Defined contribution programs have been the plan of choice for small- and mid-sized firms.
In the current environment where attracting and retaining top talent is essential, yet the pressure to keep costs down is imperative, small- and mid-sized companies are often challenged to keep their pension offerings competitive.
Retirement programs are highly valued by Canadian employees, and are considered an integral component of a company’s compensation package. Where no retirement program is offered, a company’s total compensation program can be perceived as deficient or uncompetitive relative to its competitors in the marketplace. So how do small- and mid-sized companies go about offering competitive plans? DC plans have become the “plan of choice” for small to mid-sized employers.
These plans are attractive because:
•they are simple to administer;
•benefit costs under a DC program are predictable;
•DC plans are attractive to a young and more mobile workforce;
•they offer flexibility to members;
•they allow members to control the plan investments; and
•DC plans are portable for members.
Small- and mid-sized firms are flocking to DC plans because they are looking for lower costs and simplified administration. (For larger organizations, other drivers are involved as well, such as: employee preferences, a desire to avoid compliance requirements and cost stability.)
A strength of DC plans is the flexibility of their design. A company can tailor its DC plan to target a certain profile of employee, support company objectives and reinforce employee behaviours. At the same time, the program can be designed to offer features that will increase member satisfaction with the program.
To maximize the success of the program, it should be carefully designed and should be structured to meet the objectives of both the organization and its employees.
The following issues should be carefully considered in designing a DC retirement program.
Plan type
A number of different plan vehicles or tax structures can be utilized for a DC retirement program. The following is a brief description of the key features associated with some of the most popular DC plan structures in Canada:
DC pension plan: The most notable feature of a DC pension plan is the fact that plan accumulations are considered “locked-in.” This means that plan accumulations cannot be accessed in a lump sum at termination or retirement. They can only be used to provide regular income starting at retirement age (either through an annuity or a Life Income Fund). Since they are pension plans they are covered by the requirements of local pension regulation. DC pension plans are attractive to paternalistic companies that want to ensure accumulations are used for retirement.
Group Registered Retirement Savings Plans (RRSPs) and Deferred Profit Sharing Plans (DPSPs): These are tax-sheltered savings vehicles. Unlike a DC pension plan, accumulations under savings plan, such as Group RRSPs and DPSPs, are not considered locked-in. This means that members can access plan accumulations at termination or retirement in the form of a lump-sum payment, less tax withholdings. Since they are tax-sheltered vehicles, members can also elect to transfer accumulations to a personal RRSP on a tax-sheltered basis. From an employee’s perspective, the ability to access funds at termination is a very attractive plan feature. Since Group RRSPs and DPSPs are not formal pension plans they are not subject to local pension standards legislation.
Employees’ Profit Sharing Plans (EPSPs) and other after-tax savings vehicles: An after-tax option is often used to accommodate plan contributions in excess of the tax limits for tax-sheltered plans ($13,500 in 2001). This enables higher income employees to fully participate in the program without regard to the tax-sheltered limits. An after-tax program is sometimes used to accommodate the investment in company stock, which may be restricted under a tax-sheltered plan vehicle.
Contribution formula
The most critical element to the plan design is the contribution formula. This will determine how much the member receives from the employer as a plan contribution each year. The first concern from a design perspective should be to ensure that the company contribution is competitive. This can be achieved by benchmarking your plan within your industry.
The establishment of this competitive benchmark target can, in turn, help set a company’s contribution target. Factors to consider when setting a formula include: other components of the compensation package, the current competitive position of the labour market and where the organization wants to be in terms of median levels in its sector.
There are many different ways that the formula could be structured in order to achieve different objectives. Some of the more common contribution formula structures are:
•a basic company contribution that is provided regardless of whether the employee elects to contribute to the plan. This structure helps to ensure that all employees are accumulating a basic level of retirement savings;
•company contributions that are structured as a match of member contributions. This is the most common contribution formula structure. This structure encourages an environment of shared responsibility for retirement savings;
•all or a component of the formula tied to company profitability levels. This structure will assist in aligning the interests of the employee with those of the company; or
•a contribution that increases with the employee’s length of service. This is a common method of rewarding longer service in an attempt to encourage employee retention.
