Are you employed by the public sector? If so, it’s probable that you have a defined benefit pension plan.
It’s common to contribute between 7% to 13% of your income to these plans.
That’s a good chunk of coin when aggregated over a 25+ year career.
Naturally, you may wonder how the pension compares to a case where you instead invested contributions on your own. More specifically:
- With the standard market return, what would be the value of my portfolio if I self-invested the money I contribute to my pension plan?
- Would this portfolio provide retirement income comparable to my pension payments?
- What rate of return would I need to get the same retirement income as my defined benefit pension will provide?
- How would my defined benefit pension compare to a defined contribution pension with a 100% employer match?
This post exists to answer these questions. It will also be useful for those with a defined contribution pension to compare to a defined benefit pension.
I use concrete examples with numbers from the pension for Canadian Armed Forces members.
These numbers will be accurate well to most other Defined Benefit pension plans. I don’t have time to look at all plans, but can confirm my assessment will apply well to the following plans:
- Public Service Pension Plan
- Health Care Of Ontario Pension Plan (HOOPP)
- Ontario Teachers Pension Plan
Table of Contents
What Is A Defined Benefit Pension
A defined benefit pension provides a payment in retirement that is guaranteed by your employer.
Your income in retirement is “defined” based on a formula. And that formula has nothing to do with the investment performance of the pension plan.
That’s nice for you.
The employer takes on all of the investment risk. Relative to the average Joe, that means you can afford to take on more investment risk when self-investing outside of your pension.
The money you contribute is invested in assets by the pension plan. It’s often a mix of stocks, bonds, and real estate.
You can check out your specific pension plan to figure out where the money is invested. I like knowing where my hard-earned money is invested.
The PSP Plan for example invests for the Canadian Armed Forces, Public Service, and RCMP pension plans.
In this snip, capital markets are stocks and bonds.
Private equity is ownership in small businesses. Since a stock represents ownership of a business, it is very similar to stock market investing.
If you have a DB pension, you are technically a stock market investor, indirectly.
The "Defined Benefit": Your Retirement Income
The benefit in retirement is “defined” based on a fancy formula. That’s why it’s called a defined benefit pension plan.
Most defined benefit pensions calculate your benefit based on the average of your best 5 years of pay and your number of years of service. This is how it works for the Public Service, Military, RCMP, Ontario Health Care, and Ontario Teacher’s plans.
Here is the formula:
Annual pension income= (2%) x (years of service) x (Avg of Best 5 Years of Pay)
With 25 years of service, you’ll get an annual pension income of 50% of the average of your best 5 years of pay. Work for 30 years, and this increases to 60%.
Example: Defined Benefit Pension Income
Fred retires in 2020 as a Captain in the Canadian Armed Forces after 25 years of service. He makes $110,000 per year in each of his best (and last) five years.
Fred’s annual pension income= (2%) x (25 years of service) x ($110,000) = $55,000.
After 25 years of service, Fred pulls $55,000 per year of pension income. That $55,000 of income is his defined benefit.
Once Fred hits age 60, his pension will be indexed for inflation, meaning his $55,000 income will increase with the cost of living based on the Consumer Price Index.
What Is a Defined Contribution Pension Plan
With a defined contribution plan, an employer helps you beef up contributions to an investment plan. These helpful contributions from the employer are “defined” by a formula, hence the naming convention.
Unlike a defined benefit pension, you are responsible for the investing portion of your plan, and your retirement depends on how well your investments perform.
The investment risk is on you, not your employer.
The defined contribution is defined by a formula that is often some form of an employer match. Under a 100% employer match, your employer would match your contributions 1:1.
For example, say you invest $6,000 into your RRSP this year. Your employer will also contribute $6,000. In total, you’ll invest $12,000 for retirement.
I like to view a 100% employer match as an immediate 100% return on your money.
Below I’ll crunch the numbers for a 100% match defined contribution plan versus the Canadian Armed Forces defined benefit plan. They come out surprisingly close.
Your Contributions To The Defined Benefit Pension Plan
It is probable that you contribute 7% and 13% of your income to your defined benefit pension plan.
