A volatile situation
Defined benefit pensions are continuing commitments. They look and behave much like long-term fixed income investments, such as Government of Canada bonds. If one wants to match the asset to the commitment, this is the type of investment one would make.
The problem with this approach is that the return generated by a fixed income investment such as Government bonds is lower than the expected return from other, more risky investments. This means that, in order to have affordable contributions or target higher benefits, a conscious decision is made to mismatch the assets held versus the pension commitment being made. This mismatch results in volatility in plan costs and contributions required for DB plans and variability in the level of retirement benefits provided by DC plans. Finding a solution to better manage this volatility without driving required contributions up too much or sacrificing benefit levels forms the basis for the development of an outcome focused approach to the development of pensions built to last.
Defined benefit pension plan challenges
The primary challenge for traditional DB plan sponsors is the ability to withstand both the level and the volatility in required contributions. Many plans benefited from solvency funding relief only to realize later that the solvency deficit kept growing. Other plans left the game early and moved to a DC type of arrangement. Either way, plan members are left with having to absorb increased risk.
Traditionally, DB benefits have not been managed as guarantees even though many, if not most, plan members believe they are. The security of the benefit is ultimately dependent on the plan sponsor’s ability and willingness to pay the required funding level, whatever that turns out to be and whenever it is needed. If the required funding is not available for any reason (i.e., financial limitations / insolvency of sponsor) the only other lever available is to adjust benefits: for all members, for future service only or for future members. None of these produce highly efficient models and run the risk of being unaffordable at some point down the road.
While long term average costs could be manageable, actual investment results on a year by year basis are rarely average. History has shown us that in periods of excess funding, more risk is assumed either by taking contribution holidays or increasing the benefit promise. In periods of underfunding, sponsors and members often struggle to find solutions that, in many cases, have proven only temporary and have led to intergenerational inequalities that could be questioned. Current pension legislation in most jurisdictions does not allow for a reduction in accrued benefits in an ongoing traditional DB or similar pension plan. Consequently, the only actions available to rebalance the funding position are:
- Increasing active member contributions
- Increasing employer contributions
- Reducing the value of future active member benefit accruals
- Reducing certain ancillary benefits for past service, if possible
If the solution adopted is to increase employer contributions to the pension plan, this will create financial pressures elsewhere on the employer, as all employers, in both private and public sectors, need to operate within certain budgetary parameters. Efforts to moderate any increased pension funding may ultimately be borne by the active plan members via wage restraint, other benefit reductions, job losses, hiring freezes, etc.
While general consensus would support the notion that the pooling of risks in larger groups of plan members should prove more efficient and effective in the long term, the traditional DB approach does not appear to be a realistic option. If not a traditional “guaranteed” DB, then what?
Any proposed solution should ideally be both effective and efficient. Effective so that benefits are adequate and contributions are affordable for the long term future; efficient in the sense that the use of retirement savings is maximized through risk pooling to produce larger, more secure and even-handed benefits for participants.
Are defined contribution plans the answer?
A DC pension plan is the converse of a DB plan in that individual plan members bear all of the risks including the risk of investment performance (good and bad) and the possibility that one might outlive his or her savings. For that reason, many individuals and labour unions have a strong preference for DB type plans over DC plans.
DC plans are also impacted by volatility. The challenge for DC members and sponsors occurs when there are changes in financial markets. In a market downturn, employees may need to work longer. If returns are up, employees may retire earlier. This volatility creates employee retention problems and workplace management issues.
Furthermore, even well-planned, well-managed and well-performing DC plans will result in some plan members outliving their money, unless they buy annuities. Currently, buying annuities is perceived by many as being excessively expensive.
However, the fundamental issue with many DC plans is that they are not designed or monitored with a specific retirement income target in mind. In general, DC plans operate more as a savings vehicle than as a retirement income plan. While they provide an opportunity to set aside money for retirement, it is normally left to each plan member to identify a target, track progress toward that goal, modify their actions to stay on track and then convert their savings into a predictable or adequate retirement income. While some progressive DC plan sponsors are expanding the support given to members to help guide their retirement planning, this level of service is not common. Conducting this analysis on their own is beyond the expertise of many plan members.
There are situations where a DC plan is the best approach but for a group with a large number of individuals, an approach that tempers the volatility and permits greater risk sharing with others, including the employer, may make more sense. However, such risk pooling only makes sense if the structure allows the plan to be resilient to future outcomes from an uncertain future.
Are Target Benefit Plans the answer?
For purposes of this discussion, a target benefit plan is any type of plan that requires participation of plan members in addressing the volatility in financial results as it occurs. These include the simpler version of multi-employer pension plans with fixed contributions and potentially variable pensions, through jointly-sponsored pension plans which require current and future contributors to bear the risk for all plan members, to shared risk pension models that take a comprehensive approach to risk sharing among all plan members and everything in between.
Theoretically at least, any of the above can work. However, to reach reasonable levels of efficiency and effectiveness and to be resilient to future outcomes, whatever they may be, all of these plans need to incorporate strong governance and an integrated approach to risk management articulated within the founding and long term objectives of the plan. Without sound risk management, in particular, these plan designs could also lead to disappointments later on if the onus on the payers becomes too great to bear or the value proposition no longer makes sense to those required to pay.
In order to develop a sound and resilient pension plan, sponsors and other parties in the discussion need to follow an Objectives-driven process focused on outcomes, with clear Alignment of benefits, contributions, funding and investment policies to the founding and long term objectives, in a manner that is Transparent to plan members and other stakeholders (taxpayers or stock owners) and introduces a High degree of sound risk management on all fronts. All of this should be wrapped in a sound, disciplined and effective governance structure focused on delivering the best overall plan performance possible under any set of future economic circumstances.