ADB plan has risk of DC for employers, promise of DB for workers
It sounds too good to be true: A plan that delivers retirees a predictable, defined-benefit- (DB) style pension while giving employers the financial risk control of a defined contribution (DC) plan.
But that’s the concept a white paper released in Vancouver last month by Aon Consulting, Restoring Retirement Security: Recommendations for Updating Canada’s Pension System, explores in what it’s calling the affordable defined benefit (ADB) plan.
In Canadian pensions, there are two risk-sharing extremes, with DB (employer takes the risk) on one end of the spectrum and DC (employee takes the risk) on the other, said Barry Gros, vice-president of Aon Consulting.
“With the tremendously bad downturn in the economic conditions and financial markets, we can’t predict the future, so having the ability to make some alterations to your program part way through, which is what the ADB does allow you to do, introduces a greater level of fairness to all parties,” said Gros.
Plan based on UBC model
The ADB plan is based on a model put in place at the University of British Columbia in 1972, and the white paper summarizes it this way: “An ADB pension plan combines the best features of both DB and DC pension plans on a neutral platform that is not biased in favour of either employers or employees.”
One reason UBC’s pension plan has been successful is a unique arrangement negotiated with Canada Revenue Agency that allows a contingency reserve of up to 40 per cent of best estimate liabilities included in the actuarial valuation of the plan. This does not impact the approximately 10-per-cent surplus permitted by the regulations under the Income Tax Act and has allowed for a cushion that has protected plan members from any reduced benefit to date, said the plan’s executive director Jay Parker.
This reserve was especially useful during the rocky financial times from 2000-2002, when many plan sponsors found themselves under funded.
“If we had the normal surplus allowed under the CRA rules, we would have been in trouble too,” said Parker.
Plan gives employers cost certainty
The ADB plan allows for a high level of transparency, with known, set employer contributions, according to Aon. The plan also offers two release valves in times of financial hardship: A built up level of contingency reserve and indexing.
“If there has to be any cutbacks as part of underfunding, the first thing that gets cut back is indexing,” said Gros. “If you take the basic benefit, and then you take indexing and then you build a contingency reserve, you’ve got a fair bit of ability to deal with bad occurrences in the market before anybody would lose any benefit. It works very well from the employer’s perspective.”
From the employee’s perspective, employees know they own the surplus outright, so there won’t be any legal disputes over it. The employee is in line to receive a defined benefit plan, which most employees who are retirement age want to receive anyway, Parker said.
One roadblock to the implementation of the plan is legislation. While British Columbia’s pension legislation allows for a basic version of an ADB plan, regulatory changes would need to be introduced in other jurisdictions.
Plan draws criticism
But not everyone is sold on the idea of an ADB plan. A better alternative is a structured, group RRSP plan, said Jim Cartin, president of Cartin & Associates, a Calgary-based employee benefit consulting firm.
“These plans are well accepted by employees and provide a greater degree of flexibility for both employer and employee,” he said. “Furthermore, the employer is not faced with unknown potential unfunded liabilities inherent under DB plans.”
Bill Keech, a principal at IPP, an actuary and retirement specialist firm in Calgary, said while ADB plans would benefit some organizations, he doesn’t think it’s the answer.
“It’s more of a band-aid solution for a small group,” said Keech. “You can write all the white papers you like, but unless all the stakeholders agree, the primary stakeholders being the regulatory authorities, these things won’t happen.”
The plan may not be able to work countrywide, but Gros said it shouldn’t preclude the plan from being offered where available.
“Not every employer is national, so I don’t think that we should see that as a major concern or stumbling block,” Gros said.
Aon might roll the program out to Saskatchewan and Alberta, even though the laws in those provinces don’t currently allow this kind of approach.
“We think there is some interest,” he said.
How it works
How an ADB functions
• Employer and employee contributions are fixed under the terms of the plan.
• Plan liabilities are determined on a best-estimate going concern basis, with an explicit contingency margin.
• It provides a conditional formula benefit promise subject to an affordability test.
• If costs rise to a level at which the full formula benefit promise is not affordable, the benefit is scaled back to a level commensurate with the available financing. The adjustments would be applied equitably and automatically in accordance with contractual and well-commuted provisions of the plan.
• If funding increases beyond expected needs, the excess is first applied to reinstate any past benefit reductions, then used to build a strong contingency reserve and, only after that, to increase benefits. To prevent the plan’s ongoing cost from rising, the increases will apply to only past service.
