A palatable pension plan

Flex benefits are popular, but flex pensions have been a bust — here’s a DB/DC combo that might make them more desirable all around

The flexible pension plan has proven to be a big bust. It’s expensive to operate and extremely difficult for members to understand. The consequence is very low enrolment in the flex portion, exacerbating the expense element. Flexible benefits, on the other hand, have thrived because employees generally understand the choices offered and like the ability to select coverage that meets their needs.

But there is a flexible pension plan that offers compelling benefits, is easy for plan members to understand and offers flexibility consistent with members’ life needs.

It starts with a basic defined benefit (DB) component. It’s designed to provide a pension in retirement that will support a basic lifestyle. For example, a benefit equal to one per cent of final average earnings for each year of service, with a spousal pension. Since it is a basic level benefit, providing some portion of inflation protection should be considered. This uses up a little less than half of the retirement savings room available under the Income Tax Act.

Next is a defined contribution (DC) component with member options. The total contribution available is nine per cent of earnings plus $600 per year. (That is the contribution room left after recognizing the pension adjustment for a one-per-cent DB pension.) It is with this DC component that members get flexibility. Some of the possible choices available are to direct the contributions to one or a combination of the following:

•A retirement fund, such as a money purchase pension plan or a group registered retirement savings plan (RRSP). By using an RRSP, members get more flexibility with access to home equity and tuition loans.

•An enhancement to the basic DB pension. The cost for each 0.1-per-cent increase to the benefit rate could be expressed as a fixed per cent of payroll or could vary by age. The former is simple and easy to understand, but discourages younger members from selecting this option.

•A health spending account (HSA). If there is already an HSA, this provides the ability to contribute additional funds.

•Mortgage principal pay-down. The contributions are retained by the employer until a date selected by the employee. Generally, that would be just prior to the anniversary of the employee’s mortgage, and then the funds are remitted to the mortgage company to pay down principal.

•A stock purchase plan for company shares.

•A non-registered savings plan.

•A registered education savings plan to save for a child’s post-secondary education. While this is paid for with after-tax money, contributions are enhanced by a 20-per-cent match (on the first $2,000 of contributions each year) from the federal government.

•A cash payment made in April to assist with paying the income tax arising from any of the “taxable” choices.

These options have different tax consequences for the plan members. The retirement fund is tax deductible and the HSA uses non-taxable money. The rest of the options are funded with after-tax dollars (including the cash payment designed to pay for the taxes due). However, that does not mean they are less attractive to a plan member. For example, studies comparing a dollar contribution to either an RRSP or a principal payment on a 20- to 30-year mortgage shows they are about equal in the after tax effect over the long term.

This flex plan permits members to make financial decisions consistent with their current life needs and goals. The choices are all ones that most people can relate to because they deal with them from time to time in their lives.

From a plan member perspective, this flexible pension plan is really just an extension of an existing flexible benefits plan to provide a single arrangement with pension, savings, health and welfare benefits in one package. From the plan sponsor’s perspective, it means there are more choices to handle, revised communication and education requirements and, with the mortgage principal pay down, the need to track and arrange payments throughout the year.

Why is there a DB component? For a career employee, DB provides the guarantee of delivering a pension consistent with pre-retirement earnings. In this case, it delivers a liveable pension, although maybe not in the high style some retirees might like. For employees who terminate, it reduces the money directed at their pension in relation to an equivalent DC pension. This allows relatively more pension dollars to be directed to career and older employees.

How expensive is this program?

In total, the cost is the sum of the DB cost and the actual allocations made. For most organizations, a one-per-cent DB pension without post-retirement indexing costs about five per cent to six per cent of payroll. With post-retirement indexing (at 75 per cent of inflation), the cost would be about seven per cent to nine per cent. The flex dollar allocations could cost up to nine per cent of payroll (plus $600 per person if that portion is recognized). So the cost for a fully implemented plan would be expected to average about 17 per cent of payroll plus administration.

This cost could be entirely employer paid or could be allocated between members and employer. The amount of flex dollars paid by the employer could be related to the contributions made by plan members.

What the plan might look like

One implementation of this plan might look like the following:

DB component: Member contribution is two per cent of earnings each year. Balance paid by the employer.

Flex dollars: Employee contributions of up to 4.5 per cent, matched by the employer.

This results in a maximum employee contribution of 6.5 per cent of earnings. The employer contributes about 10.5 per cent (six per cent to the DB component plus 4.5 per cent match to the flex component). Of course, other contribution rates could be used.

Nine per cent of earnings plus $600 is the maximum that could be allocated by a member to the retirement fund component. (Unless a group RRSP is used for the retirement savings component and the employee has unused RRSP room from prior years.) More flex dollars would be permitted as long as the allocation to the retirement fund remains within the Income Tax Act limits.

Is this plan for you?

Do the plan goals fit within the company’s culture? Is it willing to provide a better than average plan? Is it willing to empower members with personal decisions? Will the cost fit within the budget?

There are many ways to customize this plan to fit differing corporate goals and cost constraints. But in any event, it will be more expensive to administer than non-flexible alternatives. For some organizations, the additional value delivered may be worth more than that administrative cost.

Peter Gorham is a partner with Morneau Sobeco in Toronto. He can be reached at (416) 383-6438 or [email protected].

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