Defined benefit or defined contribution, it’s always costly

In the past decade, many pension plan sponsors (especially small employers) converted their defined benefit (DB) plans to defined contribution (DC) plans.

The move from defined benefit to defined contribution was caused by a number of forces including increasing administrative costs, lack of appreciation by employees, and uncertainty in budgeting.

Countless articles have been written detailing the popularity and benefits of DC plans versus DB plans. The differences have been somewhat overstated, and defined contribution plans are no longer considered to be the ideal pension solution they once were.

Disappointed with DC plans, employers are once asking themselves how they could provide employees with an “adequate pension” and the experts are once again looking for the next great solution. Should small and mid-size employers be reconsidering the defined benefit plan? Perhaps.

The apparent “high cost” of managing small defined benefit plans now seems reasonable when compared to the effort required to effectively manage a small defined contribution plan.

The issue is no longer the size of the employer because the reality is that any plan, DB or DC will require management time and effort, and the smaller the employer, the more disproportionate this time commitment will seem.

The context
The history of the rise and fall in the popularity of the defined benefit plan is well known. However, for context, the history is generally accepted as follows:

Stage I (1950s and 1960s) — Tax deferral of contributions to pension plans created incentives for employers to establish plans. Usually underwritten by insurers, the employer was protected from most or all of the investment and mortality risks.
Stage II (late 1960s to 1980s) — Employers saw the investment gains accruing to insurers and wanted to share in these gains. Sharing in investment gains generally reduced employer costs and increased the volatility of contributions from year to year.
Stage III (late 1980s to early 1990s) — Legislation, legislation, legislation. The change that most disturbed employers was the introduction of the concept that they are responsible for deficits, while employees own surpluses.
Stage IV (late 1990s) — Employees saw the investment gains accruing to employers and wanted to share in these gains — since investing seemed so easy and without real risk. Employers desired a fixed cost for pension commitments. Defined contribution plans seemed to offer the solution by fixing the cost of employer contributions and at the same time giving employees more freedom to make investment decisions and to try to maximize their returns.

Current challenges
Today, the costs associated with managing a defined contribution plan are better understood than they were 10 years ago. Further, a slumping market and negative returns have reminded both employers and employees that investing is not a risk-free proposition. Current issues for DC sponsors include greater fiduciary responsibility, as well as increased demand for an obligation to provide employee education. Furthermore, some employers complain of an increased employee focus on investing rather than doing their jobs.

The recent paper by the Canadian Joint Forum of Financial Market Regulators titled Proposed Regulatory Principles for Capital Accumulation Plan (see hrreporter.com Article No. 1123 or CHRR, May 21, 2001) provides a clear message that employers have a great deal of responsibility to plan members when sponsoring a defined contribution plan. Many plan sponsors have been unaware of these responsibilities and will need to spend both time and money to get up to speed.

What lies ahead
What responsibility will employers want or have to take if members of defined contribution plans reach retirement with insufficient funds to provide an adequate pension? The answer to this question will determine the future of employer-sponsored pension plans in Canada. Some employers have already started to respond by forming internal governance committees to undertake a more proactive management of their defined contribution plans.

Even for an employer that proactively manages a defined contribution plan, some limitation on the fiduciary responsibility and liability of the employer is necessary. The industry is looking to the regulators to impose these limitations because without limitation, sound business judgment will cause employers to abandon these vehicles.

Many employers are still inclined — and will continue to be so — to offer employees programs to assist in the accumulation of assets for retirement. For these employers, defined benefit plans, though costly, may well be the answer.

Unfortunately, a greater number of employers are likely to abandon the concept of employer-assisted retirement savings altogether, reverting to cash payments, and leaving each employee to their own devices. This latter approach would be unfortunate, since it would come with a loss of bulk purchasing power as well as the loss of the interjection of the employer’s expertise regarding investing.

Hopefully the regulators will clarify the rules before members resort to taking employers through the courts to get what they think is “fair.”

What should be clear is that the defined benefit plan is not the exclusive tool of large employers. If a small or mid-size employer wants to sponsor a pension plan, then there will be risks to manage and efforts to make in ensuring the smooth operation of the plan. This will be true whether it is a defined benefit or defined contribution program.

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