Market volatility, aging population make it difficult to predict the future
What a different world it is for pension plan sponsors. Not long ago surpluses and contribution holidays seemed the norm.
Today doomsayers are abuzz about the ever-increasing costs associated with an aging population. And changing capital markets have highlighted the different risks to employers and employees alike, associated with the pension vehicles available. In this light, what should we expect for retirement planning?
It seems that the traditional defined benefit (DB) plan — so scorned by employees just a few years back — has turned out to do exactly what we always expected it would; it provides a benefit at retirement that is predictable.
But predictable benefits come at a cost — a cost to employers. In periods of dismal market activity and low interest rates, such as we are currently experiencing, these plans tend to have higher costs and reported expenses. And made surpluses disappear and deficits emerge. But, except in extreme cases, benefits to employees are still secure.
On the flip side, the allure of defined contribution (DC) plans has disappeared along with the double digit returns of the 1990s. It is now five and a half years since Chairman of the U.S. Federal Reserve, Alan Greenspan made his famous warning about “irrational exuberance” in the markets speech sent a chill down investors’ spine. Organizations that were so quick to convert their DB plans to DC plans when investors were being irrationally exuberant, now realize that employees may not be able to afford to retire.
The problem is that the contributions, although stable for the employer, do not translate into a predictable pension at retirement.
The economic impact on DC plans in the near term is very clear. Those who were planning to retire now or within the next few months will have to postpone their retirement plans or else tailor their living standards accordingly.
Given all the variables, those with a long-time horizon, should sit back and try not to panic. Market volatility is one of the risks inherent in a DC Plan. Anecdotal evidence indicates that most DC plan members have not made drastic changes in their investment strategy over the last year. This is good news as it suggests that employees are absorbing and even understanding the investment education they’ve been receiving.
As for DB plans, the short-term impact depends on where these plans sit in the valuation cycle. If a Dec. 31, 2001 valuation was performed, employers can expect significant deficits that will require large injections of cash. From an employee’s perspective, it is business as usual, since their benefits are guaranteed. However, we are not likely to see any benefit improvements or indexing of pensions in the next few years.
Unfortunately, DB plans will also be adversely affected by the aging population. As the plan membership ages, so does the cost of providing benefits. This is a result of the time value of money, since the dollars contributed have less time to earn investment returns before benefits must be paid.
For DC plans, an aging population does not directly impact the cost to employers since contributions are set at a percentage of payroll.
As for the impact of labour shortages, the lack of skilled employees could lead to higher salaries overall as employers compete for fewer employees. The increase in payroll will directly impact the costs of both DB and DC plans to the extent that benefits or contributions are based on earnings.
In spite of the increased costs, DB plans can be used to help employers hang on to valuable older employees. Plan design can encourage later retirement or allow for phased retirement.
This is not the case with DC plans though the unpredictability of benefits may turn out to be a good thing. Employees who have long dreamed of retiring and spending their days on the beach, may need to rethink their retirement. Where benefits are insufficient to retire, employees will have to work longer to compensate for inadequate pensions. This unfortunate scenario from an employee’s perspective will be a windfall to employers desperate for experienced employees.
A strong argument can be made for introducing hybrid plan designs to help mitigate some of these problems for both DB and DC plans.
Adding a flexible contribution account to a DB plan can allow members to share in any potential positive investment returns yet still maintain a guaranteed defined benefit. Other than administrative and upfront costs, a flexible pension plan has no ongoing additional cost to the employer and allows employees to enhance their pensions at retirement. The only concern with this plan in the context of demographic trends is in allowing members to purchase early retirement benefits at a time when employers don’t want experienced employees to leave.
Adding a minimum guaranteed benefit to a DC plan introduces an element of security to members exposed to market volatility. As opposed to the flexible pension plan described above, in this case, the cost to the employer would increase as there would be a requirement to fund the minimum guarantee. When markets are performing well, more often than not, the DC account would be greater than the minimum benefit and therefore no cost would be incurred. The opposite is true when market performance is poor and the minimum benefit kicks in.
No one can really say with certainty what to expect from the years ahead. However, the demographic trends we are seeing today are going to force employers to rethink the delivery of pension benefits. The tradeoff is security of benefits for employees versus cost to employers. The big unknown, as always, is the economic scenario down the road. How that plays out is anyone’s guess.
