Wednesday, 5 July 2017

Defined Contribution (DC) Pension Plan

For the unfortunate majority of workers who do not participate in company sponsored Defined Benefit (DB) pension plans, but instead contribute to DC plan instead, below are a couple of watch-outs. The typical DC plan includes a 50% matching contribution from the Employer up to 5% of salary (or 2.5% Employer + 5% Employee).  This is great because you get to double your money from get go.  However, unlike a traditional DB plan where future benefits are promised, you have to roll the dice with a DC Plan and select your own investments, ranging from targeted benefit investments to various equity and fixed income funds. And the biggest drawback is that future benefits are not certain despite the constant belief that the stock markets have always provided an average return of 10% or so. Tell that to the folks who suffered a 30% haircut in 2008 during the U.S. credit crisis when they were about to retire.

What I wanted to discuss further is actually the Management fees, or also known as MER, IMF and a host of other names. These are fees charged by the investment managers to operate the fund, regardless of whether the fund returns are positive or negative. The fees can range from a low of 0.1% to more than 2%. 

What I finally realized from looking at the fund prospectus is that in a typical DC Plan, the average fund in a DC plan is higher by at least 0.3% compared to a similar Exchange Traded Fund (ETF) as illustrated below. This, despite the promise that there are savings to be generated. The truth of the matter is that there are other fees tacked on to the MER besides the typical MER in a similar ETF.  I am not exactly sure what these fees are, but will try to find out.

On many  occasions, one can even leave the funds in the DC Plan when one retires.  But if I can make a suggestion, you would be best served if you move the money to a self- managed ETF. For a $1 million portfolio below, there are savings of at least $3,500 per year pre-tax by doing so. It may appear insignificant at first, but the amount adds up if you consider the fact that you will live an additional 20-25 years to live assuming you retire at the age of 65.

ETF
DC Plan
Savings in Fees
TSX Composite Index (70%)
$700,000
$700,000
Management Expense Ratio (MER)
0.050%
0.335%

  Fees
$350
$2,345
$1,995
Canadian Corporate Bonds Index (%)
$300,000
$300,000
Management Expense Ratio (MER)
0.090%
0.345%

  Fees
$270
$1,035
$765
Assume 70% Equity/30% Bonds
$1,000,000
$1,000,000
Management Expense Ratio (MER)
0.062%
0.338%

  Difference in Fees on a $1M portfolio
$620
$3,380
$2,760
     Assume 20% tax on $60,000 income, annual pre-tax income on savings in fees
$3,450
ETF - Exchange Traded Funds, managed by individuals, commissions may apply
DC Plan - Company sponsored, management and OTHER fees (MER) paid by employees

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