In defence of the much-maligned DB plan

Defined benefit plans are not dead in Canada, nor should they be put to pasture

Contrary to statements appearing in recent articles in the media, the workhorse of pensions — the defined benefit plan — is not dead. It has merely been resting before once again rising to prominence on the Canadian pension scene. Furthermore, while the private pension system in Canada is far from perfect, that is no reason to throw out the baby with the bath water. Rather, I suggest we keep what’s good about the current system and replace or fix what’s not.

You will always hear doom and gloom views expressed when times are tough and, make no mistake, times are tough today for pension plans in Canada with the recent prolonged investment market downturn.

Markets have seen three successive years of poor investment results on the asset side which, combined with declining interest discount rates on the liability side have created the “perfect storm” for pension plans in Canada. Big deal — it’s happened before and it will happen again.

It is also the perfect time for previously proposed and disposed ideas — like financial economics — to enter the scene, exploit the situation and gain momentum. But, just as sure as day follows night, the markets will turnaround (and have already started to) and produce positive investment returns once again.

Plan sponsors must not be driven by short-term cyclical phenomena and must resist the urge to be reactive and, instead, be proactive with respect to the Canadian pension system.

Critics of the pension system have raised some valid points recently:

•The legal framework needs to be reworked to have a more balanced perspective and consistency between the taking on of risk and allocation of reward.

•Pensions are risky. The system has matured, the risks are large and they cannot be swept under the carpet — nor should they be.

•Current pension accounting is ineffective and misleading.

•Pension plan designs are often outdated and may not reflect the HR strategies in the future.

But I disagree fundamentally with an overriding theme — that the pension system doesn’t work anymore, therefore let’s scrap it and leave it up to individuals to worry about, plan for, and invest for their retirement.

The suggestion that organizations shouldn’t offer pension plans or, at most, a defined contribution (DC) rather than defined benefit (DB) plan, places the entire risk of retirement income security squarely on the shoulders of individuals, most of whom are laypersons at determining how much money to put aside and how to invest it. Essentially, it is suggested the best way to deal with the substantial risk is to transfer it from employers to employees. I disagree.

Clearly there are risks for DB plan sponsors. There is a choice to make: throw in the towel or face the challenge and manage the risk. Surely plan sponsors, with access to the various types of expertise required, investment, actuarial and otherwise, are far better equipped to deal with these risks than are individuals.

DB plans offer the advantage of risk averaging over the entire group. Some members will terminate, die or retire when the timing is bad for the fund and produce a loss; others will do so when the timing is favourable. In group situations these risks average out, but not in the case of an individual’s personal savings or DC accumulations. This co-mingling of risks allows plan sponsors to take more risk and ultimately lower the cost of providing benefits or provide higher benefits at the same cost. In addition, economies of scale can be achieved in respect of both the fund’s investment and the plan’s administration, once again leading to lower costs and higher benefits.

Much is said about the stake that plan sponsors and plan members have in pensions. But what about the taxpayers’ stake?

These are tax-deferred plans which cost the government, and therefore the taxpayer, substantially in terms of delayed and perhaps forgone taxes. In exchange for this cost, the taxpayer assumes that registered pension plan members and individuals with RRSPs will not come forward cap-in-hand asking for government handouts in future years because of insufficient retirement incomes. Any decision that hurts employee retirement increases the risk that the taxpayer will have to foot the bill for increased government assistance.

The government-provided CPP/QPP and Old Age Security (OAS) can only account for a portion of retirees’ income. But the pension system is based on there being two more components — the employer-provided and the individual-provided.

The individual-provided portion — personal savings — is, by its very nature, DC. Amounts are contributed and saved, which accumulate with investment earnings to retirement, and then provide whatever income is possible. An employer-sponsored DB plan, then, offers increased diversification as to retirement planning and funding.

DB plans have worked well for employers to do their part in providing retirement income security. Employers benefit from an educated working class, free trade, and other advantages of operating in Canada. Canceling their DB plan may make sense if guaranteeing stable costs or the next quarter’s profit are the only measures, but most employers take seriously their responsibility to look at the long-term and help provide for their employees’ retirement.

Is DB better than DC? A well-designed DC plan for a young, investment-savvy employee group may provide superior retirement income to a DB plan. But for the vast majority of working Canadians, a DB plan is the best vehicle for guaranteeing a level of retirement pension above CPP/QPP and OAS.

In a country whose people value retirement income security almost as much as universal health care, pension plans are clearly a worthy enterprise. Here are suggestions for strengthening the current system:

•Effective and responsible plan design, reflecting relevant HR strategies and plan sponsor objectives; this may include joint employer-employees sponsorship of DB plans, sharing of costs and risks and of gains and losses and balancing the pendulum regarding ownership of surpluses and deficits.