Other design issues
Additional design features can be tailored to reinforce company objectives and to maximize the attractiveness of the plan for employees. These additional plan features include the following:
•eligibility for membership;
•vesting rules for company contributions;
•allocation of plan expenses;
•in-service withdrawals; and
•a range of investment options.
A final issue to consider is the selection of a third-party record keeper. Again, the proper selection criteria can help in the selection of a record-keeper that can help to reinforce plan objectives. A carefully selected record-keeper can shoulder much of the administrative burden associated with the plan. There are third-party record-keepers in Canada that are capable of handling all direct interaction with the plan members, including taking investment directions and executing trades for members, taking a lead role in member communication, answering members inquiries and issuing statements. Particularly for small- and mid-sized companies, who typically have smaller human resources departments, these services can be invaluable.
In the future, the strong trend towards DC plans will likely continue for small- and mid-sized companies. The ability to provide a retirement program that is relatively simple to administer, offers more flexibility and appeals to a broad and diverse range of employees is attractive to these companies. If used effectively, and properly designed, a DC plan can also be a powerful business tool.
Colin Ripsman is a principal with the investment consulting practice of William M. Mercer Ltd. in Toronto, and head of Mercer’s defined contribution consulting group. He can be reached at (416) 868-2685 or [email protected].
SIDEBAR
Options for retirement plan offerings
There are three main ways for companies to approach the issue of retirement programs:
1. A company can elect not to offer a retirement program and adjust its remuneration package to compensate employees for a lack of a formal retirement arrangement. This would involve increasing each employee’s base compensation by an amount equal to the contribution to a competitive plan (usually four to six per cent of pay).
The principle advantage to this approach is that the company can avoid the regulatory requirements and administrative burdens associated with offering a formal retirement program.
The primary drawback to this approach is that, over time, employees begin to consider this enhanced compensation as a component of base pay, and feel that their retirement needs are not being looked after by their employer. For those employers with a paternalistic outlook, this approach leaves no way for the employer to ensure members are actually saving for retirement. For these reasons, this approach is not commonly utilized.
2. A Company could introduce a formal defined benefit (DB) pension plan. Historically, these programs have been the most popular type of retirement program in Canada. A DB pension plan provides employees with a defined pension benefit at retirement. Normally, the defined pension relates to the member’s earnings at retirement, as well as the number of years of service that the member has at retirement. For example, a DB pension formula might promise an employee a pension at age 65 equal to one per cent of the member’s highest average three-year period of earnings, multiplied by the years of employment the member has with the company. A member that retires at age 65, having worked for the company for 30 years and having an average salary of $50,000 over his last three years, would receive an annual pension equal to $15,000.
The problem with this approach is that DB plans can be costly to administer, as they require by-laws, as well as other legislative requirements and regular filings. These fixed costs associated with operating a DB plan can be particularly costly on a per member basis for small companies. Another difficulty associated with this approach is the fact that the company bears the investment cost associated with a DB arrangement. This allocation of investment risk to the company makes long-term program costs more difficult to predict. Finally, both the unfavourable tax treatment for DB programs and accrual patterns make DB programs unattractive for younger and short-service employees. The requirement to treat DB benefits as locked-in pensions also makes these schemes appear even more unattractive to prospective employees.
These issues have lead to a drastic decrease in the number of new DB programs introduced over the last 10 years. This movement away from DB is even stronger among small and mid-sized companies.
3. A company could introduce a defined contribution (DC) retirement program. A DC plan will normally provide an employee with an annual company contribution that will be invested by the employee, together with the employee’s own contributions to the program. At retirement or termination, the employee is entitled to receive the account balance accumulated by the employee under the plan to use for his or her retirement. The flexibility that these plans offer, together with their ease of administration, account for the growth of popularity of DC plans in Canada.
