Pension plan choices: DB versus DC

In the 1970s, plan sponsors and consultants used to talk about the relative merits of defined benefit (DB) plans and defined contribution (DC) plans and the choice was clear. Typically public-sector plans and the large private-sector plans had always been DB. Smaller, entrepreneurial companies had mostly DC plans or group RRSPs. (The box on page 26 highlights the features of each type of plan.)

Today, the situation is less clearcut:

•across Canada, major revisions to provincial legislation in the 1980s increased the challenges of compliance and blurred distinctions between the two types of plans. Ongoing practices of the regulatory authorities continue to exacerbate this situation;

•new income tax rules in the early 1990s inextricably linked personal savings to pension plan membership and, in the process, spawned a new generation of hybrid plans; and

•today’s younger employees are looking for a different relationship with their employers, and in many cases, this is better accommodated through a DC plan.

As a result, many employers in both the public and private sectors are now providing DC benefits to their employees in one form or another. In this context, four major questions arise:

•Why would an employer want to keep a DB plan?

•What design features work best in today’s environment?

•Are there issues around DC plans as well?

•What does the future hold?

Why would an employer want to keep a DB plan?

To start with, there is the obvious point that, for some plan sponsors, the DB plan is simply the right answer. These organizations may have one or more of:

•a tradition of ensuring their employees’ financial security;

•a low-turnover “job-for-life” culture; or

•a global strategy of providing DB plans.

This approach represents a deliberate, informed decision to stay DB, as opposed to other sponsors who may have retained their DB plans through inertia, or because the DB plan is currently in surplus and they are not required to contribute.

Another key issue may be the influence of any unions involved in negotiating the terms of the DB plan. Historically, unions have been proponents of DB plans because of:

•the ability to negotiate changes that impact on past service as well as future service;

•the greater degree of benefits security that attaches to a DB plan; and

•the typical flat dollar, non-contributory benefit design that does not present many of the administration or communication challenges inherent in other types of DB plans that do not have a great deal of union input.

Finally, the plan sponsor may value the ability to use the DB plan’s flexibility to reinforce HR objectives such as:

•early retirement windows;

•buy-back of past; and

•enhanced provisions for mid-career hires.

What design features work best in today’s environment?

The pension world has not been the same since the new income tax rules governing retirement savings were introduced in the early 1990s. At the heart of these rules lies the Pension Adjustment (PA) that reduces an individual’s personal RRSP contribution room to allow for the value of the benefit accumulating in a registered pension plan or a deferred profit sharing plan.

The formula adopted by the Canada Customs and Revenue Agency (formerly Revenue Canada) for calculating the PA for a DB plan can seriously overstate the value of the benefit being earned, and correspondingly reduce the individual member’s RRSP contribution room to a significant extent.

As a result of these new tax rules, many plan members started to look at their pension plans as an impediment to their overall retirement planning rather than as an integral part. This made plan sponsors anxious to find new approaches to meet their corporate obligations. For some, the answer was a straight switch to DC. For others, the answer lay in finding a more flexible combination of DB and DC plans that would eliminate some of the negative tax consequences while retaining some of the attractive DB plan features. Of course, the consulting community was happy to oblige.

Generally speaking, the “new era” plans have fallen into three categories:

•providing a choice between DB and DC so that members can select the type of plan they want, depending on their progress through the retirement savings cycle and their lifestyle preferences;

•providing a combination of DB and DC using a more tax effective approach to the DB plan design, frequently combined with a savings plan to encourage members to contribute towards their own retirement;

•introducing a flexible pension plan, designed to allow members to customize their DB plan by using their voluntary pension contributions to buy their choice of features, (enhanced early retirement rules, improved spousal benefits, and so on). Properly designed, these DB plans can give members increased tax-deductible savings, and reduce the inequitable impact of PAs.

It is fortunate that plan sponsors’ desire to provide employees with more flexibility for tax reasons has coincided with a general move to more flexibility in the workplace.

Are there issues around DC plans?

I remember sitting through a presentation some time ago, where the speaker proudly announced that his company had switched from a DB plan to a DC plan, and was now able to provide larger pensions at a reduced cost.

I asked myself how this was possible. Despite claims to the contrary, pension plans are really very simple. Contributions go into the Plan and earn investment income. Benefits and expenses are paid out. There is no evidence that employee controlled investments will outperform employer controlled investments. Intuitively, you might expect the opposite to be true. The real issue here is that the redistribution of wealth, which used to occur in traditional DB plans paying a pot of gold to the lucky few who actually retire, does not occur in DC plans, where you get what you pay for.

The other issue worth debating is whether DC plans represent a real drop in administrative time and expense. Attendees at any recent pension industry meetings will have noticed a major proportion of the subject matter deals with the governance of DC plans. If plan sponsors are to avoid the risk of costly litigation, the story goes, then they must spend more time on communicating fundamental investment principles to members. Speakers also bemoan the lack of any “safe harbour” rules around investment choices, similar to those found in the United States. These rules are sure to come.

The bottom line is: don’t switch plan types solely to save money, the savings may be an illusion. The change should complement corporate strategy around the attraction and retention of employees and the use of financial resources.

What does the future hold?

Recent evidence suggests that even the largest and most stable organizations are prepared to be open-minded about using DC plans as at least one element of their retirement programs. This represents a major swing from 10 years ago, when the majority of these organizations were staunchly in the DB camp. What might slow this trend down?

A prolonged period of poor or negative investment returns may have plan members longing for the good old days when their pensions were guaranteed. However, plan sponsors may be highly relieved that they are not facing the large unfunded liabilities, which historically accompanied such a downturn, for example in the early 1980s.

Unions still have a strong role to play in the future development of the pension system. Recently we have seen a number of examples of unions negotiating for DC programs. In addition, the large industry-wide multi-employer pension plans already represent a combination of the DB and DC approaches. The benefits are defined, but only to the extent that the negotiated contributions can pay for them.

The final say will be with the workforce:

•those closest to retirement are looking at phased retirement as an attractive alternative to going “cold turkey;”

•baby boomers are waking up to the fact that they have to start thinking about retirement planning, if they have not already done so; and

•the younger generations are expecting a future with multiple roles and careers, and are hoping they will not make the financial mistakes of their parents.

Flexibility is the key.

Patrick Longhurst is a senior consulting actuary with Watson Wyatt Worldwide. He can be reached at (416) 943-6021 or [email protected]

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