Canada’s remaining defined benefit pension plans are fundamentally flawed and require a drastic overhaul if they are to survive, according to a report out of the C.D. Howe Institute.

The report, penned by David Laidler, C.D. Howe fellow-in-residence and professor emeritus at the University of Western Ontario, and William B. P. Robson, president and CEO of the think tank, calls for a completely new pension model to ensure the long-term health of the retirement system.

“Current problems in the DB sector are not simply the result of a series of unfortunate financial events,” reads the report, entitled Ill-Defined Benefits: The Uncertain Present and Brighter Future of Employee Pensions in Canada. “They are symptomatic of deeper problems in the single-employer DB model.”

Simply tinkering with tax and regulatory issues would provide some help in the short term, but DB plans as a species can survive only if sponsors are able to pool risks, control costs and avoid the agency problems that currently plague the structure.

The report concedes that DB plans remain the favoured pension instrument among workers and that the “guaranteed” benefit does offer an important social support. But the report’s authors point out that the erosion of DB plans’ health poses a significant threat to that important social benefit.

“The under-funded state of many DB plans in Canada means that the retirement incomes of their members are less secure than they once seemed,” the report points out. “The obligations of most DB plans, furthermore, are liabilities of their sponsors, many of which are entities with publicly traded shares and debt obligations.”

The sponsors’ obligation compounds the problem, as their share prices usually do not accurately reflect their liability. Since other pension funds invest in the public market, they are very likely invested in overvalued companies, which face a pension funding crunch. The report authors refer to this as “a pyramid of mispricing that raises a prospect of systemic risks.”

The report cites four factors underpinning the current funding problem. Life expectancy has continued to rise, making pension payments a longer-term obligation than anticipated. Plan sponsors face the prospect of an ever-increasing number of benefit recipients while the number of current employees paying into the plan increases at a slower rate, if at all.

Another factor in the underfunding issue is the length of time it took for equity markets to recover from the stock market crash of 2000. The major indexes have only recently recovered all of the ground they’d lost.

At the same time, interest rates have remained in the gutter—especially long-term rates—making it harder for plan managers to earn a decent return on their fixed income investments.

Finally, new accounting principles have been introduced, with assets marked to market. This move has not reduced plan assets, but has illuminated the underfunding, which had gone unnoticed in the past.

To allow recovering pension plans to recover more quickly, the report recommends a shift in policy to remove the asymmetry between gains and losses. Currently, the plan sponsor must make up for any losses in the pension plan, but any surpluses are off limits.

Another problem facing DB plans is that while the assets are managed by an outside manager, the liabilities are determined by the human resources department of the plan sponsor.

“No single person or body deals with the overall asset–liability picture and, in particular, with the mismatches that have rendered so many plans vulnerable to the asset-price and interest-rate movements of recent years, and will continue to expose them to such risks in future,” the report says.

“Between the public system’s minimum guarantees and the often deceptive promises of the classic DB model, there is a large space that other, and perhaps quite innovative, occupational pension arrangements might occupy.”

The report’s authors give few hints as to what a new model would look like, but suggest that the best elements of defined contribution plans, RRSPs and possibly tax-prepaid savings plans could be drawn upon to bolster the DB model.

Such a new model may be structured largely along the lines of a DC plan, but include a minimum guaranteed benefit. Investment risk could be pooled across a larger number of plan members to reduce administrative costs. Meanwhile, contribution rates could be allowed to fluctuate to remain in line with target payouts to retirees.

For individuals approaching retirement, improved guidance from the plan sponsor should steer their portfolios toward a safer asset mix, which could expand the market for advisors working in the group benefits space.

To read the report on C.D. Howe’s website, click here.