About Us > How Pension Plans Work

How Pension Plans Work

Pension plans are complicated, but the basic theory can be broken down into a few simple parts. They are:

Funded or Non-Funded
Defined Benefit or Defined Contribution
Contributory or Non-Contributory
Integrated or Non-Integrated

The main objective of a pension plan is to pay a lifetime stream of payments to retired employees and, after their death, to their surviving spouses. It is not like a life insurance policy, where the objective is to leave one large cash payment to a beneficiary.

The usual way for pension plans to meet their objective is to accumulate and invest contributions while the member is employed, and build up a pool of assets sufficient to pay out a pension during the member’s retirement years.

Funded or Non-Funded

Funded pension plans build up assets during members’ employment so that the total contributions plus investment earnings for each year will be sufficient to pay for the pension benefit earned each year by every member.

In a non-funded or “pay as you go” plan, there is no fund created - benefits are paid from an employer’s current revenues, or by government out of current taxes.

All pension plans registered with the government are funded, including the CAAT Plan. Even the Canada Pension Plan (CPP) is now partially funded.

Defined Benefit or Defined Contribution

In a Defined Benefit plan, the pension you will receive is defined up front as a promised dollar amount or promised per cent of your earnings for each year of service. The obligation of the plan is to ensure it has sufficient assets to pay out the pension promised. If it doesn’t, contributions have to be increased.

The CAAT Plan is a Defined Benefit plan because your pension is a defined percent of your earnings for each year of service.

In a Defined Contribution plan, the contribution going into the plan is defined up front, rather than the benefit. A Defined Contribution plan is also known as a money purchase plan, because the pension is equal to whatever the contributions plus investment earnings will purchase at retirement.

In contrast to a Defined Benefit plan – where the contributions must be sufficient to pay for the promised benefit – in a Defined Contribution plan the employer’s only obligation is to contribute the promised amount. There is no guarantee about what the ultimate pension will be. If the value of the investments goes up just before the plan member retires, then it will buy a bigger pension.

On the other hand, if the value of the investments goes down just before a retirement, then the amount of pension it will buy will also go down. In a Defined Contribution plan, the investment risk is with the employee.

Any Registered Retirement Savings Plan (RRSP) that you may have is a type of Defined Contribution plan. You know what your contribution is, but you don’t know what the ultimate value will be. A Defined Contribution plan is like an RRSP to which your employer contributes.

Contributory or Non-Contributory

In a contributory plan, both you and your employer contribute to the funding. In a noncontributory plan, only the employer contributes. The CAAT Plan, like most public sector plans, is contributory as both you and your College contribute. In our Plan’s case, the College contributions are equal to the employee’s contributions.

In a typical Defined Benefit plan, the employer is responsible for funding any deficiencies or shortfalls that emerge. In our Plan, employees and Colleges share equally in funding any shortfalls through equal increases in contribution rates. However, in our Plan, both Plan Members and Colleges also have the right to share equally in any surpluses.

Integrated or Non-Integrated

This concept, which applies only to Defined Benefit plans, is possibly a little harder to grasp.

Let us first look at non-integrated plans, also known as “stacked.” In a non-integrated plan, the pension formula does not explicitly take into consideration the additional pension benefits that are provided from government social security – the Canada Pension Plan in our case.

On the other hand, many pension plans, including most in the public sector, have an objective that all employees across all salary levels should receive roughly the same percentage of total retirement income from the employer’s pension plan and CPP combined.

The only way to achieve this is to have an integrated formula in which government social security – CPP – is explicitly recognized.

It is commonly accepted that in retirement, a typical retiree should plan on needing about 70% of pre-retirement income in order to maintain a similar standard of living. At the time the modern pension structure came into existence, 35 years of service was the maximum amount that the government recognized for paying pension benefits. As a result, pension calculations tend to assume that an individual will need 2% of preretirement income annually, over 35 years of service, to reach the required 70%.

The CAAT Plan, like most public sector plans in Canada, has an integrated pension formula that reflects this concept: 1.3% of Highest Average Pensionable Earnings (HAPE) up to the Average YMPE (AYMPE) and 2% of HAPE for earnings above the AYMPE.

Why do we have a lower benefit rate for earnings up to the AYMPE than for earnings above the AYMPE?

To answer this, we must keep in mind the objective of providing a total pension for the CAAT Plan and CPP combined of 2% of HAPE for each year of service with the Colleges across all salary levels.

Also, the CAAT Plan assumes that a Member will earn the full CPP pension over 35 years. The CPP pension is equal to 25% of a contributor’s Pensionable Earnings up to the AYMPE. If we divide 25% by 35 years, we end up with 0.714%. For the sake of simplicity, the CAAT Plan rounds this to 0.7%.

If the retirement income objective is 2% for each year of service, and CPP is equal to 0.7%, then the CAAT Plan needs to provide a pension of 1.3% on earnings up to the AYMPE so that the objective of 2% can be attained:

1.3% + 0.7% = 2.0%.

This only applies on earnings up to the AYMPE as CPP does not provide any pension on earnings above the AYMPE. That is why, for earnings above the AYMPE, the full 2% benefit rate comes from the CAAT Plan.

Bridge Benefit

When CPP was first established, the CPP benefit could only start at age 65. This meant employees retiring before age 65 would have a shortfall in their pension of 0.7% of Highest Average Pensionable Earnings up to the AYMPE for each year of service.

So that the 2% objective could be met, the CAAT Plan, like most major pension plans, provided an extra benefit roughly equal to the CPP benefit earned while working for the College until CPP started at age 65. This extra benefit was called a “Bridge Benefit” as it bridged the pensioner from time of retirement to age 65 when CPP started.

Even though CPP can now start as early as age 60 on a reduced basis, the CAAT Plan assumes everyone starts collecting their CPP at age 65 for the purposes of paying the Bridge Benefit. This means that Pensioners will continue to receive their Bridge Benefit from the CAAT Plan up to age 65 even if they started to receive a reduced CPP benefit before then.

January 2008