© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the July 2005 edition of BENEFITS CANADA magazine.
Reinventing the wheel
With society aging and perceptions of retirement changing, new approaches to defined benefit and defined contribution plans are springing up around the globe.
By Bernard Mercier

Retirement benefits are one element of the employee rewards system that differs significantly around the world. Differences in legislation, tax, social security and culture have given rise to vastly different pension environments. And in many countries, retirement programs are undergoing dramatic changes in response to a number of forces, such as the privatization of social security, increasingly older populations, economic volatility, and changing career paths.

The result is a wide array of approaches to defined benefit (DB)and defined contribution(DC)schemes with the U.S., the U.K., and Australia at the forefront of change. Canada, with its challenging DB environment and DC dilemmas, has a number of models to consider.

The primary reasons for global pension changes are as follows:

1. The privatization of social security: Growing demographic and fiscal pressures are prompting governments around the world to modify their traditional social security programs. While some countries have moved away from DB programs and adopted DC models, others have maintained and modified their DB systems(e.g., reducing social security benefit levels, increasing contribution rates and/or delaying the age at which workers can receive benefits, among other changes). The end result is a movement toward greater reliance on private employer-sponsored retirement plans and individual savings.

2. Aging populations: Gradually aging populations in the world’s leading economies are putting growing financial pressure on public and private retirement programs alike. The ratio of retirees to the overall population, referred to as the “dependency ratio,” continues to escalate in most of the industrialized nations. In countries with the oldest populations(i.e., Italy, Japan), it is projected that this dependency ratio will rise above 50% during the first half of the 21st century.

3. Financial volatility: Faced with volatile capital markets and growing pension obligations, employers are struggling to manage retirement program costs in a fiercely competitive global marketplace. Although stronger equity markets have eased funding pressures for some organizations, pension financials still loom large because interest rates remain low and deferred pension costs continue to rise. Converging international accounting standards and the adoption of market-based pension accounting standards in countries like the U.K. have also heightened the visibility of growing pension obligations and deficits.

4. Changing career patterns/employment relationships: With the tradition of lifetime employment at a single employer increasingly giving way to shorter careers at multiple employers—even in countries like Japan— today’s employees place greater value on “portable” retirement programs that can follow them from job to job.

Looking beyond Canada’s borders and understanding the many alternative pension systems can be instructive in formulating new approaches to one of the country’s most pressing public and private sector problems: the future of its retirement system.

While retirement programs remain an integral part of the overall reward system in corporate America today, it is clear that tomorrow’s employees are likely to find a different mix of retirement programs from those offered to employees in the past. One of the key trends in corporate retirement programs has been the shift in emphasis from DB pension plans to DC plans. Today, DC plans have become almost universal in corporate America.

In the DB arena, the most common approach to managing program costs has been to convert traditional pensions to hybrid pension plans, such as cash balance plans or pension equity plans. In many cases, employers maintain both traditional DB plans and hybrid plans, having introduced hybrid plans for future employee service and “frozen” their traditional DB plans for current employees.

These hybrid plans, which typically combine the account balance features of DC plans while also providing guaranteed investment returns and the security of traditional DB plans, offer employers a way to manage future pension costs without shifting all of the investment and longevity risk to employees.

It’s likely that the shift to cash balance plans will slow until lingering legal questions about hybrid pension plans are resolved. A federal district court in Illinois ruled that IBM’s conversion to a cash balance plan in the 1990s improperly discriminated against older workers(Cooper v. IBM). The ruling has touched off a frenzy of lobbying activity in Congress, with employer groups asking the lawmakers to provide clarity about the status and ground rules for hybrid plans.

At the same time, cash balance plans are becoming more prevalent in countries like the U.K., Switzerland and Japan. Here in Canada, though cash balance plan designs—which mirror the typical U.S. approach—cannot be implemented under our current tax environment, a number of Canadian employers have implemented pension equity plans.

A pension equity plan is DB in nature, but looks to employees more like a DC plan. The pension promise can be communicated in terms of a lump sum payable at retirement(rather than a lifetime income). The lump sum benefit is typically expressed as a percentage factor(tied, for example, to age and service) multiplied by the highest average earnings and years of service.

Towers Perrin’s 2004 UK Survey of DC Pensions underscores the unprecedented transformation underway in the U.K. as one employer after another has moved to close their DB plans to new hires. Now the spotlight appears to be turning to existing employees, and there is growing interest in providing cash as an alternative means to help employees save for their retirement.

According to the survey, nearly two-thirds(65%)of respondents now offer new employees a DC plan, up from only 28% in 2002. And there is still more to come: 45% of respondents say they will make a significant change to their pension arrangements in the next three years.

A number of these changes will be building on earlier pension changes, including the closure of DB plans. More strikingly, one-quarter of respondents indicated that they are considering, or would consider, introducing a cash alternative to their current pension plans. Cash as an alternative to pension arrangements is therefore set to become more common in the U.K., with some companies seeking to remove all pension risks and responsibilities—administrative, regulatory and financial risk—by simply increasing pay in lieu of pension. Should this policy achieve momentum in the UK, it would place an even greater responsibility for retirement income provision on the individual.

Australian employees will soon have a right to choose to have their compulsory employer superannuation(pension)contributions paid to a pension plan other than the one sponsored by their employer.

Under the Superannuation Legislation Amendment(Choice of Superannuation Funds)Act 2004 that will take effect July 1, 2005, employees will be able to select among a variety of pension plans and individual arrangements offered by financial institutions and possibly industry- wide plans that open membership to employees of non-participating employers—in addition to their own company-sponsored plan. At present, most employers do not offer a choice of pension plans to their employees.

With the increase in globalization and movement of employees between countries, the diverse pension environments around the world are beginning to converge. More and more employers worldwide are rethinking— and, increasingly, revising—their approaches to providing retirement benefits, including:
• decoupling their traditional DB pension plans from today’s shrinking social systems;
• redefining their global retirement philosophies to provide more meaningful benefits for shorter-career employees and to encourage greater employee participation and a sense of shared responsibility for retirement planning, savings and investments;
• placing added emphasis on capital accumulation types of retirement plans to enhance benefit portability, encourage and facilitate employee savings, achieve greater cost predictability and avoid the increasingly costly compliance burdens imposed on traditional pension plans;
• enhancing the level of investment education and choices offered to employees.

It will be interesting to see how successful these strategies will be in the coming years. And it’s certain Canadian plan sponsors will be watching. Already, many are changing their plans today based on the realities of the current legislative environment. If the government takes the necessary lead to change the pension environment to more closely mirror the needs of Canadians in the 21st century, we could see Canadian plan sponsors take radically different approaches to retirement design in the future.

Bernard Mercier is a principal with Towers Perrin based in Vancouver. bernardmercier@towersperrin.com