I can’t give you an exact amount because your contributions depend on the pension plan and how much you earn. With some light research, you can find specific rates for your pension plan.
This does not include the other 6% of your income that you give to the Canadian Pension Plan (CPP).
Here are some contribution rates pulled from the Treasury Board for the public service pension plan, the Canadian Armed Forces Pension. I also pull the Health Care of Ontario Pension Plan (HOOP).
Note the two-tier system. You pay a lower rate on the first $64,900. The reason for this is due to CPP.
But it’s not as it seems. I’ll show below that you actually pay a higher rate on the earnings up to the CPP maximum ($64,900 in 2022).
Below are the HOOP pension rates for healthcare workers in Ontario. Thanks for your work by the way. YPME stands for yearly maximum pensionable earnings and is related to your payments into CPP up to the CPP maximum ($64,900 in 2022).
Let's Talk About CPP Contributions
The defined benefit plans above all integrate CPP payments into your pension income. The defined benefit income (based on the formula) includes the CPP payments once they start coming in at age 65.
Therefore, you must include CPP contributions when comparing the defined benefit pension to self-investing. When self-investing, you are just going to invest the total contributions and see what that produces in retirement.
And you contribute a good chunk of income to CPP. In 2022, you contributed 5.7% of your income on the first $64,900 of earnings.
You contribute nothing to CPP on earnings above that amount. That’s why your paycheck jumps at the end of the year if you make more than ~$65k/yr. You can find CPP contribution rates here.
For the total contributions that result in your defined benefit, I will add 5.7% to the first tier of contribution rates below the CPP maximum as defined by your pension plan.
This shows the total contributions that result in your defined benefit pension cash flow in retirement. I show the total contributions (CPP + Pension Plan) for three big pension plans below in 2022:
|CAF Pension||Public Service Pension||HOOPP Pension|
|Earnings Up to the CPP Maximum Including CPP||15.06%||15.06%||14.90%|
|Earnings Over The CPP Maximum||12.48||12.48||9.20%|
Using Safe Withdrawal Rates To Find A Portfolio Value Equivalent
Retirement income comes from investments.
In my above example, Fred received $55,000 per year for life as his defined benefit pension.
But what size of an investment portfolio would Freddy need to pull $55,000 for life?
For this, I must cover safe withdrawal rates. This will allow you to calculate a portfolio value equivalent to your defined benefit pension.
Safe Withdrawal Rates
By definition, retirement is possible when you can live off investment income.
A safe withdrawal rate (SWR) is an annual amount you can safely withdraw from an investment portfolio, adjusted for inflation, without running out of money. It is expressed as a % of the total portfolio value.
For example, you can pull $30,000 from a $1,000,000 portfolio with a 3% SWR.
The income comes from selling off stock for capital gains, through dividend income, or via interest income if there are bonds in the portfolio.
Learn more about SWRs in this post, including picking one that works for you based on your unique retirement circumstance.
Investment Portfolio Required To Match the Defined Benefit Pension Plan
Now you can figure out what size of a portfolio Fred would need to match his $55,000/year pension.
Using an SWR of 3%, Fred’s portfolio must be ($55,000)/0.03 = $1.8 million.
A $1,800,000 portfolio is expected to provide Fred with $55,000 of investment income, adjusted for inflation.
What is the portfolio value equivalent of my defined benefit pension?
I like the 3% SWR. To figure out your portfolio value, take the pension amount under your defined benefit pension plan, and divide it by 0.03.
Accounting for inflation is a must over a 25-year period. Everything will cost twice as much in 25 years if inflation averages 3% ( 1.03^25 = 2.1x). Over 25 years your purchasing power of cash will erode to 50% of its original value.
Inflation has three main effects when it comes to your pension:
- Your wages will increase over the 25-year period, and so your contributions to the pension plan will also increase.
- The best 5 years will be much higher than the pay scales say today, adjusting the start of your pension to inflation.
- Inflation will continue once pension payments come in, so the payments need to increase with inflation (called “indexing”) to sustain purchasing power.
I’ll keep everything in 2020 dollars to keep the comparison between the defined benefit plan vs self-investing simple.
