What a difference two years make. With slowed economic markets and corporate accounting scandals, the infatuation with defined contribution pension plans (DC) has waned.
Double-digit returns are gone, replaced by negative or minimal growth. Plan members, many of whom don’t remember the pain of a prolonged bear marked, have been unprepared for this outcome and notably upset with the diminished value of their retirement portfolios. Some DC plan members may be longing for the good old days when their pensions were guaranteed under a defined benefit plan (DB). Many older members now believe that they must defer their retirement age by a few years.
While DC plans may currently be out of favour among employees who do not properly understand investment strategies and are not willing to patiently sit out market volatility cycles, they are still a viable and appropriate vehicle for providing retirement incomes.
Among the options
A myriad of retirement schemes exist — DB, DC, Flex Pensions, Group Registered Retirement Savings Plans (RRSPs), Deferred Profit Sharing Plans (DPSP) and Hybrid Plans — all with a variety of structures and options making them unique for each organization. The key to having the right plan is in understanding the needs and values of your workforce and the role played by pension plans in overall attraction and retention strategies.
Group RRSPs are typically found in smaller companies or as an added savings element to an existing DB or DC plan. This is likely due to the fact that Group RRSPs are not subject to provincial pension legislation and therefore are seen as easier to administer than a registered DC plan. For this reason Group RRSPs are viewed by both the employer and the employee as a savings plan not a pension plan since benefits vest immediately and are not locked in.
DC plans are more prevalent in mid-size to larger companies that either believe that they should be helping employees save for their retirement or where there is a competitive pressure to have some form of pension plan in place, but where there is no desire by the employer to assume the risks associated with a DB plan. As DC plans are subject to provincial legislation, there are rules that dictate the minimum vesting period for benefits and how benefits can be paid out on termination and retirement.
Hybrid Plans, such as Flex Plans, tend to evolve from DB plans where employees are concerned about the loss of tax sheltered savings. These plans allow DB members to make tax deductible contributions that do not impact their RRSP room and they get to control how these contributions are invested, thereby benefiting from the safety of the DB benefit yet participating in the markets through their contribution accounts. These plans pose no additional cost to employers other than the costs associated with the increased communication and administration required as a result of the flexible contributions.
Finally, Deferred Profit Sharing Plans usually exist side by side with another form of plan, often a Group RRSP. Since DPSPs require that the contribution formula be related to profits, these plans tend to suit companies that want to motivate employees by having them share in the profits.
Employees are not allowed to make contributions and there is a much lower limit on the employer contribution to the DPSP than there would be in the other plans referred to above.
The advantage of a DPSP over a Group RRSP is that employer contributions do not have to vest immediately, so that short service employees forfeit their benefits which can lower the employer cost.
Also employer contributions to a Group RRSP can lead to higher payroll taxes since contributions made by an employer to a Group RRSP must be made by grossing up employees’ pay and then deducting the contributions.
This is not the case for employer contributions made to a DPSP since contributions can be made directly without having to flow through the employee. This is an especially important difference in the case of an employer with a low paid workforce.
One last comment on the differences between these plans: DC plans have always been seen to have a higher fiduciary responsibility than a Group RRSP or DPSP and usually came about where an employer had sufficient internal resources, such as a pension committee, to monitor the plan and the funds.
The current trend in the governance of these plans, is that Group RRSPs and DPSPs will be subject to the same fiduciary responsibilities as DC plans and, therefore, require internal resources to a greater extent than originally thought.
DC pension plans face many challenges, including optimizing investment efficiencies and returns, creating a sound governance structure and dealing with employee expectations and understanding of investment risk. Nevertheless, they are expected to continue to grow and overcome these potential obstacles simply because they can be used by plan sponsors to offer a retirement benefit that has a stable contribution rate and is relatively easy to administer.