• Because the employer’s contribution is fixed and there is no unfunded liability risk, an ADB pension plan is treated like a DC pension plan in the employer’s financial statements.
But that’s the concept a white paper released in Vancouver last month by Aon Consulting, Restoring Retirement Security: Recommendations for Updating Canada’s Pension System, explores in what it’s calling the affordable defined benefit (ADB) plan.
In Canadian pensions, there are two risk-sharing extremes, with DB (employer takes the risk) on one end of the spectrum and DC (employee takes the risk) on the other, said Barry Gros, vice-president of Aon Consulting.
“With the tremendously bad downturn in the economic conditions and financial markets, we can’t predict the future, so having the ability to make some alterations to your program part way through, which is what the ADB does allow you to do, introduces a greater level of fairness to all parties,” said Gros.
Plan based on UBC model
The ADB plan is based on a model put in place at the University of British Columbia in 1972, and the white paper summarizes it this way: “An ADB pension plan combines the best features of both DB and DC pension plans on a neutral platform that is not biased in favour of either employers or employees.”
One reason UBC’s pension plan has been successful is a unique arrangement negotiated with Canada Revenue Agency that allows a contingency reserve of up to 40 per cent of best estimate liabilities included in the actuarial valuation of the plan. This does not impact the approximately 10-per-cent surplus permitted by the regulations under the Income Tax Act and has allowed for a cushion that has protected plan members from any reduced benefit to date, said the plan’s executive director Jay Parker.
This reserve was especially useful during the rocky financial times from 2000-2002, when many plan sponsors found themselves under funded.
“If we had the normal surplus allowed under the CRA rules, we would have been in trouble too,” said Parker.
Plan gives employers cost certainty
The ADB plan allows for a high level of transparency, with known, set employer contributions, according to Aon. The plan also offers two release valves in times of financial hardship: A built up level of contingency reserve and indexing.
“If there has to be any cutbacks as part of underfunding, the first thing that gets cut back is indexing,” said Gros. “If you take the basic benefit, and then you take indexing and then you build a contingency reserve, you’ve got a fair bit of ability to deal with bad occurrences in the market before anybody would lose any benefit. It works very well from the employer’s perspective.”
From the employee’s perspective, employees know they own the surplus outright, so there won’t be any legal disputes over it. The employee is in line to receive a defined benefit plan, which most employees who are retirement age want to receive anyway, Parker said.
One roadblock to the implementation of the plan is legislation. While British Columbia’s pension legislation allows for a basic version of an ADB plan, regulatory changes would need to be introduced in other jurisdictions.
Plan draws criticism
But not everyone is sold on the idea of an ADB plan. A better alternative is a structured, group RRSP plan, said Jim Cartin, president of Cartin & Associates, a Calgary-based employee benefit consulting firm.
“These plans are well accepted by employees and provide a greater degree of flexibility for both employer and employee,” he said. “Furthermore, the employer is not faced with unknown potential unfunded liabilities inherent under DB plans.”
Bill Keech, a principal at IPP, an actuary and retirement specialist firm in Calgary, said while ADB plans would benefit some organizations, he doesn’t think it’s the answer.
“It’s more of a band-aid solution for a small group,” said Keech. “You can write all the white papers you like, but unless all the stakeholders agree, the primary stakeholders being the regulatory authorities, these things won’t happen.”
The plan may not be able to work countrywide, but Gros said it shouldn’t preclude the plan from being offered where available.
“Not every employer is national, so I don’t think that we should see that as a major concern or stumbling block,” Gros said.
Aon might roll the program out to Saskatchewan and Alberta, even though the laws in those provinces don’t currently allow this kind of approach.
“We think there is some interest,” he said.
How it works
How an ADB functions
• Employer and employee contributions are fixed under the terms of the plan.
• Plan liabilities are determined on a best-estimate going concern basis, with an explicit contingency margin.
• It provides a conditional formula benefit promise subject to an affordability test.
• If costs rise to a level at which the full formula benefit promise is not affordable, the benefit is scaled back to a level commensurate with the available financing. The adjustments would be applied equitably and automatically in accordance with contractual and well-commuted provisions of the plan.
• If funding increases beyond expected needs, the excess is first applied to reinstate any past benefit reductions, then used to build a strong contingency reserve and, only after that, to increase benefits. To prevent the plan’s ongoing cost from rising, the increases will apply to only past service.
• Because the employer’s contribution is fixed and there is no unfunded liability risk, an ADB pension plan is treated like a DC pension plan in the employer’s financial statements.