That means I’ll be using “real” investment returns when assessing DIY self-investing. This is the annual return after inflation, sometimes called inflation-adjusted returns.
Since 1922, the S&P 500 has provided 10% nominal stock market returns. But with a 2.7% inflation rate during that time, the real return was 7.3%. Real returns are what you should care about.
Defined Benefit vs. Self-Investing: The Showdown
This is where the fun starts.
I’ve crunched the numbers for a Canadian Armed Forces member named George (my dog’s name).
George enrolls as a private in 2020 and retires 25 years later in 2045 as a Warrant Officer.
I assume George can opt out of his defined benefit pension and that he invests those contributions instead.
Who comes out on top?
Will George be able to match the defined benefit pension income by investing in stocks on his own? And what rate of return would George need to match the pension?
The assessment should be very similar for federal workers in the public service, RCMP, teachers, and Ontario Health Care Workers. A high salary just means more contributions and more retirement income.
Crunching The Numbers
What rate of return would George need if he invested his contributions instead?
- George earns $84,804 in each of his best five years.
- After 25 years of service, George receives 50% of his best five years.
- His pension income is therefore $42,402, in 2020 dollars.
Here is a breakdown of George’s contribution rates over his career, including CPP:
|Pension Contribution Rates (2022)|
|Earnings Under $64,900||15.43%|
|Earnings Over $64,900||12.26%|
Throughout his career, George contributes a total of $272,300 to CPP and the pension plan. As I covered above, CPP payments make up a portion of George’s pension income.
George has $42,402 of pension income in retirement. What portfolio size is needed to produce $42,402 in annual investment income?
Using a Safe Withdrawal Rate of 3%, George’s pension income is equivalent to a portfolio of $1,413,400 (2020 dollars).
What portfolio size would George have if he invested his pension contributions instead?
I assume George invests in a portfolio of 100% stocks, using a total market global index fund. George is brilliant. He knows that markets are efficient and that index funds optimize risk-adjusted returns.
To estimate future returns, George reflets on the last 122 years of global stock market returns. He uses a return of 5.3% after inflation. That’s 8% before deducting 2.7% for inflation.
By investing his pension contributions, George ends up with an investment portfolio of $639,512 in 2020 dollars. Using a 3% SWR, that only provides $16,000 in pension income.
|Annual Pension Cashflow||$42,402||$16,223|
|Portfolio Size Needed (3% SWR)||$1,413,400||$540,700|
Clearly, there is no comparison. The defined benefit pension and CPP combo provide more than twice the income of a DIY investing approach.
If you are curious about specific characteristics of investing, check out my assessment of 30 Years Of Stock Market Returns: Top Pains and Gains.
What Returns Do You Need To Beat The Defined Benefit Plan?
To match the pension, George would need his investments to grow to $1,413,400 in 25 years.
To match the pension George would need a 12% real annual return, or 15% before inflation adjustment, compounded over a 25-year period.
Alternatively, George could invest $2,350 per month (in 2020 dollars) for 25 years, for a total of $690,000 in contributions. That’s way more than the $272,300 George put into the defined benefit plan.
Wish George luck. He will need it to get those returns over a 25-year period.
Defined Benefit Vs. Defined Contribution Plan
Let’s now compare George’s defined benefit to a defined contribution plan where the employer provides a 100% employer match.
George self-manages his investments and uses a global total market index fund. I assume he gets a 5.3% inflation-adjusted return (8% before inflation) over the 25-year period.
I simply double the contributions from the defined benefit plan example above since his employer matches his contributions under a defined contribution plan.
Total Contributions: $544,700
Total Portfolio Value at Year 25: $1,081,500
Pension Income Using 3% SWR: $32,450
Pension Income Using 4% SWR: $43,260
Defined Benefit Pension Income: $43,402
The defined benefit and defined contribution plan are close using a 3% SWR. And I am surprised to see that the defined contribution plan outperforms using the more aggressive 4% SWR.
But my comparison between the defined benefit vs the defined contribution pension is not complete. I need to consider risk and human behavior.
Self-Investing vs. Defined Benefit: Other Factors
The defined pension comes with massive benefits that can’t be described with numbers. These benefits relate to investment risk and human behavior.
