In order to get to the bottom of this, it is important to consider risk as falling under three main categories: investment risk which is fairly self explanatory and has grabbed everyone’s attention recently given the volatility in the market; lifetime risk which is simply the risk of outliving one’s retirement funds; and demographic risk which looks at the risk allocation among plan members, whether old or young, married or single, male or female. If demographic tradeoffs among plan members do not exist, the plan sponsor bears the consequences of the demographics.
INVESTMENT RISK
Delving deeper into these definitions of risk, there is a perception that the main difference between DB and defined contribution(DC)plans is that investment risk sits with the employer for DB and with the employee for DC.
For a DC plan, the investment risk is predominantly with the employee, however the employer may in the future be exposed to potential class actions. This happens when employees nearing retirement realize that the pension they will receive is much smaller than they had anticipated. This realization is not so much a function of poor investing or savings habits as it is a reflection of the tendency of many people to place a much higher value on an immediate lump sum than on an annuity. Once employees realize that their lump sum won’t provide the lifetime income that they thought it would, they then try and pass the buck back to the employer. Theoretically, they argue that the employer was deficient in providing good enough investment options and adequate investment training.
One approach to allocating investment risk is to have the employer control all investment decisions for employer contributions and have the employee control all investment decisions for employee contributions. The employer would also provide the employee with the opportunity to mirror the employer’s investment decisions as well as an opportunity to select from a variety of standardized funds which have been deemed acceptable for tax sheltered investments. The employer should not have any risk as a result of the investment decision of employees. Future regulation should provide this protection for the employer.
LIFETIME RISK
Elsewhere on the spectrum, employers have the lifetime risk in DB plans whereas employees have it in DC plans, RRSPs and any other capital accumulation plan. The lifetime risk is one for which a ready solution is available—annuities. Annuities should be required on any plan that receives a tax shelter. Such a requirement would reduce risk for both employees and employers and could be immediate or designed to begin at a fixed point after retirement if the employee is still living. For employees who do not have the benefit of an employer-sponsored pension, annuitization of a defined amount should be required. The amount would be calculated to provide a mandated income replacement ratio(including government benefits such as Canada Pension Plan and Old Age Security). The income replacement ratio, and the income it is applied to, would reflect the year-by-year tax sheltered limits up to the date of retirement.
DEMOGRAPHIC RISK
Demographic risk seems to get very little discussion. Traditional DB plan designs frequently create situations in which one category of members effectively subsidizes another: younger subsidizes older, short service subsidizes long service, normal retirement subsidizes early retirement and single subsidizes married. Most of these hidden subsidies are a function of the plan design. Most are also considered to be ancillary benefits.
We can largely separate the demographic risk from the investment risk and the lifetime risk by recognizing that much more of the demographic risk is within the control of the employee rather than the employer. The decision to marry, the decision to change jobs, the decision to retire early are all aspects which are, to varying degrees, within control of the employee rather than the employer.
Logically then we should use an approach similar to investment risk and have separate employee and employer accounts. The employer portion should be a very stripped down DB plan or a DC accumulation account with the requirement to annuitize as previously described. The employee portion should be used to recognize demographic differences such as retirement age, marital status etc. The DB design and regulation should be such that the accumulated benefit for a particular year of service, and a prescribed normal retirement age, is consistent for all employees regardless of gender, marital status, job changes or target retirement age.
To this point we have labeled contributions as either employee or employer. From a risk point of view the better labels are “lifetime contributions” and “demographic contributions.” Two of the three major risk labels (lifetime, investment and demographic)define the two contribution streams. The third, investment, becomes the label for managing the contribution streams.
As a result, sponsors and members should aim for a retirement package that has tax shelter limits, normal retirement age and contribution limits that would be established by reference to a known and predictable benchmark(e.g. the Canada Pension Plan average Yearly Maximum Pensionable Earnings). All contributions, whether employee or employer, will be considered “lifetime contributions” until the mandated income replacement ratio has been attained for the employee’s current age, earnings and service. Additional “demographic contributions” up to an amount equal to the maximum “lifetime contributions” based on the employee’s current age, earnings and service can then be made.
We can minimize the employer business risk and the employee retirement risk through a simple, well structured, prioritizing and direct assignment of the risk components. Both the lifetime risk and the demographic risk should be funded for directly and for equal tax sheltered amounts. The investment risk then enters the picture as the tax-sheltered funds are invested and investment risk is directly assigned to employer and/or employee. The lifetime risk should take priority over the demographic risk and be fully funded before a direct allocation to demographic risk is made. Tax shelter consistency amongst different employees and employers can be achieved by using a direct link to a well-designed public system like the Canada Pension Plan. A transition to an entirely new, risk-reduced and more fair system like this can be done.
Tom Walker is a principal and consulting actuary with Buck Consultants in Toronto. tom.walker@buck-consultants.com
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