This illustrates the flip side of stable employer costs in DC plans.
The pension that a DC plan member can reasonably expect at retirement will fluctuate significantly as economic conditions change. The pension that a DC plan is currently expected to provide could be very different from what it was originally projected to provide when the plan was established.
DC plan sponsors are not inclined to monitor and make adjustments to contribution rates as economic conditions change. This is why they moved away from DB plans.
Very few plan members have a realistic sense of how much pension their DC plan will provide and how much it varies until they are very close to retirement. By then, it’s generally too late to adjust their personal savings rate to preserve their original retirement plans. More likely, they will be forced to make tough choices, such as postponing retirement, accepting a lower standard of living in retirement or continuing to take an uncomfortable amount of investment risk.
Not many DC plans have been around for more than 20 years. However, as employees who have participated in a DC plan for their entire career reach retirement, the replacement ratio issue is likely to come to the forefront. Plan sponsors will have to improve communication so that employees can better understand how much retirement income they can expect from their DC plans.
In fact, the recently issued draft CAPSA Defined Contribution Pension Plan Guideline recommends that sponsors provide this kind of information to members on an annual basis. As this type of communication becomes more prevalent, it will likely lead to employee pressure to increase DC contribution rates, which were often set when interest rate levels were much higher. Some plan sponsors will resist making such increases, as they believe that employees will not easily accept a subsequent reduction in contribution rates if interest rate levels rise in the future.
On Target
Given that many sponsors don’t want DB plans, and many employees are likely to struggle in DC plans, what, then, is the answer?
Recently, target benefit plans have been touted as a possible solution. Many jurisdictions have announced their intention to permit and encourage the establishment of target benefit plans. New Brunswick, in particular, has taken significant strides in this area with its announcement of the shared risk plan framework and the introduction of supporting legislation.
Target benefit plans may appeal to sponsors because they have stable contributions like DC plans. Target benefit plans may also appeal to employees because they aim (but do not promise) to provide a predictable pension in retirement like a DB plan. Target benefit plans will address many of the concerns noted above with DC plans, including the following:
- the delegation of investment decisions to professionals rather than individual plan members;
- the pooling of longevity risks, thus avoiding the need for DC members to oversave or to accept the risk of outliving savings;
- an increased likelihood of members choosing to receive their entitlement as a lifetime pension rather than a lump sum, since pension amounts will not be based on point-in-time market interest rates; and
- an improved understanding from members as to how much pension to expect from the plan and, therefore, an increased ability to plan appropriately for retirement.
Due to the lower need for liquidity, target benefit plans of sufficient size will be able to use alternative investments to a much greater extent than DC plans and hopefully reap additional returns as a result. The use of DB going-concern funding mechanisms will allow for more predictable retirement benefits than DC plans. In good times, a portion of the experience gains can be banked to build up margins (rather than improve benefits or reduce contributions). These gains can then be drawn down under adverse conditions (before benefits have to be reduced or contributions have to be increased).
Target benefit plans appear to hold a lot of promise as a compromise solution that will improve employer cost certainty but still provide members with reasonably predictable benefits. However, if target benefit plans are to provide reasonable benefits over the long term, contribution rates cannot remain unchanged forever. Pensions cost more in low interest rate environments than they do in high interest rate environments. Plan sponsors can’t be dogmatic about fixed costs or else they’ll be faced with large numbers of employees who are unable to retire.
Traditional DB plans will continue to make sense in some organizations—particularly where labour costs are a small part of the cost structure and where they can be used to attract and retain employees in a competitive labour market. DC plans may make sense in other organizations, particularly those in which employees could be expected to have strong financial literacy. However, for many other organizations, target benefit plans appear to be the most promising path to a sustainable retirement plan.
Manuel Monteiro is a partner with Mercer (Canada) Ltd. manuel.monteiro@mercer.com