While defined contribution pension plans currently outnumber defined benefit pension plans, this wasn’t always the case, recalls Bita Jenab, a principal at RetirementWorks Services Inc.
DC plans began to gain popularity in the mid-1980s, due to a combination of legislative and economic changes, she adds. “This period marks the introduction of pension accounting rules under the Canadian Institute of Chartered Accountants, which, in my opinion, were the primary driver of these conversions [around the move from DB to DC plans].”
Under these rules, notes Jenab, private sector DB plan sponsors were required to recognize their pension obligations in their corporate financial statements. “Before, they didn’t have to record their pension liabilities and basically expensed their contributions. But under these rules, if you had a DB plan, it affected corporate profits and valuation of the company.”
This period also marks one of the longest stretches of stellar equity market performance, she says. “The stock markets did very well at this time and interest rates were high. It looked deceivingly good to switch from a DB plan to a DC plan. That’s how the momentum started.”
In addition, the change was also spurred by the increasing costs of DB plan sponsorship. “These plan sponsors had to deal with the variability of this cost,” says Jenab. “DC plans offered predictable costs and far simpler accounting requirements. These rules had less to do with pension legislation and more to do with how public companies had to prepare their financial statements under accounting rules.”
Early DC plans were created to mimic DB plans, with contribution rates escalating as plan members aged, says David Morton, senior director at WTW.
“A lot of these plans were in a much higher interest rate environment — a DC plan contribution rate of seven per cent might have been enough to replicate the value of a DB plan. We’re nowhere near that today. Plan members didn’t worry too much about their DC plans because many of them had historical DB plan benefits that were going to provide them with a really good [retirement income] base. Returns were strong, interest rates were high and these plan members were able to get enough out of their DC plan.”
In the 1990s, the shift from DB to DC continued to pick up, mainly driven by a strong stock market, he adds. “[Plan members] saw how well the stock market was doing and DB plans were on contribution holidays at that time. By the early 2000s, it became an employer-pushed change to better manage the risks they were exposed to under DB plans.”
And as DC plans became more prominent, plan sponsors’ focus shifted to member engagement and plan governance. “The focus was placed on increasing member participation, getting them to save more, investor education, self-serve tools and innovations such as target-date funds where you could park your money and forget about it,” says Jenab.
The decumulation challenge
The last 10 years have been marked by a growing focus on the decumulation phase of DC plan membership.
“We’ve seen an entire generation of workers retire from purely DC plans with no trace of a DB promise,” says Jenab. “Plan sponsors, members and the industry as a whole are waking up to the realities of a mature DC plan system, where plan members have to navigate longevity risk, investment risk and inflation risk in their retirement.”
Quebec-based Bâtirente, which is No. 37 in the 2022 Top 50 DC Plans Report, was one of the first DC plans to integrate decumulation products such as life income funds and retirement income funds. “It’s important for us to not just bring plan members to retirement, but help them through retirement and support them in the transition from accumulation to decumulation,” says Éric Filion, the plan’s general manager. “It’s part of our core values to not just give them a cheque but to really help them succeed in retirement.
“There’s still a lot of education left to do [on decumulation] — there are a lot of questions from plan members about fiscal implication. We need to make sure they understand the risks and that they may outlive their savings. They may not be fully aware they may live to age 90 or 95, so we really need to help them to not outlive their money.”
Nicole Quintal, communications manager at the Co-operative Superannuation Society Pension Plan, ranked at No. 2, says decumulation is a key focus in its plan member education strategy. “We’re here to help our members ensure financial security in retirement. We want them to feel taken care of both during and after their working years.”
And while significant changes to federal and provincial legislation will be required in the future before variable payment life annuities become widely available to DC plan members, this option presents one possible solution to the decumulation problem, says Nadine Tabet, associate partner of wealth solutions at Aon. “We need VPLAs to make [DC] plans work correctly. If plan members don’t have the means to retire, they’re going to stay with their employer. From a social standpoint, this isn’t a good situation.”