Lori Satov is a retirement consultant, Western Canada for Watson Wyatt Worldwide. She can be reached at (866) 206-5723.
Today doomsayers are abuzz about the ever-increasing costs associated with an aging population. And changing capital markets have highlighted the different risks to employers and employees alike, associated with the pension vehicles available. In this light, what should we expect for retirement planning?
It seems that the traditional defined benefit (DB) plan — so scorned by employees just a few years back — has turned out to do exactly what we always expected it would; it provides a benefit at retirement that is predictable.
But predictable benefits come at a cost — a cost to employers. In periods of dismal market activity and low interest rates, such as we are currently experiencing, these plans tend to have higher costs and reported expenses. And made surpluses disappear and deficits emerge. But, except in extreme cases, benefits to employees are still secure.
On the flip side, the allure of defined contribution (DC) plans has disappeared along with the double digit returns of the 1990s. It is now five and a half years since Chairman of the U.S. Federal Reserve, Alan Greenspan made his famous warning about “irrational exuberance” in the markets speech sent a chill down investors’ spine. Organizations that were so quick to convert their DB plans to DC plans when investors were being irrationally exuberant, now realize that employees may not be able to afford to retire.
The problem is that the contributions, although stable for the employer, do not translate into a predictable pension at retirement.
The economic impact on DC plans in the near term is very clear. Those who were planning to retire now or within the next few months will have to postpone their retirement plans or else tailor their living standards accordingly.
Given all the variables, those with a long-time horizon, should sit back and try not to panic. Market volatility is one of the risks inherent in a DC Plan. Anecdotal evidence indicates that most DC plan members have not made drastic changes in their investment strategy over the last year. This is good news as it suggests that employees are absorbing and even understanding the investment education they’ve been receiving.
As for DB plans, the short-term impact depends on where these plans sit in the valuation cycle. If a Dec. 31, 2001 valuation was performed, employers can expect significant deficits that will require large injections of cash. From an employee’s perspective, it is business as usual, since their benefits are guaranteed. However, we are not likely to see any benefit improvements or indexing of pensions in the next few years.
Unfortunately, DB plans will also be adversely affected by the aging population. As the plan membership ages, so does the cost of providing benefits. This is a result of the time value of money, since the dollars contributed have less time to earn investment returns before benefits must be paid.
For DC plans, an aging population does not directly impact the cost to employers since contributions are set at a percentage of payroll.
As for the impact of labour shortages, the lack of skilled employees could lead to higher salaries overall as employers compete for fewer employees. The increase in payroll will directly impact the costs of both DB and DC plans to the extent that benefits or contributions are based on earnings.
In spite of the increased costs, DB plans can be used to help employers hang on to valuable older employees. Plan design can encourage later retirement or allow for phased retirement.
This is not the case with DC plans though the unpredictability of benefits may turn out to be a good thing. Employees who have long dreamed of retiring and spending their days on the beach, may need to rethink their retirement. Where benefits are insufficient to retire, employees will have to work longer to compensate for inadequate pensions. This unfortunate scenario from an employee’s perspective will be a windfall to employers desperate for experienced employees.
A strong argument can be made for introducing hybrid plan designs to help mitigate some of these problems for both DB and DC plans.
Adding a flexible contribution account to a DB plan can allow members to share in any potential positive investment returns yet still maintain a guaranteed defined benefit. Other than administrative and upfront costs, a flexible pension plan has no ongoing additional cost to the employer and allows employees to enhance their pensions at retirement. The only concern with this plan in the context of demographic trends is in allowing members to purchase early retirement benefits at a time when employers don’t want experienced employees to leave.
Adding a minimum guaranteed benefit to a DC plan introduces an element of security to members exposed to market volatility. As opposed to the flexible pension plan described above, in this case, the cost to the employer would increase as there would be a requirement to fund the minimum guarantee. When markets are performing well, more often than not, the DC account would be greater than the minimum benefit and therefore no cost would be incurred. The opposite is true when market performance is poor and the minimum benefit kicks in.
No one can really say with certainty what to expect from the years ahead. However, the demographic trends we are seeing today are going to force employers to rethink the delivery of pension benefits. The tradeoff is security of benefits for employees versus cost to employers. The big unknown, as always, is the economic scenario down the road. How that plays out is anyone’s guess.
Lori Satov is a retirement consultant, Western Canada for Watson Wyatt Worldwide. She can be reached at (866) 206-5723.
