Double Vision Part I

Pension issues rarely make the front page, but they have been in the news a great deal lately. In fact, a national Canadian newspaper recently ran this front-page headline: Pension plans suffer historic losses: Companies face challenge to provide ‘significantly higher’ benefit contributions to make up for shortfalls as solvency hits record lows.

The troubled economy has clearly highlighted the risks of investing in the stock market, as well as how those risks affect different types of pension plans. As the panic subsides, many plan sponsors will start asking questions such as Can I afford to maintain my current plan? Am I taking on too much risk? Am I putting too much risk on my employees?

The obvious plan design dilemma is, Do I stay with a defined benefit (DB) plan or a defined contribution (DC) plan, or do I switch to another design? But the question really should be, Do I want my plan to be primarily one or the other? Many plan sponsors have a blend of both designs.

For plan sponsors looking to determine the primary delivery vehicle for retirement benefits, both DB and DC plans have their pros and cons. And as one of my colleagues often tells me, ‘When you’ve seen one pension plan, you’ve…seen one pension plan.’ In other words, every situation is different. The key drivers are the company’s business, HR and workforce strategies, and its ability to take on financial risk.

Key Advantages of DB Plans

Despite their challenges, DB plans offer many advantages to plan sponsors and members, including the following.

Efficiency – The DB plan is cheaper to operate if plan assets are sufficiently large. Some of the largest plans in Canada cost only 25 to 50 basis points to run if one considers all of the operating expenses. Most DC plans are significantly more expensive to operate, often costing 100 basis points or more.

Risk pooling – Both investment risk and mortality risk can be shared among DB plan members, allowing members to better plan for retirement. Although DC plans are now offering more sophisticated investment strategies such as target date funds to help reduce investment risk, the plan member remains on the hook in market downturns, particularly if multiple asset classes are affected. The only way a DC plan member can eliminate mortality risk is through the purchase of an annuity, and this may not be cost-effective—or even possible—depending on the plan design.

Risk absorption – Compared with individuals, most plan sponsors are better able to absorb risk, allowing them to invest in asset classes that have produced superior returns in the past. DC plan members often take a short-term outlook as they approach retirement, taking on less risk and therefore giving up the opportunity for superior returns. DB plans, on the other hand, can invest for the long term.

Access to investments – DB plans, particularly larger ones, have access to specialized investment strategies such as infrastructure that are generally not available to DC plans.

Employee knowledge – DB plans have investment professionals or knowledgeable pension committees making decisions about asset mix and other important aspects of the investment policy. DC plan members, on the other hand, often make the investment mix decision for themselves within the constraints of the funds offered. While some degree of financial literacy is desirable for DB plan members, financial literacy is clearly more important for DC plan members. Basic concepts, such as the fact that it takes about $12 to $15 of capital at retirement to produce $1 of pension, are foreign to many people. Even those who are financially literate often do not have the time to manage their retirement planning and investments properly. ‘Set and forget’ investment strategies such as target date funds can help with investment management, but members still need to plan for retirement.

Consistent and orderly retirements – A DB plan generally provides more predictable retirement patterns than a DC plan. This is important not only to plan members but also to plan sponsors, which need to be able to renew their workforces to ensure the longterm survival of their businesses. The Watson Wyatt/Conference Board of Canada 2008 Survey on Pension Risk showed that DB plans are more than twice as likely as DC plans to encourage orderly exits from the workforce.

Lessons From the Financial Crisis

The solvency level of the typical DB plan is at its lowest level ever. While governments across the country have enacted or are considering solvency relief measures, it will likely take time and significant additional contributions from plan sponsors to return DB plans to secure financial footing. <pagebreak/>