Retirement programs are highly valued by Canadian employees, and are considered an integral component of a company’s compensation package. Where no retirement program is offered, a company’s total compensation program can be perceived as deficient or uncompetitive relative to its competitors in the marketplace. So how do small- and mid-sized companies go about offering competitive plans? DC plans have become the “plan of choice” for small to mid-sized employers.
These plans are attractive because:
•they are simple to administer;
•benefit costs under a DC program are predictable;
•DC plans are attractive to a young and more mobile workforce;
•they offer flexibility to members;
•they allow members to control the plan investments; and
•DC plans are portable for members.
Small- and mid-sized firms are flocking to DC plans because they are looking for lower costs and simplified administration. (For larger organizations, other drivers are involved as well, such as: employee preferences, a desire to avoid compliance requirements and cost stability.)
A strength of DC plans is the flexibility of their design. A company can tailor its DC plan to target a certain profile of employee, support company objectives and reinforce employee behaviours. At the same time, the program can be designed to offer features that will increase member satisfaction with the program.
To maximize the success of the program, it should be carefully designed and should be structured to meet the objectives of both the organization and its employees.
The following issues should be carefully considered in designing a DC retirement program.
Plan type
A number of different plan vehicles or tax structures can be utilized for a DC retirement program. The following is a brief description of the key features associated with some of the most popular DC plan structures in Canada:
DC pension plan: The most notable feature of a DC pension plan is the fact that plan accumulations are considered “locked-in.” This means that plan accumulations cannot be accessed in a lump sum at termination or retirement. They can only be used to provide regular income starting at retirement age (either through an annuity or a Life Income Fund). Since they are pension plans they are covered by the requirements of local pension regulation. DC pension plans are attractive to paternalistic companies that want to ensure accumulations are used for retirement.
Group Registered Retirement Savings Plans (RRSPs) and Deferred Profit Sharing Plans (DPSPs): These are tax-sheltered savings vehicles. Unlike a DC pension plan, accumulations under savings plan, such as Group RRSPs and DPSPs, are not considered locked-in. This means that members can access plan accumulations at termination or retirement in the form of a lump-sum payment, less tax withholdings. Since they are tax-sheltered vehicles, members can also elect to transfer accumulations to a personal RRSP on a tax-sheltered basis. From an employee’s perspective, the ability to access funds at termination is a very attractive plan feature. Since Group RRSPs and DPSPs are not formal pension plans they are not subject to local pension standards legislation.
Employees’ Profit Sharing Plans (EPSPs) and other after-tax savings vehicles: An after-tax option is often used to accommodate plan contributions in excess of the tax limits for tax-sheltered plans ($13,500 in 2001). This enables higher income employees to fully participate in the program without regard to the tax-sheltered limits. An after-tax program is sometimes used to accommodate the investment in company stock, which may be restricted under a tax-sheltered plan vehicle.
Contribution formula
The most critical element to the plan design is the contribution formula. This will determine how much the member receives from the employer as a plan contribution each year. The first concern from a design perspective should be to ensure that the company contribution is competitive. This can be achieved by benchmarking your plan within your industry.
The establishment of this competitive benchmark target can, in turn, help set a company’s contribution target. Factors to consider when setting a formula include: other components of the compensation package, the current competitive position of the labour market and where the organization wants to be in terms of median levels in its sector.
There are many different ways that the formula could be structured in order to achieve different objectives. Some of the more common contribution formula structures are:
•a basic company contribution that is provided regardless of whether the employee elects to contribute to the plan. This structure helps to ensure that all employees are accumulating a basic level of retirement savings;
•company contributions that are structured as a match of member contributions. This is the most common contribution formula structure. This structure encourages an environment of shared responsibility for retirement savings;
•all or a component of the formula tied to company profitability levels. This structure will assist in aligning the interests of the employee with those of the company; or
•a contribution that increases with the employee’s length of service. This is a common method of rewarding longer service in an attempt to encourage employee retention.
