There’s more to pensions than defined benefit versus defined contribution

Flexible plan design or combination plans offer alternatives to the DB versus DC dichotomy

Within the private sector in Canada, employer-sponsored retirement plan designs are changing.

In an environment of funding deficits, complex pension laws, and asymmetrical sharing of risks between plan sponsors and members, it’s perfectly understandable that a number of employers with traditional defined benefit (DB) pension plans are contemplating how much better life might be if only they could adopt the apparently simpler, better understood, and less risky defined contribution (DC) pension model.

As such, more employers are converting from DB to DC. In board meetings, directors ask management why they haven’t moved to DC yet. Newly hired human resources executives can make their mark by undertaking a conversion to DC as one of their first initiatives. Analysts closely scrutinize DB obligations in assessing potential investment opportunities. There aren’t many outspoken champions of DB plans within the business community these days. It seems everyone you ask says DC is the way to go.

But DC plans don’t come without risks for plan sponsors.

Has HR done an adequate job educating employees to make informed decisions about how much to contribute, how to invest and how to avoid outliving their savings when they eventually retire? Is a good enough job being done monitoring the performance of investment managers and other DC service providers, and taking decisive corrective action when needed? Is HR sure that, when the time comes, employees will be able to afford to retire and will leave the workforce in an orderly pattern, or is the organization exposed to the risk that retirement will be driven by fluctuations in stock market returns and interest rates?

In the long term, perhaps the solution isn’t as simple as converting from DB to DC.

What are plan sponsors doing?

Rather than speculate on whether DC is the best solution, it’s worth looking at what private-sector employers in Canada are actually doing with their traditional DB pension plans. Are they converting en masse to DC or are other alternatives emerging?

Looking at a cross-section of employers in Towers Perrin’s Benefits Data Bank over a recent five-year period — and confining the analysis to benefit programs covering salaried employees and non-negotiated broad-based plans (arguably only looking at situations where the employer has a fair degree of latitude to unilaterally implement changes in plan design) — several interesting observations emerge.

•Ten per cent of 232 DB plan sponsors converted to DC during this period. This is what everyone’s taking about. It’s certainly an important shift in the landscape, and shows little sign of abating in the near future.

•At the same time, more than 13 per cent of the DB plan sponsors converted to some form of flexible plan design or combination plan design retaining fundamental DB elements, but offering more choice or flexibility to plan members.

•Nearly 77 per cent of the DB plan sponsors maintained their DB design (sometimes with changes in design, but still maintaining the DB approach).

It’s understandable that the 77-per-cent segment of DB plan sponsors doesn’t get much attention in the pension debate. Few commentators want to write articles about something that hasn’t changed — it’s much more interesting to explore alternative trends and ideas. It’s also important to recognize that the 77-per-cent segment isn’t completely static — there are certainly some employers that want to move to DC to reduce cost volatility, but find the current economic environment (with historically low interest rates and large accumulated investment losses) makes it costly to consider implementing a DB-to-DC conversion.

What’s surprising is that there’s relatively little discussion about the 13-per-cent segment. Nearly one in seven DB plan sponsors in this survey has converted to a flexible or combination plan design during a relatively short period and, cumulatively, one-quarter of the employers in this survey now offer this type of pension coverage. These employers are implementing some of the most innovative plan designs, achieving a balance between DB and DC that reduces risk for stakeholders and that may be more appealing both to employers and employees than the pure DB or pure DC approach. They’ve adopted plan designs that break out of the traditional DB versus DC dichotomy.

What do these alternative plan designs look like?

In some plans, members earn both DB and DC coverage. They get the security of a predictable, guaranteed basic lifetime benefit, plus the control and flexibility offered by a DC account balance. And the employer’s risk is reduced with respect to both cost volatility and the impact on employee turnover and workforce planning.

Some plans offer employees a choice between DB and DC coverage. The choice may be one-time-only, or members may have an opportunity to switch coverage once or more in their careers. This can help support broader attraction and retention strategies, ensuring employees can select a form of pension coverage that best suits their current needs. And, if the DB and DC coverage levels are set appropriately, the total cost doesn’t need to be materially different from the cost of a DB-only or DC-only plan design.

Other plans offer two or more DB options, with different levels of employee contributions. Employee contributions may buy a higher DB accrual rate or, in some plans, employee contributions buy a specific ancillary benefit such as indexing. Members can decide between investing in the employer’s plan to earn a better DB pension, or investing in their own RRSPs to produce a personal retirement nest egg to complement a lower level of DB pension.

Finally, some plans offer flexible ancillary accounts — DC accounts in which employees can set aside additional retirement savings to be used to enhance the specific DB plan provisions that are actually of personal value to them. One employee may want a better early retirement pension, while another wants enhanced survivor benefits for a spouse. Each employee can decide what’s most important, and effectively tailor the plan design to meet personal needs, with no additional benefit cost incurred by the employer.

As one can see from these examples, a wide range of plan design variations is possible.

Are flexible or combination plan designs perfect? No. More care and attention has to be invested up front to develop a suitable plan design and explain it to employees. From the plan member’s perspective, with the benefit of greater choice and control comes the challenge of making an appropriate informed decision. And on an ongoing basis, the employer takes on greater administrative responsibilities than would be the case with a pure DB or pure DC design.

Indeed, some sponsors of flexible or combination plans have shifted back to more traditional DB-only or DC-only plans for these reasons. But, so far this decade, the net movement has been toward rather than away from such plans.

At the end of the day, each employer needs to adopt a retirement plan design that best addresses its own unique set of business objectives and employee needs. There are no universal solutions; there’s no magic plan design to fit all circumstances. However, in an environment where talk of converting from DB to DC continues to be on everyone’s lips, it’s important to recognize there may be other alternatives to the pure DB versus DC dichotomy.

C. Ian Genno is a principal with Towers Perrin in Toronto. He may be reached at (416) 960-7420 or [email protected].

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