Despite the huge growth in defined contribution(DC) plans in Canada and globally, there appears to have been very little focus by plan sponsors on the critical issue of plan design. The primary focus of plan sponsors has been on the selection and maintenance of investment structures and member communication.

Plan design is typically addressed initially, when the plan is introduced, but then is rarely revisited. When the plan design is structured, it is common for plan sponsors to focus primarily on the competitiveness of the plan design in a relevant industry, rather than evaluating the adequacy of the benefit formula to deliver a given level of income in retirement. When rolling out the plan to employees, the member communication message will often position the plan as being competitive.

The movement from defined benefit to DC plans has signalled a shift in corporate philosophies from paternalism to empowerment or self-determination. However, it remains important that the plan sponsor consider the adequacy of the plan, when designing the formula, and more importantly, in the development of communication messages to the plan members.

There is no obligation that companies provide any specific level of retirement benefits to their employees. In fact, absent of competitive pressures, a plan sponsor is not obligated to provide any formal retirement program. However, where a DC plan provides employees with a modest benefit, it is important that members have a reasonable understanding of expected plan accumulations at retirement and the need to save beyond the parameters of the basic plan formula.

With the introduction of the Guidelines for Capital Accumulation Plans(CAP)in 2004, more plan sponsors are considering the issue of benefit adequacy in the context of their plan design. The CAP Guidelines require plan sponsors to introduce a formal statement of plan purpose, which identifies the primary objectives of the plan, and ensure that all decisions relating to the plan are consistent with the stated plan purpose. In addition, the CAP guidelines are encouraging plan sponsors to increase their focus on improving the quality of information provided to employees, in order to improve the quality of member decision-making. A key element of this decision support envisioned by the CAP Guidelines involves tools such as retirement planning tools and projection aids, to help employees understand expected accumulation levels under the program.

In the face of this changing environment, Mercer Investment Consulting conducted a DC survey this year which was designed to help to evaluate potential changes in DC plan sponsor behaviour, as it relates to the issue of plan design.

The 2006 survey received responses from 334 Canadian DC sponsors, covering 366 different plans. The respondents included a cross section of employers, representing all major industry groups. The asset size ranged from start-up plans with no existing assets to those with over $4 billion in assets, with a median plan size of $12 million in assets. The number of plan participants ranged from less than 100 to over 25,000 with the median plan having between 500 to 999 members.

Despite the continued shift to DC plans and the increasing concerns about potential litigation, there has not been a significant enhancement of basic benefit formulae in the DC marketplace. The median maximum contribution available under Canadian DC plans, across all sectors, is 5% of pay. This is the same level as was identified in a similar survey conducted by Mercer in 2002. While this number continues to vary significantly across different sectors, it has not increased overall.

As was observed in 2002, the most common benefit formula structure continues to incorporate a match of member contributions (81%). The most common matching percentage incorporated in DC formulae is a 100% match of member contributions (approximately 69% of plans provide a 100% match).

For a typical 30-year-old employee, fully utilizing this competitive plan(with a 100% match of member contributions, to a maximum of 5% of pay)over a 30-year career, the plan(plus CPP)would be expected to yield a retirement income of approximately 43% of earnings at the time of retirement(based on today’s annuity rates). That is well below the 70% income replacement ratio target identified by many financial planners. Where the member under-utilizes the plan(by contributing less than 5% of pay per year), this retirement savings gap widens.

Seventy-three per cent of the plans surveyed provide a mandatory minimum company contribution under the plan. Approximately 60% of those companies structure the contribution as a basic company contribution, without any required employee contribution. The remaining 40% also require a basic minimum employee contribution.

While this type of structure does not raise the overall appearance of competitiveness for the plan, it does increase the expected cost of the program to the employer. At the same time, it helps ensure that a minimum benefit level is provided to all employees, regardless of whether they elect to contribute voluntarily.

