legal requirements are met and to adjust benefit design as warranted.
• Coordinate activities of any plan professionals supporting plan operations. Actuaries, attorneys, investment consultants, accountants and technology consultants are just some of the service providers that are key to the operation of a pension plan. A plan administrator often has a significant role in selecting and evaluating these persons, identifying matters that should be referred to these consultants, assuring expert reports are provided in a timely fashion and so forth.
• Communicate with plan participants and other plan stakeholders (e.g., employers, regulators). Administrators are often the “point persons” for communication with participants, service providers, contributing employers, labour groups, etc. If a plan is voluntary, the administrator informs employees they can participate. The provision of documents describing plan benefits and other regular communication with plan participants enhances their understanding of benefits and their ability to plan for retirement. The administrator is also responsible for providing annual personalized benefit statements. At retirement, the administrator must provide clear explanations of the benefit choices available.

Whether a DB plan, a DC plan or something in between is chosen, the purpose of any pension plan is to provide plan members with a retirement income. Any new plan or program must address what type of benefits will be provided and how they will be paid for—In other words, what is the plan design? After that, what are the infrastructure or administrative requirements?

Bio

Karen Reed is an actuary and Principal at Eckler Ltd and is an expert in the design and oversight of corporate and multi-employer pension plans across a broad range of industries and jurisdictions.