The shift away from DB to DC plans (Money Purchase Plans-MPPs) is well underway in both the US and Canada. Employers view DC plans as a way of reducing the exposure to DB pension risks as well as benefiting from lower administration costs and contributions. While sponsors, as the plan administrators, retain legal and fiduciary risk, DC plans shift the bulk of legal responsibilities from the sponsor and the pension funding burden from the employer to employees.
The first DC plans were introduced in the US in 1978-1980 but became popular in 1994 when “safe harbor” legislation, ERISA Section 404(c), was introduced. In Canada, the number of DC plans has also increased as awareness of the perceived economic and competitive advantages increased. In 2008 approximately 23% of pension plans were DC plans. Sponsors are anxious to extricate themselves from DB plans because they are more costly, represent a potential financial risk, are heavily regulated and are expensive to administer.
Each member has an account in a DC plan to fund their own unique pension liabity i.e. their personal mini-DB plan. Often, this reality is not understood or is conveniently overlooked or ignored by most sponsors and DC service providers.
In almost all cases DC members do not appreciate the subtly or understand the difficult and complex task of managing and funding their pension liability. Retirement planning and education is presented as an exercise in managing (maximizing) returns rather than the difficult task of funding a pension liability. A benchmark indicating the funded status of each member’s account is also often not provided or understood by members.
A 2007 study in the US concluded that DB plans are less likely to generate very low retirement wealth than a DC plan and also noted that the impact of timing and the type investments used in a DC plan were difficult to assess. A study in the US by Friedburg & Owyan (2002) concluded that DC plan member retirement age increased by two years and that elderly DC plan members were likely to outlive their DC pension assets. The documented and well known problems faced by many experienced administrators and investment professionals in managing DB plans point to the challenges faced by the average unsophisticated DC member. It is therefore hard to understand why governments in Canada and the US are encouraging DC plans as the pension program of choice for individuals given these hurdles.
DC plans can also inhibit members from successfully achieving an equivalent level income due to a long list of problems, including:
a) Members do not understand investment risks and the impact of volatility on returns.
b) Members are not aware of the impact of time and the concept of normally distributed returns with respect to funding.
c) Members focus on achieving high returns vs. adequate consistent returns.
d) Members do not take advantage of other tax assisted savings programs e.g. RRSPs, TFSAs which can boost retirement income.
e) Sponsor contributions in most cases do not adequately compensate members for the investment risk.
f) The risk sharing regarding time and investment timing available in a DB plan is not available in a DC plan.
g) Investment losses in a MMP cannot be made up from additional contributions and tax deductions as is the case in a DB plan.
h) DC members pay high fees from their plan assets which significantly reduces investment asset accumulation before and after retirement.
i) It is difficult to make up for investment losses in the draw down stage of a retirement program because of interest and equity premium risk i.e. timing.
j) Longevity risk is borne entirely by the DC member.
k) Having to sell units of fixed income investments to create a monthly income after retirement increases the member’s exposure to interest rate and duration risk.
l) Investments by pooled (mutual) funds are limited (prospectuses) as to the types of investments that can be used. DB funds can invest in higher yielding alternative /diversifying investments.
m) Most DC plans do not include duration matching products e.g. long bond funds to minimize duration risk.
n) Purchasing an annuity to create a retirement income is an option but dependent upon a sufficient amount of savings and a favorable interest rate environment.
To recover investment loses or increase retirement income MMP members, unfortunately, must take on greater investment risk.
DC plans have only been available in the US since 1974: they have not stood the test of time in either the US or Canada. Given the added limitations and investment hurdles presented to DC plan members why is it assumed an individual will be successful in managing a funding their personal “DB” plan?
The reliance being placed on DC type plans by governments and employers to generate adequate retirement incomes is perplexing. Perhaps this is just another example of grasping for a “silver bullet” solution to a complex problem. The question remains – are DC plans a new evolving frontier or, fatally flawed?