There is a lot to be said for defined contribution(DC)plans. From the plan sponsor’s perspective, they can alleviate concerns about cost volatility and funding deficits that are associated with defined benefit(DB)plans. They are usually better understood by the members than DB plans, because they look and feel like individual RRSPs. And we all know of other advantages of DC plans from the member perspective, including extra RRSP contribution room for most members, higher benefits for those who terminate service early in their career, and a greater sense of member involvement in their futures.
But will DC plans actually deliver what the members hope for? Based on current economic expectations for the returns under various major asset classes, today’s annuity rates, and looking at the typical contribution rates paid under these plans, there may be some major disappointments in store for future retirees. The trouble is that if DC plans do not actually live up to member expectations in terms of acceptable income replacement ratios, the realization of this by members will likely only occur in their final few years before retirement, when it will most likely be too late to correct.
Will DC plans facilitate a relatively stable pattern of exits from the employer in a world where mandatory retirement is being abolished? From a human resource planning perspective, such stability is usually helpful, especially when employers who are facing labour shortages may not be able to handle a large volume of retirements after a bull market has increased the older workers’ DC pensions.
And will DC plans be best suited for attracting skilled workers to replace the mass of retiring baby boomers? Older workers, for example, typically find DB plans more attractive than DC plans.
Is this message meant to be a slap in the face for DC plans? Not at all. As recently as 2002, median DC plans were producing income replacement ratios for long service employees at retirement that were comparable to those of typical DB plans in the private sector.
But the market expectations around the world have changed in the last few years. Central banks have gained control of inflation for a long enough period that the markets generally believe that low inflation is here to stay. That is one factor that has driven interest rates down, both short term and long term. That in turn has affected expectations of investment returns from all asset classes—reduced inflation concerns mean that the nominal reward for taking risk can be lowered.
In the DB pension world, these lower expectations have had a dramatic impact on both the pension numbers appearing in corporate financial statements and the solvency liabilities that have increasingly been driving employer contributions recently. Not only that, but increased life expectancy has driven up the liabilities, and has the prospect of driving them up even further as medical advances continue. Large pension deficits emerged and are now being paid off via comparatively huge employer contributions.
But those same market forces have impacted members of DC plans—except that most of them don’t realize it. If they were to use the same techniques that actuaries often use for modeling future long-term rates of return on a DB pension fund(for the purpose of setting the actuarial discount rate in the going concern valuation of the DB plan), they might have a shock. That analysis would reveal typical employer contribution rates under DC plans are now likely to lead to a pension over one’s whole career that is considerably below what the median DB plan can produce. This phenomenon is quite new, and not many DC plan sponsors seem to have realized it—or if they have, they haven’t adjusted their contribution rates upwards.
This effect is compounded by the fact that most members of DC plans do not have the investment expertise of a DB plan sponsor, and tend to select more conservative investment strategies. The more conservative the approach, the lower the expected long term return on their DC assets, and the worse their expected income replacement ratios at retirement.
Sponsors of DC plans should consider studying these projections for different age groups and salary progressions, to judge for themselves whether their pension plan will provide an adequate pension. Inadequate pensions will inevitably lead to postponed retirement for those employees who have the skills and good health to enable them to continue to work well into their 60s—and yet this may not reflect an orderly exit pattern that their employer may have been seeking.
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