Other design issues
Additional design features can be tailored to reinforce company objectives and to maximize the attractiveness of the plan for employees. These additional plan features include the following:
•eligibility for membership;
•vesting rules for company contributions;
•allocation of plan expenses;
•in-service withdrawals; and
•a range of investment options.
A final issue to consider is the selection of a third-party record keeper. Again, the proper selection criteria can help in the selection of a record-keeper that can help to reinforce plan objectives. A carefully selected record-keeper can shoulder much of the administrative burden associated with the plan. There are third-party record-keepers in Canada that are capable of handling all direct interaction with the plan members, including taking investment directions and executing trades for members, taking a lead role in member communication, answering members inquiries and issuing statements. Particularly for small- and mid-sized companies, who typically have smaller human resources departments, these services can be invaluable.
In the future, the strong trend towards DC plans will likely continue for small- and mid-sized companies. The ability to provide a retirement program that is relatively simple to administer, offers more flexibility and appeals to a broad and diverse range of employees is attractive to these companies. If used effectively, and properly designed, a DC plan can also be a powerful business tool.
Colin Ripsman is a principal with the investment consulting practice of William M. Mercer Ltd. in Toronto, and head of Mercer’s defined contribution consulting group. He can be reached at (416) 868-2685 or [email protected].
SIDEBAR
Options for retirement plan offerings
There are three main ways for companies to approach the issue of retirement programs:
1. A company can elect not to offer a retirement program and adjust its remuneration package to compensate employees for a lack of a formal retirement arrangement. This would involve increasing each employee’s base compensation by an amount equal to the contribution to a competitive plan (usually four to six per cent of pay).
The principle advantage to this approach is that the company can avoid the regulatory requirements and administrative burdens associated with offering a formal retirement program.
The primary drawback to this approach is that, over time, employees begin to consider this enhanced compensation as a component of base pay, and feel that their retirement needs are not being looked after by their employer. For those employers with a paternalistic outlook, this approach leaves no way for the employer to ensure members are actually saving for retirement. For these reasons, this approach is not commonly utilized.
2. A Company could introduce a formal defined benefit (DB) pension plan. Historically, these programs have been the most popular type of retirement program in Canada. A DB pension plan provides employees with a defined pension benefit at retirement. Normally, the defined pension relates to the member’s earnings at retirement, as well as the number of years of service that the member has at retirement. For example, a DB pension formula might promise an employee a pension at age 65 equal to one per cent of the member’s highest average three-year period of earnings, multiplied by the years of employment the member has with the company. A member that retires at age 65, having worked for the company for 30 years and having an average salary of $50,000 over his last three years, would receive an annual pension equal to $15,000.
The problem with this approach is that DB plans can be costly to administer, as they require by-laws, as well as other legislative requirements and regular filings. These fixed costs associated with operating a DB plan can be particularly costly on a per member basis for small companies. Another difficulty associated with this approach is the fact that the company bears the investment cost associated with a DB arrangement. This allocation of investment risk to the company makes long-term program costs more difficult to predict. Finally, both the unfavourable tax treatment for DB programs and accrual patterns make DB programs unattractive for younger and short-service employees. The requirement to treat DB benefits as locked-in pensions also makes these schemes appear even more unattractive to prospective employees.
These issues have lead to a drastic decrease in the number of new DB programs introduced over the last 10 years. This movement away from DB is even stronger among small and mid-sized companies.
3. A company could introduce a defined contribution (DC) retirement program. A DC plan will normally provide an employee with an annual company contribution that will be invested by the employee, together with the employee’s own contributions to the program. At retirement or termination, the employee is entitled to receive the account balance accumulated by the employee under the plan to use for his or her retirement. The flexibility that these plans offer, together with their ease of administration, account for the growth of popularity of DC plans in Canada.
