Canadian pension rules and regulations are in need of reform in order to properly address the reality of the 21st century workplace pension landscape, according to a new report by the C.D. Howe Institute.
The report, authored by Bob Baldwin, a pension industry veteran and chair of the C.D. Howe’s pension policy council, argued that the age-old debate between the merits of defined benefit and defined contribution pension plans obscures the myriad plan design changes that have taken place on both sides over the years and the risks that plan members face in all cases.
“The diversity in the design of the plans, combined with current financial and economic circumstances, has varied results for all types of pension and retirement savings plans, making it difficult to generalize the merits of each plan,” said Baldwin in a press release.
The most important priority, according to the report, is to assess plan members’ retirement income needs and the risks they face and “make sure they are addressed in a way that is fair among plan members and is reasonable in terms of the level and volatility of required contributions.”
The exclusive focus on pension plans’ gross replacement rate is too limited because contributing to a pension plan affects members’ living standards before and after retirement. “In the pre-retirement period, we have to be concerned with the extent to which the pension plan is depressing the ability of plan members to buy goods and services,” wrote Baldwin. “Ideally, the pre-retirement sacrifice will combine with post-retirement benefits so that living standards will be the same in both periods.”
Instead, he noted, it would be more appropriate to focus on a net replacement rate, which takes into consideration expenses plan members have during their working lives that they aren’t likely to face during retirement — such as mortgage payments, financial support for their children, a higher tax burden and pension contributions — and the support they’ll receive from government pension programs including the Canada Pension Plan or Quebec Pension Plan and old-age security.
“The [net replacement rate] comes much closer to defining the actual standard of living enjoyed in the pre- and post-retirement periods than does a [gross replacement rate]. An appropriate target [net replacement rate] would be close to 100 per cent,” he wrote.
The report also suggested that plan sponsors add employer contributions into the calculation of what plan members sacrifice during their earning years in order to see a better pension in retirement. “In most situations, it is fair to surmise that an employer is most worried about total labour costs not the component parts of the cost. To the extent this is true, a rational employer will discount other elements in the compensation package of employees to take account of the contributions to the pension plan that are predictable. Thus, the economic burden of employer contributions will be shifted from employers to employees — rather like sales taxes being shifted from vendors to consumers.”
While DC plan sponsors generally have predictable employer contribution rates, DB plan sponsors don’t have that same certainty and may suddenly be hit with special contribution requirements after an actuarial valuation report, noted Baldwin.
As well, muted investment returns, lower interest rates, rapid growth in wages and salaries and increasing life expectancies have all placed an upward pressure on DB contribution rates and played a role in the shift from DB to DC plans in the private sector. These factors have also pushed a move in the public sector to place more financial risk on the benefit side of the plan and to introduce target-benefit plans.
Baldwin urged plan sponsors to adopt measures that would help reconcile the uncertainty between pension contributions and benefits. He also suggested they make their plans more transparent, including establishing a clear appreciation of existing and future members’ financial needs through their retirement, balancing their retirement income requirements with the impact on their pre-retirement living standards to achieve continuity between them.
Plan sponsors should also be clear about cross-subsidization within the plan and be clearer with members about what will happen to contributions and benefits if liabilities increase substantially and/or investments don’t provide sufficient returns.
“Pension plan design is more like a spectrum of choice rather than a binary choice between clearly defined DB and DC plans,” wrote Baldwin. “The position of plans on the spectrum will be established by the way that financial risk is allocated between contribution and benefit variability and between and within cohorts of plan members and employers — to the extent that the latter bear financial risk. Plan governors have to decide where they will fit on the spectrum.”
Regulatory and tax policy should also be adapted to allow for that spectrum of choice and the incorporation of both DB and DC elements, he added.
He called on regulators to incorporate measures already identified as good practice for plan sponsors, such as requiring them to identify an outer limit of acceptable contribution rates, set out a process for what happens when that limit is reached and assess and disclose the likelihood of hitting that limit.
On the target-benefit side, while such plans have previously been restricted to multi-employer pension plans, Baldwin suggested that the provinces that are adopting or looking at the option for single-employer plans only allow for a reduction in accrued benefits if joint governance is in place.
He also recommended that regulatory law be revised so jointly governed plans face a more “principles-based” regulation. Plans that have employer-dominated governance structures should continue to be rules-based. Plans choosing to incorporate flexibility around benefits and financing rules should be encouraged to turn to a joint-governance model to ensure safety for plan members.
“The regulatory law that governs [workplace pension plans] was crafted at a point in time when most members of [workplace pension plans] in both the public and private sector belonged to DB plans,” wrote Baldwin. “The objective of the law was to protect DB plan members from errors and/or abuse by employers. . . . [Regulatory law] needs to be complemented by more flexibility to adapt to changing circumstances.”