The Defined Benefit Pension and Self-Discipline
Let’s assume you can opt out of your defined benefit plan tomorrow. The income hitting your bank account suddenly increases by about 10%.
Self-discipline is the only thing preventing you from spending this new-found dough on a new Camaro or an annual trip to Europe.
This self-discipline applies to a defined contribution plan. Under these plans, the individual must sacrifice spending today to get the employer match. Self-discipline is required.
Defined benefit pension contributions are automatically removed from your pay. Your mandatory pension plan contributions are a form of forced savings. They require zero willpower from you.
It may be frustrating to see 10% of your pay removed every year. But you’ll be thankful later down the line.
Defined benefit income is based on a formula. I don’t see investment performance anywhere in that formula!
Your pension income is not dependent on the performance of investments. The government eats the risk of poor investment outcomes.
This is way different from a defined contribution plan where you absorb the investment risk.
Stock and bond market returns are not risk-free returns. There is uncertainty in the end-wealth value. And therefore, there is uncertainty in your pension income after 25 years. Learn more about investment risk in this post.
The risk-free nature of DB plans is comparable to an insurance product rather than an investment plan. Your DB pension is more similar to annuities offered by insurance companies.
What does the risk-free nature of the defined benefit pension mean for you?
Well, you have a higher ability to take on investment risk outside of the pension (such as in the TFSA).
For a fair comparison to a defined benefit pension, you would have to compare the returns on a risk-free asset such as government bonds.
I like to use the 10-year treasury bill yield as my risk-free return benchmark. It returns around 4% in 2023.
Investing Knowledge and Human Behaviour
A defined benefit plan takes care of the investing for you. You don’t see your investment value fluctuate from day to day, month to month, or year to year. This limiting the emotional rollercoaster that causes most investors to buy-high and sell low.
For example, the money you contribute to your defined contribution plan probably did something like this during the 2020 COVID crash without you even knowing:
Emotions make investing hard, even for the best investors.
The emotions experienced during market crashes trigger a strong desire to panic sell that is rooted in biological loss aversion tendencies.
We all feel this. Loss aversion evolved to keep you and me alive.
Trouble remaining invested is the primary reason that individual investors underperform the market. Loss aversion drives decisions that cause you to buy high and sell low.
It’s hard to let your money sit. Investing is the only activity where it is hard to do nothing. It’s also the only activity I know of where doing nothing is needed for success.
You can learn more about how to do nothing and remain invested in my post on Behavior and Investing: 7 Ways To Control Emotional Biases.
Taxes and Employer Contributions to the Defined Benefit Plan
I disregarded taxes in this post to minimize complexity. Both defined benefit and defined contribution plans work under a tax-deferred mechanism.
That means that the income you contribute to the pension is not taxed today, and can grow tax-free. Defined contribution plans use the RRSP.
But you are taxed when on your pension income in retirement. The taxes are “deferred” into retirement.
Finally, I left out employer contributions to the defined contribution plan.
You can figure out employer contributions by looking at your T4. You’ll see that box 52 “pension adjustment” is higher than box 20 “RPP Contributions”.
The difference between these amounts represents your employer contributions.
I’m glad you made it this far. This post was supposed to be short. It instead exploded in length.
DB = Defined Benefit
DC = Defined Contribution
Summary of key points:
- Under a DB plan, the employer guarantees your pension income based on a “defined” formula. The employer takes on investment risk. There is certainty in pension income.
- With a DC plan, the employer “defines contributions” based on a set formula. They often match your contributions. You take on investment risk and are responsible to manage investments. There is high uncertainty in pension income.
- The DB pension and DC pension can produce similar income in retirement if the employee gets a 100% employer match and a 5.3% inflation-adjusted return (real) return.
- The DB pension provides the equivalent of a risk-free return and eliminates demands on your self-discipline.
- To beat a defined benefit pension plan, you would need to achieve 12% real annual returns or 15% after inflation.
- A 100% match-defined contribution plan invested in a total market index portfolio of global equities (stocks) will provide pension income similar to a defined benefit plan if the market returns are in line with the historical average.