The 2006 survey results also indicate a trend towards a more expansive definition of included earnings. As the chart opposite illustrates, more than half of the companies surveyed, that pay commissions and shift premiums, will include those amounts as member earnings for the purposes of calculating DC contributions. Approximately half of the companies surveyed who pay overtime, will include the overtime amount in pensionable earnings and just under half will recognize bonuses. This represents an increase from 2002 survey results, where less than 50% of respondents included any of the above elements in the definition of covered earnings under the plan.

The definition of earnings for DC plan purposes should incorporate any component of member compensation that is reasonably expected to be a significant and consistent component of regular members’ earnings. Where the employee has a small base compensation level and a significant component of compensation is tied to commissions or bonus, these amounts should be included in pensionable earnings. On the other hand, where the bonus amount varies widely and is not closely tied to member performance(but perhaps is tied to company profitability), these amounts could be excluded from pensionable earnings. The trend towards greater recognition of these alternative components of compensation, reflects a correction within the DC industry.

The most common plan structure utilized by DC plan sponsors, continues to be a registered pension plan, which represents 61% of the total plans in the survey.

This is comparable to the 2002 results, where registered pension plans accounted for approximately 58% of all DC plans surveyed.

However, it is interesting to note that the proportion of savings plans, including stand-alone registered retirement savings plans(RRSPs)and combination RRSP/deferred profit sharing plans(DPSPs), have increased. In the 2006 survey they represent approximately 27% of all plans, compared to 16% of all plans in 2002.

The movement toward savings plan structures introduces a significant element of flexibility for DC plans. In contrast to accumulations under a registered pension plan, RRSP and DPSP accumulation are not locked-in upon termination. Subject to plan rules, in service withdrawals of contributions may even be permitted under these types of structures.

The growth in non-locked-in savings structures reflects the shift away from paternalism. The ability for members to access plan accumulations upon termination is considered by many to significantly enhance the value of the benefit. This value enhancement comes at no additional cost to the plan sponsor. At the same time, savings plans are not covered by pension standards legislation, so they can be more cost efficient to operate. For these reasons, we expect the trend towards more flexible savings plan structures to continue.

However, it is important that the plan sponsor balance the perceived member benefit offered by a nonlocked- in savings plan structure against the issue of introducing an additional disincentive to save for retirement. Where the primary objective of the plan is to encourage retirement savings, a locked-in structure may be preferable. On the other hand, where the primary objective of the program is to offer tax-sheltered compensation, this structure could be quite effective.

The prevalence of savings plan structures increases for smaller plans. Among smaller plans(with less than 1,000 members)stand-alone RRSPs represented 20% of all plan structures. In contrast, only 11% of the plans with greater than 1,000 participants, offered a stand alone RRSP. On the other hand, the prevalence of DC pension plans is much higher among larger plans. Clearly, the additional legislative requirements associated with operating a registered pension plan(such as the requirement to audit the plan) act to discourage small plan sponsors from utilizing this type of structure.

Looking back over the last four years, there has been a maturation of the Canadian DC market. The CAP Guidelines have introduced broad governance and plan management standards which have caused plan sponsors to formalize governance structures and refocus their efforts to ensure the effective operation of their DC plans. Most notably, there have been significant improvements in the governance and plan management practices for smaller and mid-sized plans, many of which did not have any formal governance or oversight structures in place, prior to the introduction of the CAP guidelines.

Historically, plan design and benefit adequacy have been the most neglected elements of DC plan management by plan sponsors. While the 2006 survey results did not illustrate any significant change in the level of benefits provided under DC plans, it did illustrate small changes in the way plan sponsors were structuring their plans, in order to better tailor them to the needs of their members. Over time there will be increased industry focus on the important issue of plan design and benefit adequacy. While this may not result in improvements in plan benefits, it should result in plan designs and plan communications that support reasonable expectations about plan accumulations.

Colin Ripsman is Canadian head of DC consulting. Vartkes Rubenyan is a consultant. Both are with Mercer Investment Consulting in Toronto.;

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