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The Institute for Research on Public Policy recently published a paper by economist Keith Horner entitled A New Pension Plan for Canadians: Assessing the Options, in which he concludes Canadians would be better served by proposals to expand the CPP, which delivers DB pensions, over other options such as the pooled registered pension plan (PRPP) that deliver pensions on a DC basis.

The DB versus DC debate drives me crazy in that it perpetuates a number of DB plan myths that seem opaque to even those who have a fair degree of financial sophistication, including many pension experts.

Here are some of the points that are ignored in the acceptance of these DB myths along with some very simple math that shows how DC benefits can be better than DB.

1. The best lesson I ever learned from a wise actuary is that “money in equals money out.” Although this sounds trivial, when it comes to DB pension funding it is anything but, as the dimensions of time and pooling of risks/rewards add a high degree of complexity. Thus regardless of whether a plan is DC or DB, the simple math is as follows:

2. DB plans and DC plans can be invested identically across a diversified portfolio. Offering investment choice is a weakness for most DC plans—the administrative complexity of offering investment choice drives up administration costs, and when averaged among a cohort with many unsophisticated investors, investment returns fall short of those in a pooled diversified portfolio.

Removing investment choice and mandating investment in an appropriately diversified portfolio removes investment results as a differentiator between DB and DC, except for the effects of timing of contributions/benefits relative to individuals. Thus In becomes a constant “k” for comparisons between pure DB and pure DC:

3. DC with no investment choice is simpler to administer than DB, thus lowering expense payments, which leaves more for benefits.

The formulae above do not account for the following:

  • Longevity risk pooling, which is a feature of DB that is absent from DC (except to the extent that a DC plan may offer life annuities at retirement)
  • Timing of contributions relative to delivery of benefits (e.g. risk pooling between age cohorts as articulated in the Horner paper), which can also be characterized as intergenerational funding

These are critical differentiators that result in requirements for intergenerational funding increases when the following population and economic factors are present.

  • Increasing longevity
  • Demographic bulge (e.g. baby boomers) moving into benefits phase
  • Recessionary periods

Of course, intergenerational funding requirements can decline if any or all of the above factors reverse direction, but often the tendency is to instead increase benefits while holding funding steady or even to reduce funding through a “contribution holiday,” as has been widespread practice in the private sector.

Alternatively, excess funding reserves could be built up to weather periods of adverse population and economic factors, but few governments—Canada being a notable exception in respect of the CPP—and almost no private plan sponsors have perceived the wisdom of building such reserves. This is why there is worldwide concern, at crisis levels for many countries, about pension funding for all models.

The Horner paper is an excellent treatise. However, its principle failing is that the risks of the “critical differentiators” I describe above have not been assessed.

How can the significance of such risks be ignored in the context of riots in Europe and widespread media coverage of the state of public sector pension plans in the U.S. and elsewhere? The current policy direction being followed in Canada is to preserve the stability of our current government programs and to enhance them with stronger, more universal DC arrangements (in the form of the PRPP framework).

The former provides a strong, basic level of pension, while the latter can empower individuals to ensure their own retirement income security with far less exposure to the demographic and economic risks that have undermined the security of DB plans worldwide.

Greg Hurst is a Vancouver-based pension consultant with Greg Hurst & Associates Ltd.

These are the views of the author and not necessarily that of Benefits Canada.

© Copyright 2014 Rogers Publishing Ltd. Originally published on benefitscanada.com

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See all comments Recent Comments

Marty:

Several problems with the PRPP solution. First, employers don’t have to contribute at all. Typical DC in this country is a 5% match. That’s not enough money to fund an adequate pension, even if you had DB-like, low-fee investment. Voluntary retirement savings isn’t working — look at the $600 billion in unused RRSP room, and the fact that the typical Canadian has only $60,000 at age 55 in their RRSP. I would have hated to be retiring from a DC plan in 2008 — it’s a very volatile arrangement.

Wednesday, July 20 at 2:59 pm | Reply

Bob:

First you need ot consider the past, the stats to realize why there is unused room. The ability to contribute to an RRSP was only enhanced/increased in the 90′s, and those in DB plans do not always make their additional contirbutions or need to. Those under $30,000 in annula income have limited need to contribute even if they had the money. Add these up and soon the numbers many not be s bad as an initial look portrays. Additionally, if you took an individual, contributing the 5% with a match over the last 35 years add the investment income, you would likely find a more than adequate pension income. I have seen a few people under this scenario retire with close to 80% of their final years income. May not happen in future but?

Tuesday, July 26 at 8:09 am | Reply

Mike Murphy:

Another BIG plus for DB plans has to do with the old saying “there’s strength in numbers”. With DB plans the individual gives up control of the plan investment, administration etc. to the group (owners of the plan), in return there is the advantage of economy of scale and, more importantly, present and future members of the DB plan undertake the promise to pay the monthly benefit to those who retire. A kind of insurance that doesn’t have to be purchase seperately as DC members do when they purchase a Lifetime or Retirement Income Fund.

Thursday, July 21 at 7:34 am | Reply

Bob:

Both still miss many points of why the differences exist, if were looking for the best arrangement, I would be in the DC plan with a 10% total contribution rate until I was around 50 and then a DB plan with a contribution rate of 10% until I retired and I would have the best pension.

I would also hope the DB plan used the unit credit method and had an average age of the members of about 40.

Explaining why this works best will answer a few other questions.

The other disconnect is the risk, plan sponsors, actuaries and the legislators allowed/accepted and then define the problem as the DB plan. It was not the DB plan that failed.

Thursday, July 21 at 1:37 pm | Reply

Dr Owen Corbin:

My Defined pension is far better. I’m looking at 300k per year presently with annual 3% cola’s. That coupled with my part time private practice gives me 600k per year and that allows me to live comfortably in Maine.

Friday, July 22 at 1:34 pm | Reply

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