How pensions got tangled in total rewards

Once a fringe benefit, pensions are now considered a right and employees are more savvy about the type of plan they want

Back in the “old days” companies provided employees with something called fringe benefits. These benefits were supplements to the wages paid to workers and included items such as health benefits, pensions and even hot lunches.

These benefits did have a cost, but the total cost was not large relative to the cost of equipment and wages, and, as such, the costs were not managed aggressively nor were the benefits promoted to workers as significant pieces of their total compensation.

As time passed, the cost of these fringe benefits increased and a consulting industry grew out of a demand for expertise in managing these costs. At the same time, tax policy evolved and some benefits such as car allowances started to vanish from the landscape.

From fringe to a must-have

Pensions, which were usually defined benefit plans, were widely adopted in the 1960s and 1970s as employers realized these plans offered a viable mechanism to provide for employees in retirement and as the tax advantages of deferring compensation came into clearer focus. As this evolution progressed, pension promises increased and costs rose.

No longer were pensions a fringe benefit. They had become an important component of the total compensation package offered to workers. At the same time this pension evolution was occurring, a change in the general workforce was also evolving. No longer were workers staying with one employer for life. Shorter stints with multiple employers was becoming commonplace and being unemployed for two or three months was not guaranteed to brand an employee negatively as it would have 20 years earlier.

With changes in the importance and value of pensions, combined with a mobile workforce, pensions started to become a tool used to attract and retain good staff.

Through the 1980s, accounting standards started to place greater emphasis on measuring the cost of pensions and many financial executives started to question the viability of sustaining rich defined benefit plans.

At the same time, a mobile workforce wondered why they needed a defined benefit plan since retirement from a current employer was not as likely as retirement from the next, second next or even third next employer. There was no longer consistency between the employer’s perception of the cost and the employee’s perception of the value.

In response to this disconnect, finance departments started to consider the merits of defined contribution plans in managing the cost of pensions, and HR departments started to look at the merits of defined contribution plans to please workers ever hungry for more compensation.

After all, defined contribution plans were easily explained in the context of compensation and, for most workers, the appeal of earning double-digit returns on their own investments appeared more valuable than the old insurance-style promise of a fixed pension in the distant future.

HR and finance could finally agree that defined benefits were no good and what the company needed was a defined contribution plan, and so the wave of conversions occurred. HR departments produced statements of “total rewards” showing five per cent of base salary under the heading of pensions, and finance departments simply plugged-in five per cent of payroll into its budgets on the pension line.

No free lunch for defined contribution plans

After a solid decade of plan conversions and wind-ups, the defined benefit plan is not the common pension program it was once, and some commentators have been declaring it all but dead. During this time, however, things have not gone so well for defined contribution plans.

The double-digit returns are gone. The median balanced fund in the Watson Wyatt Pooled Fund Survey returned just seven per cent over the five-year period ended Sept. 30, 2004. Worse, the law profession has finally clarified in their own minds, but more importantly in the minds of the regulators and the consulting community, that there is no free lunch in defined contribution plans.

Employer’s have big responsibilities when it comes to selecting and managing investments and even more responsibilities to educate plan members. Last year saw regulators publish Guidelines for Capital Accumulation Plans which details all of these responsibilities ad nauseam. No longer are defined contribution plans the ideal solution, as employees grow increasingly unhappy with the investment results.

Where employers were once reluctant to spend a lot of time and effort to educate employees about the value of defined benefit plans, a giant industry educating employees about defined contribution plans has arisen.

The buzz in the industry is that maybe employers should be offering members investment advice since education alone does not seem to be succeeding.

Where employers were once worried about staff spending too much time concentrating on the management of their retirement assets in the short term, most are now worried about the majority of employees who aren’t doing any managing at all. Worried not only about how they will fare in retirement, but also worried about whom the class-action lawyers will persuade them to chase after.

A number of employers are looking at traditional defined benefit plans and asking whether a defined contribution solution makes sense. Notwithstanding the difficult financial markets in recent years, defined benefit sponsors are not quick to change since they better understand the challenges of running a defined contribution plan than those employers that blazed the conversion trail in years past.

Will defined benefit plans make a comeback?

Does this mean the defined benefit plan will be back soon as the preferred vehicle to provide for retirement benefits? Maybe yes, maybe no. For the defined benefit plan to make a comeback the regulatory authorities and legislators have to get their act together. After close to 20 years of waiting, how realistic it is to expect this to happen is uncertain. More importantly, for defined benefit plans to make a comeback, there must be employee demand. Employees must send a message that they understand the value of a defined benefit plan — and that message is starting to come on three fronts:

•members of existing defined benefit plans are not in a hurry to see their plans converted to defined contribution plans;

•unions, understanding the value of defined benefits, continue to make them a key piece of every negotiation; and

•executives, those well educated, and even more well-paid, folks at the top of organizations are demanding defined benefit plans.

As disclosure about these executive plans continues to progress, the employees further down on the corporate ladder may well start to realize what is good for the goose is good for the gander.

Joe Nunes is a pension consultant and actuary with Actuarial Solutions Inc. in Windsor, Ont. He can be reached at [email protected].

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