The shift from DB to DC plans has done nothing to address Canada’s retirement funding crisis, aside from insulating plan sponsors from the risks of underfunding. Because there are no benchmarks for a DC plan, the concept of “underfunding” has lost meaning to all but the plan members, who risk underfunding their retirement needs.
That’s according to James Keohane, senior vice-president, investment management, and chief investment officer, of HOOPP—his plan is a standout in the DB world for being fully funded.
He was speaking at the 10th annual Canada Cup of Investment Management in Toronto on Tuesday.
No benchmarks for DC
Most DB plans are designed to replace between 60% and 75% of working income, but with the shift to “unbenchmarked” DC plans, no one knows if the individual’s pension is adequately funded, he said.
Denise Kehler, director of investment services with Saskatchewan’s Public Employees Benefits Agency, agreed that no one is measuring the future shortfalls in DC plans but pointed out that it is difficult for the employer to know what the plan member will need down the road. Members may have large personal RRSPs, for example, and not need to contribute as much to their DC plan.
Key to DC success
The key for success in using a DC plan is that the sponsor and the member must commit to making sufficient contributions. Kehler’s multi-employer pension plan has an average contribution arrangement of seven-and-seven, with both the plan sponsor and the member contributing 7% of income to the plan. At the high end, some members have nine-and-nine agreements.
Workforce make up should determine pension model
But the debate over which model is better must be framed within the context of the employer and the demographics of its staff, said Lawrence Swartz, a principal with Morneau Shepell.
Some employers are better suited to DB plans, because they have long-term employees—such as public sector employees. The stability of this workforce insulates the plan sponsor from the risks associated with high turnover—it’s difficult to invest for the long term if plan members come and go every couple of years.
On the other hand, many private sector employers have a younger, more mobile workforce, and it makes more sense to provide a DC plan because staff might only remain at the employer for three to five years.
Kehler says her pension plan has only about 1,000 retired members, with 50,000 active members. But the largest cohort of active members is between the ages of 45 and 55—and the average retirement age is 58.
A DB pension that is largely made up of older workers can be worse for younger colleagues than a DC pension, according to David Lawson, chief investment officer of the Worker’s Compensation Board, Alberta. With a large proportion of members nearing retirement, the risk profile of the DB plan may be significantly lower, threatening the accumulation ability of the younger workers.
There is a third way, but so far there has been little uptake of target benefit plans (TBPs) in North America. Keohane pointed out that TBPs have found success in Europe, however, and that the DC and DB models could evolve into TBPs.
He sees DC and DB plan designs moving toward each other, with new risk-sharing arrangements between active and retired members and plan sponsors. His own plan, HOOPP, is owned by members, and shortfalls are made up by both employees and the hospital corporations that employ them.
Kehler says her agency is not about to embrace the TBP any time soon but is looking at ways of sharing risk.
Risk an issue for DB and DC pensions
Aside from underperformance, one of the big risks for the DC member is the transition to retirement. In the past, Kehler said retirees were required to withdraw their entire pension and build their own income portfolio—typically either an annuity or a personal retirement income fund (PRIF).
But with interest rates plumbing the depths of historical lows, retirees lost interest in annuities, while PRIFs represented a massive increase in fees from what they were paying in the accumulation stage.
In 2006, Saskatchewan changed its Income Tax Act to allow members to take a variable pension benefit. This allowed retiring members to leave their pension assets in the plan for their drawdown stage. These assets now account for 6% of assets among Kehler’s members.
For DB sponsors, inflation remains a major risk; indexed benefits represent an immediate increase in payouts, while rising wages mean larger liabilities down the road. Inflation is best dealt with at the plan design level, and Keohane says plan designers should assume that wage inflation will outpace the consumer price index.
Keohane’s own plan has a cap on indexation, limiting the sponsor’s exposure to extreme cases. Also, the indexation is ad hoc, so the plan’s board can withdraw cost-of-living adjustments.
On the asset management side, inflation hedges such as infrastructure, real estate and real return bonds can help keep the plan ahead of liabilities.