DC plans tend to appeal to an increasingly mobile and sophisticated workforce. A DC plan may be the right plan, if the primary objectives of the plan sponsor are to:
•allow plan members flexibility in making their own investment choices, empowering employees who want to control their own financial outcomes;
•reduce employer costs and ease financial burden, making costs controllable and predictable;
•encourage tax-effective employee savings;
•minimize the loss of RRSP room resulting from being a DB plan member;
•ease the administrative burden, as compared to DB plans;
•provide a benefit that is easy for employees to understand, increasing employee appreciation of the plan;
•provide the same annual cost to all employees, regardless of age and service;
•relative to Group RRSPs, allow employer contributions to be forfeited upon early termination of service and allow forfeited money to be used to reduce future employer contributions or be re-allocated among remaining members; and
•ensure benefits are locked-in for retirement as opposed to Group RRSPs where members can cash out their accounts.
DC plans are about the individual’s control. Thus, the appropriate long-term strategy for a DC plan should be influenced by an individual’s future earnings power (future earnings potential and future years of earnings) and personal circumstances. This is what makes the design of DC plans challenging.
In recent years, the focus on DC has been on the number of fund options offered or on contribution rates as opposed to design features which optimize the contributions actually made. Such design features include:
•lifecycle and default options that incorporate good-practices;
•education that helps individuals understand the strength of their future earnings power in order that they may adapt their investment strategy to fit their personal circumstances; and
•payout, draw-down and rollover features that facilitate post-retirement flexibility.
Just as with defined benefit plans, the asset allocation decision is of central importance, but with DC plans, these allocations are decided upon by the employee and not the employer. With defined contribution plans, success can only be achieved by giving members the right options, and helping them to make the right decisions.
Goals for best practice in DC plan design are simplicity, flexibility and efficiency. Drawing on different models from around the world, the following framework for DC plans results:
•Basic features should include a core list of funds for core contributions. These core funds should incorporate lifecycle characteristics so that members can move from one risk profile to another without a high degree of proactive choice. It is also important that members be given enough education to understand these lifecycle funds and hence feel comfortable with them.
•Extended choices should exist on top of these core funds so that members who are competent enough to make such decisions can benefit from the full range of opportunities. These extended funds should range from low-risk, long-term funds such as real return bonds through to riskier asset funds such as global equities. It should be noted, however, that many members lacking appropriate investing skills may make wasteful decisions — especially when given too many choices.
The key message is that members need to understand the context and long-term nature of their investments. They should also have a strategy in place that fits with their goals and investment expertise. This is complimented by the lifecycle principle which is supported by a very strong financial argument. According to this principle, members should not rely on a disproportionate contribution from risk too close to retirement — without making a conscious decision to do so. The lifecycle approach also fits with the basic thesis that future earnings power and individual circumstances should determine how people invest their DC assets.
Plan sponsors should also consider any legal restrictions related to DC plans. It is worth noting that while the investment risk rests with employees, plan sponsors must manage their own risks by ensuring that:
•a broad range of investment options is provided;
•sufficient information is provided to members to enable them to understand how to invest as well as both the risks and future value of their plans;
•plan members can exercise independent choice and have an opportunity to respond to market changes;
•investment education is provided rather than investment advice, and
•prudent actions are taken, decisions are documented and a due diligence process is followed when hiring the fund manager and selecting appropriate investment options.
Moreover, unlike the U.S., no “safe-harbour” exists here in Canada providing plan sponsors exemption from potential adverse legal repercussions where DC plan members make their own financial decisions. The Joint Forum of Financial Regulators has been looking at this issue and is expected to issue guidelines (Proposed Regulatory Principles for Capital Accumulation Plans) for plan sponsors by the end of the year.
What’s in the cards for the future?
DC plans are here to stay and will likely increase in prevalence — but some of the quirkiness needs to be ironed out.
In particular, there is a need to examine governance issues and obtain a clear delineation of what it is that plan sponsors are ultimately responsible for. Employees need to better understand the investment world and how they play a part in their pension outcomes. Plans need to be designed that are flexible and efficient — and they need to align with an employer’s workforce and business objectives.
Janet Robovsky is a Toronto-based consultant, investment consulting practice, Watson Wyatt Worldwide. Lori Satov, is a Vancouver-based consultant, retirement practice, Watson Wyatt Worldwide. Both are available through firstname.lastname@example.org or 1-866-206-5723.