Providing comfortably for retirement was an individual responsibility in
years gone by. Retirement from corporations was accompanied by a gold watch and
a small monthly stipend in the years following the massive industrialization in
the 1800s and early 1900s. The growth of unions and the inevitable vagaries of
human nature caused these private and informal arrangements to become regulated
by governments. This ensured funds were set aside to provide for pensions and
that these funds were safe from graft and corruption. Governments got into the
act of providing retirement benefits with Old Age Security and compulsory
pension schemes, such as the Canada Pension Plan, as their "welfare state"
grew.
Private retirement plans fall into two categories: pension plans and retirement savings plans. Both are regulated by governments and are tax
exempt under the Income Tax Act. Where they differ is in their implementation.
Pension Plans
Pension plans are essentially a promise by a sponsor, usually a company
or a union, to pay a pension to the plan member.
In a "Defined Benefit" plan, the promised pension is based on a
clearly defined formula such as years of service or hours worked. In a "Defined
Contribution" plan, the promised pension pension is based on whatever the
invested contributions grow to. The difference between the two types of plans
lies in the obligation of the sponsor and who accepts the investment risk of the
plan.
In a defined benefit plan, the sponsor owes the pension to the plan
member according to the established formula, independent of the investment
results of the plan. If the investment earnings of the plan are inadequate
to fund the promised pensions, the sponsor is obligated to pay the pension
anyway. Governments mandate that pension plans must be valued by actuaries on at
least a triannual basis to ensure the "solvency" of plan. Actuaries
estimate the amount owed the sponsor, the liability, and compare this to the
invested assets of the plan. If they are equal, the plan is said to be "funded";
if the liability or amount owed is in excess of the invested funds available,
the plan is said to be "under funded"; if the assets of the plan
exceed the potential liability, the plan is said to be in surplus. The ownership
of this "surplus" is one of the more controversial issues in the
retirement world today. Since the 1980s and 1990s have been very good years for
investment results, many defined benefit plans are in substantial surplus.
Sponsors, arguing that they are only legally liable to pay the promised pension
argue that the surplus is theirs alone. They also argue that they would have
been liable to pay any shortfall in the plan. Employees argue that the pension
plan exists to pay them pensions and any shortfall is theirs alone. As in most
matters financial, the argument has been referred to the courts who examine the
plan history and documents to decide who owns what.
Defined Contribution plans involve contributions by either a plan or a
sponsor or both. These contributions are put into an investment fund in the
plan members's account and grow with the investment earnings of the fund. At
retirement, the accumulated funds are used to purchase an annuity or a
retirement income fund, which pays a retirement income. Sometimes employers
mandate how their share of the contributions must be dealt with but there is no
argument over who owns the funds as they are clearly the employee's.
Registered Retirement
Savings Plans (RRSPs)
Registered retirement savings plans are established by individuals to
save for their retirements. They are tax sheltered, which means that the
contributions are not taxed as part of income. The individual sets up an account
which is a trusteed fund (held independently) with a bank, trust company or
insurance company. The contributions that are made are put in an investment
option chosen by the individual. Investment earnings inside the plan are not
taxed, but must be used to purchase an annuity or retirement income fund by age
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