•Effective asset allocation, investment risk diversification, and risk and reward optimization.

•Responsible funding approaches, minimizing future risks. This does not mean funding conservatively, in the sense of contributing substantial monies above minimum requirements, and may in fact be the opposite, particularly in an environment where surplus ownership issues are at best unclear.

•Legal framework: uniformity and streamlining of legislation across all jurisdictions; increase in Canada Customs and Revenue Agency maximum pension limits and more equity between DB and DC; fair balancing of risks and rewards between plan sponsors and members.

•Simplify the current accounting approach and provide meaningful financial information.

While short-term phenomena should not drive long-term decisions such as a pension plan, the irony is that the recent prolonged market downturn should encourage rather than discourage the set-up of DB as opposed to DC plans, as at least some DC plans are failing to deliver the expected benefits and many DC retirees are finding their plans are providing grossly inadequate retirement income.

In the final analysis, there are many considerations involved in the decision about a pension plan. Once decided that it is appropriate and desirable to have a plan, many factors will underlie its design — benefit objectives, HR strategies, risk, security, cost, size, demographics of the group — the end result of which may be DB, DC or some combination.

From the 1960s to the early 1980s, DB plans were predominant. From the mid-1980s to late-1990s, there was a definite and growing trend towards DC plans. This is changing, however, and DB plans are again trending back, as evidenced by recent high-profile conversions back from DC to DB. The horse is indeed not dead.

As in many of life’s decisions, it’s all about risk. The risks involved in sponsoring a DB pension plan, while significant, are manageable. The risks to employers and to the taxpayer of not providing a pension plan (or of providing a DC plan only) are not any less significant, and become quite difficult to manage and costly to resolve, as retiring employees’ personal savings or DC balances generate unpredictable pension incomes and prove inadequate to financially secure their retirement.

H. Clare Pitcher is a principal and consulting actuary with Mellon Human Resources & Investor Solutions in Toronto. For more information visit www.mellon.com/hris/Canada.




Why are DB plans under fire?

In an earlier interview with Canadian HR Reporter, Malcom Hamilton, a principal of Mercer Human Resource Consulting, said defined benefit (DB) plans are too risky to maintain for a variety of reasons. His comments — reported on in numerous media sources — sparked a firestorm of debate around the issue.

He said the double-digit returns of the last decade are likely gone for good, there are more pensioners than ever and assets and liabilities for DB plans have, in some cases, outgrown the enterprises supporting them. This means a tough business environment could threaten the very survival of an organization.

“For some, unfortunately, there is only one warning — the first wave capsizes the boat,” said Hamilton. “For most there will be many warnings and many opportunities to act before it is too late.”

He said organizations just starting out shouldn’t even create a pension plan. And if a firm has to create something, it should opt for a defined contribution (DC) plan.

“Most sponsors, if they could get out of their (DB) plan, they would,” said Hamilton.

He also said there needs to be changes in how governments handle pensions, including improving the pension system and clearing up the sticky issue of pension surplus ownership.

Ian Markham, a pension specialist with Watson Wyatt, said a lot of what Hamilton said may have been intended to shock — but there are people who need to be shocked.

“To the extent that some politicians might finally sit up and say, ‘Oh, it is that bad?,’ if it could make some people listen, that is good,” said Markham.

But while he agreed improvements are needed, he doesn’t see DB plans as being all bad. Considering only the impact on shareholders ignores the HR value of a DB plan. HR leaders still need to attract and retain the best people and DB plans are important tools to that end, he said.

Steve Bonnar, a pension specialist with Towers Perrin, agreed with a lot of what Hamilton said.

“I think we do have big problems with the private pension system in Canada,” he said. But he is confident improvements in the system may be on the way.

“I think we are at an opportune time where we can start to make some fundamental changes to the system,” he said.

Bonnar said there is an emerging consensus and agreement among professionals in the pension industry that there are fundamental problems. It’s going to take involvement from all the principals in the pension system, including sponsors and members, to find a solution.

“My personal view is that we need to rethink the overall framework of how pension plans are delivered,” he said. “It’s tempting to try to fix each of the problems individually but I fundamentally don’t believe that is the right approach. There needs to be a holistic solution. Just trying to put scotch tape in one place and stick a finger in the dike somewhere else might work, but it has the potential to cause problems somewhere else.”

To read the full text of the original Canadian HR Reporter article, click on the related articles link below.

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