Target benefit pension plans and target date funds (TDFs) may be similar in name, but they are worlds apart when it comes to the benefits they provide—and the communications strategies required to help them succeed.
Target benefit pension plans vs. TDFs
Target benefit pension plans are a special breed of pension plan. They combine a DB approach to accruing benefits with a DC approach to funding benefits. As such, they have growing appeal among employers looking to sidestep the risk that DB plan sponsors traditionally face. At the same time, thanks to economies of scale and the pooling of risk, they greatly reduce the plan member risk inherent in DC plans—and can offer employees a bigger bang for their buck.
TDFs, on the other hand, are a special breed of investment fund that is becoming increasingly popular in today’s DC plans. In a nutshell, they provide a hands-off approach to investing—members simply choose the fund with the “target date” that most closely matches their expected retirement date. As their retirement date gets closer, the fund automatically moves its allocation to more conservative investments (such as bonds and cash) and reduces its exposure to riskier investments (such as equity funds).
In the case of both target benefit pension plans and TDFs, the primary role of the employer is to make their agreed upon contributions on time and in the right amount. In both cases, plan sponsors also have an obligation to help plan members understand the risks associated with their plan and to estimate the amount of pension they can expect to receive. But here the similarities end.
Communicating TDFs
The impetus for TDFs was to address plan sponsor concerns about member apathy and lack of investment knowledge. Increasingly, they have become the recommended default option for employees who can’t or won’t make investment decisions.
But the use of TDFs doesn’t alter the fact that DC plan members are still expected to:
- decide how much to contribute,
- monitor their investment returns,
- choose when and how to convert their retirement savings into a retirement income, and
- protect themselves against the risk of outliving their savings.
Moreover, members who choose TDFs still need to understand what they’re getting. Not all TDFs are created equal. Some funds assume that members will move all their money out at retirement, so equity holdings are reduced leading up to that date. Others assume that members will leave funds invested during their retirement, and therefore maintain a significantly higher equity exposure. In addition, different TDFs have different philosophies—so asset allocations can vary widely, even for funds with the same target date.
In short, TDFs don’t change the fact that the basis for the DC plan model is to shift the onus for investment decisions and risk management to the individual member. As a result, communications strategies must still focus on engaging members and influencing their behaviour accordingly.
Communicating target benefit pension plans
Like a traditional DB plan, the benefits provided by a target benefit plan are based on a formula; they are not tied directly to the performance of an individual’s investment account because there are no individual accounts. Assets are invested on an aggregate basis and benefits are paid for life (there is no risk of individual members outliving their retirement savings).
The benefit formula is based on a number of factors, such as contributions flowing into the plan, member demographics (e.g., service and salary), ancillary benefit costs, assumptions about future investment returns, and anticipated retirements, terminations, etc.
If the pension formula turns out to be too low given actual plan experience, benefits can be increased. Conversely, if the formula turns out to be too generous, benefits can be reduced—hence the name “target” plan. The goal, of course, is to maintain a stable formula that provides members with a predictable benefit.
But, while a member’s level of engagement or investment know-how won’t have a direct impact on his or her pension outcome, that doesn’t make communication any less important. As anyone involved in a target benefit pension plan (currently over one million Canadians) will tell you, the cornerstone of a successful plan is trust—but not blind trust. Good governance and transparency around plan management are essential. Above all, members need to know:
- how the plan works,
- who’s accountable,
- how much they can expect to receive based on the formula,
- that the formula can change and what factors can affect it,
- how the plan is invested and how investment decisions are made,
- the financial status of the plan and its outlook for the future,
- the impact of their own actions, such as choice of retirement date and death benefits, on the amount of pension they receive.
As the DC market matures and we get a better understanding of the limited ability of even some of the most engaged and investment savvy members to come away with an adequate pension, there is a growing likelihood that demand for target benefit pension plans will continue to increase.