While smaller plans may not fully benefit from a VPLA’s ability to pool longevity risk, there has been talk in the industry of having pooling for smaller plans to group together to achieve that scale, says Kin Chin, head of retirement and relationship management at Franklin Templeton Canada. “[VPLA] payments are based on investment returns, but also mortality credit from those who die earlier than expected. Having a solution like this is a big improvement from RIFs or LIFs or annuities.”
Changing investment options
Morton likens the evolution of DC plan investment options to the evolution of mobile phones.
“[At first], plan members had to pick from a lineup of funds — that was like a car phone. Then there were pre-mixed funds, like a balanced fund, which is the equivalent of the first mobile phones. Those funds met the needs of maybe 10 per cent of the population — for everyone else, it was either too much or too little equity. . . . The investment community then moved to asset allocation funds. Instead of one balanced fund, there were five, varying from very conservative to growth-focused funds. These were like the flip-phone era.”
However, he notes plan members weren’t monitoring these funds and didn’t realize they needed to switch as they got older. “The investment community recognized this situation and introduced target-date funds, which are like today’s smartphones. These funds recognize everyone in the plan has the same expectation for when they need that money and, if you know it’s a long way off, the manager will add more equity exposure. The use of these plans, including as the default, has been a key innovation.”
In 2011, the CSS pension plan added an equity fund and a bond fund for a total of four investment funds that allows members to create their own asset mix. “We’ve added more flexibility for members to customize their pension according to their own situation,” says Quintal.
DC plan sponsors are also focusing more on environmental, social and governance factors in their investment approaches, notes Morton. “There was an uptick after [the 2021 United Nations Climate Change Conference]. That’s when I noticed a lot more media attention. It’s around when the chief executive officer of BlackRock [Inc.] said climate change is going to influence how certain companies will perform — they’re now making their passive funds ESG-focused in a way.”
Bâtirente’s fiduciary responsibility is inextricably linked to ESG. “It’s part of our DNA and we were one of the first signatories of the [UN’s principles for responsible investment],” says Filion. “We can’t manage our pension plan without considering long-term economic and social development, as well as sound capitalization of the plan. Both are required for sustainable economic performance. . . . We’re a non-profit organization and the board reviews our practices and investments. In 2020, we took steps to reduce our carbon footprint by 50 per cent. It’s not about managing risk — it’s about making a difference.”
While automatic enrolment and escalation could have a positive impact on DC plan members, Canadian plan sponsors have generally been wary of introducing these features due to inconsistencies between employment and pension laws, says Morton.
Auto features are more common in the U.S., where the law permits their use, he adds, noting some Canadian jurisdictions, such as Ontario, are currently re-examining legislation around auto-enrolment. “[WTW’s] last DC pension plan survey showed 67 per cent of employers are using auto-enrolment, at least for new hires, where it’s permissible. The challenge is with existing employees. If you’re doing it just for new employees, eventually you’ll get to the right place, but your entire workforce needs to turnover before you have auto-enrolment for everyone.
“A lot of employers want to apply auto-enrolment to existing workers, but that’s where employment legislation gets in the way. Some jurisdictions, such as British Columbia and Alberta, under employment law, stipulate an employer can’t deduct anything from an employee’s wages without getting the employee’s explicit permission.
“Auto-escalation is a little different. You’re running afoul of employment legislation in essentially any circumstance in most jurisdictions. Some plan sponsors are trying to do it by re-enrolling members as part of the benefits plan enrolment and they may add on the pension plan enrolment and say, ‘We want you to tell us how much you want to contribute — by the way, we’ll pre-select for you to contribute the maximum amount that gets an employer match.’”
In addition to the U.S., Tabet highlights the U.K.’s introduction of auto-enrolment in 2012 as a lesson for Canada. Before it was implemented, fewer than half of U.K. private sector employees were in a workplace pension. Today, that percentage has grown to roughly 90 per cent.
“[Auto features] are a part of smart [DC pension plan] design, but many employers are reluctant to use them because of employment law,” she says. “Employees don’t think about retirement early in their career. You can’t tell someone who just graduated and has student debt that all their money has to go to retirement, but employers have to decide how they want to support these employees and auto features can help with that. Employers have a huge role to play — they have direct access to employees and their workers already trust them. And employees with better financial health will do better at their job.”
Blake Wolfe is the managing editor of Benefits Canada.