As the saying goes, if you stay around long enough, old ideas will return. While we can only hope this does not happen with disco music, perhaps it is time to reconsider some ideas from the past in the pension context.

In a discussion with Colin Carlton, a consultant in the industry whom I have known for many years, we thought that it may be time to reconsider the hybrid pension design. Hybrids plans combine the account balance features of defined contribution(DC)plans while also providing guaranteed retirement income and the security of defined benefit(DB)plans. In effect, this design delivers the greater of a promised amount of DB pension and the pension that can be provided from a DC account.

In a way, this design produces a similar result to many partial plan wind-up situations in Ontario:

• If assets are less than the benefit value, participants get the DB promise; and,
• If assets are more than the benefit value, law cases ensue and surplus gets shared. In essence, participants receive something like their share of the contributions that have been made to the plan—something akin to a DC-type benefit.

If the hybrid design were made formal in the plan document, clarity would exist around the pension “deal.”

Why did the pension industry abandon the DB/DC design? The main driving force was the introduction of the Pension Adjustment(PA)rules in 1990. At that time, Government of Canada bond yields were roughly 10%. The introduction of the factor of nine meant that most DB/DC designs generated PAs based on the DB formula even though most of the benefits paid out were based on the DC account balance. In the current environment of 4% yields(and even somewhat higher yields), the PA system no longer makes the DB/DC design so inefficient.

What are the attractions of such a plan design? It rewards long service employees while providing more meaningful benefits for shorter-career employees. It also encourages greater employee participation and a sense of shared responsibility for retirement planning, savings and investments. For plan sponsors, the DB portion of the plan allows them to satisfy many human resource objectives related to attraction/retention of employees. Additionally, they would be able to offer early retirement windows. In exchange, part of the benefit of good plan experience is transferred to participants.

There are still several issues relating to the DB/DC design that merit further consideration.

• The funding policy and related contribution strategy: since the DB promise only represents the excess over the DC account balance, its value will be quite volatile. How might this volatility be managed to avoid poor consequences for the plan sponsor?

• The plan’s investment policy: if the impact on a sponsor’s cash flow and financial statements were to be more volatile with the DB/DC design, to what extent can this be mitigated through changes to investment policy?

• Participant investment options: since plan participants have a “safety net” with the DB promise, how should this influence the investment choices, if any, provided to them?

• Participant communications and engagement: the intent behind the DB/DC design is to capture the best qualities of each type of plan. How should communications be structured to prevent participants from perceiving the plan as capturing the worst qualities of each?

Over the balance of this year, in a series of these articles, the issues sketched out above will be expanded. The purpose of this series is not to convince the industry that the DB/DC design is the best in all possible circumstances, but rather to explore which circumstances make this design preferable, progressive, and practical.

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Comments

Unfortunately these designs are trying to find a solution to the pension problem without looking at the entire total rewards package and the culture/philosophy of the company.

We have pay practices which are base pay, some form of merit or progress through a range and then incentive plans. In life and disability we often see base and optional programs. Disability tied to various levels of base or incentive and some based on who pays.

Health and dental are going more to limits on coverage and maybe adding deductibles and then adding HCSA.

When we get to pensions we forget all the rest of the company view and try to design a program which will keep actuaries employed, play games with volatility and not truly change the program to tie to the companies philosophy.

This plan provides a minimum benefit of the DC side to the employee, the possibility if s/he makes bad investments or the market is poor, the the company will come along and take care of the employee The company still eats the volatility, if there was a surplus, it is given to the employees or if to it would be in the same situation of surplus issues as we are today.

There is a method to design a plan which is DB and has less volatility and can be managed in such a way to set a budget and run with it. The rules limit some of the ability but it can be done in a far better way and yes these plans existed in the past and they exist today.

Of course until the plan sponsors stand up and link their culture values and designs and the industry helps to get to this rather than looking within their silo, there is no good solution.

-Bob Tangey