The introduction of defined contribution (DC) and other capital accumulation programs (CAPs) to replace DB plans has made life complicated and stressful for the average worker. Most CAP members, are unqualified to invest or simply not interested in investing. They are nevertheless immersed in a fog of economic prognostications, investment jargon, generalized risk profiling, fund manager- and market-based benchmark returns and esoteric investment information. Few members have a high enough level of understanding of the key investment issues because they don’t understand how they affect them. The majority of members, for instance, do not appreciate how critical time and risk are in managing their accounts. Despite this, the only “performance” indicators provided are gross fund returns, the corresponding market-based benchmarks and account inception-to-date returns. Many CAP members, however, invest in guaranteed investments (i.e.; GICs) where they don’t know their actual returns and there is no benchmark.
CAP members are being bamboozled by information that is not sufficient to manage the DC portion of retirement savings. What members want and need to know, at least as a starting point, is how much they have in their DC account in relation to the amount needed on retiring.
A pension represents a liability that must be funded, over time, by a government, employer or, in some cases by an individual. In the CAP world however this concept is not clearly communicated or understood: CAP members are provided with return information but the “personal pension liability” aspect is ignored or glossed over. Why has this happened?
High interest rates and the ballyhoo over the concept of a “free lunch” from equities, over a long term, contributed to the impetus and demand for DC-type plans by sponsors and employees. Differences between DB and DC plans and challenges such as having to manage an individual balanced investment portfolio, asset mixes, risk sharing, changing investment horizons, time, volatility, and tax factors are ignored or downplayed.
The principles developed for managing DB plans are well established. The longer term view used in going concern valuations, for example, provides a reasonable and accepted snapshot of pension liability and required funding at a point in time. The going concern discount rate used to determine the liability represents the long term expected return on the plan investments (commonly 5%-10%). An Individual Pension Plan (IPP) for example, is simply a personalized mini-DB plan with a legislated discount rate of 7.5% to determine the liability and required funding.
The introduction of solvency valuations in the 1980s increased the risk of sponsors having to make large inopportune cash contributions and posed an additional financial risk. It also resulted in a change in focus to maximizing short term returns in order to minimize solvency contributions. The key DB return performance indicator also subtly shifted from a primary (absolute) return objective (i.e.; the going discount rate) to a relative return objective (an asset mix market-based benchmark). These changes carried over into the CAP world.
Knowing the “funded status” is as important in managing a DC account as it is in administering a DB plan or IPP. Whether a DC account made 4% or 6% over 5 and 10 years or, since inception is interesting but insufficient information and can also be misleading. To make it easier for DC plan members sponsors should provide an estimate or a “tool” which calculates an estimate of the “liability” and the funded status of their DC account. The argument against providing a personalized CAP “liability estimate”, because is “too difficult”, should be challenged by sponsors.
A reasonable pension liability “estimator” is not complicated: a) using a discount rate of say 7.5%; b) determine the present value of the annual drawdown (“pension income”) from the DC portion of a retirement plan, over the expected drawdown period; and C) then determine the present value of the calculated retirement amount today. Dividing the current value of a DC account by the estimated liability provides an estimate of the funded position. The estimate can be revised if the expected account drawdown or discount rate changes. The discount rate can also be used in determining investment strategies (e.g. asset mix). As the funded position of the account improves or decreases, the reasons for taking less or more investment risk, increasing contributions or saving more, will be more apparent.
An estimate of the of “pension liability has several advantages from a sponsor perspective: a) it should increase the members’ understanding and likelihood of accumulating sufficient assets in their DC account; b) it provides members with a meaningful and much needed risk measure and control; and, c) it will improve the awareness of riskier investments and strategies e.g. exposure to equities, over time.
The DC portion of retirement saving program needs to be managed as if it is a personal, mini-DB plan, similar to an IPP. To be effective, the objectives and expectations for a CAP need to be specified and will differ from other retirement income sources i.e.; government pensions programs, tax assisted savings (RRSPs, TFSAs, DPSP) and other personal investments, savings and assets. To further simply the investment process for CAP members, sponsors should consider the merits of using a passive investment approach.
As in the case of a DB plan, to effectively manage a retirement plan members need to know the “funded” position of the DC portion of the plan.