Are target benefit plans secure?

At the federal level, legislation is in the works to set standards for target benefits in federally regulated pension plans. At the provincial level, two provinces—New Brunswick and Alberta—have already taken steps to introduce the target concept as a design option in their legislation.

Too good to be true?

To some DB proponents, a TBP is the proverbial wolf in sheep’s clothing, promising the benefits of a lifetime pension without any guarantees. In tough times, pension income could be reduced to address a funding shortfall—a prospect traditionally considered heresy in the DB world. And in the DC world, TBPs may evoke fears about the complexities of joint governance or new actuarial, investment strategy and policy requirements.

Read: Ottawa calls for target benefit plans

However, in the right circumstances, the target benefit concept offers sustainability, efficiency and a powerful benefit. On the spectrum of pension design options, it can provide a solid middle ground. Compared with DC plans, it offers a better pension return on the dollar and also reduces DC risks around member education and poor investment decisions. But given the issue of benefit flexibility in TBPs, it’s critical to consider joint employer-employee governance and the real-life impacts and opportunities for plan members and pensioners.

For DB plans considering a switch to the target approach, “cost certainty is the key factor for employers,” says Jana Steele, a partner with Osler, Hoskin & Harcourt LLP. “If you look at operating a major organization or business, the potential for year-to-year cost swings related to DB funding can be difficult to manage,” she explains. With some target benefit designs, there can be minor changes relating to contributions, but there is certainty regarding the contribution framework. This design also eliminates some of the long-term funding risks and requirements related to DB.

Although the discussion around TBPs is relatively new, the target concept has been around for decades, mainly in industrial-sector plans (e.g., electrical workers). “It’s an idea that has been tested and works if the proper controls are in place,” says Derek Dobson, CEO of CAAT Pension Plan.

With checks and balances on both the asset and benefit sides of the equation, TBPs offer sustainability over the long haul. “If folks have to take a haircut in bad economic times, they are better off in the long term with a sustainable plan,” Dobson adds. The target concept may lend itself particularly well to certain sectors where “the pension plan outlives companies,” he continues. “For example, workers may be mobile within different companies in a certain industry, but they maintain a pension in the industry plan.”

Read: ACPM aims for target benefit plans

With good governance and risk management, TBPs have the potential to deliver a better and more secure benefit than DC plans, dollar for dollar. “Target plans could have as much as a 100-basispoint advantage over DC plans,” says Fred Vettese, chief actuary with Morneau Shepell.

Part of that advantage comes from running one pooled fund, DB-style, without having to educate members on investment options. The management expense ratio in a mid-size TBP may run at 0.5% annually, versus 1% or more for a DC plan, Vettese adds. Another advantage is asset growth. Members in DC plans often invest too conservatively, so a pooled fund can deliver a better risk/growth balance. Depending on the scale of the fund, a pooled fund may also be able to leverage more sophisticated assets such as infrastructure and private equity, which align well with the objective to pay pension income.

“Let’s take the example of a retired member who receives $1,000 a month in income derived from a DC pension,” says Dobson. “For the same cost, you could deliver approximately $1,500 a month from a low-volatility target model such as the emerging New Brunswick program. A pure DB might deliver $1,800 a month. And a target plan with a more aggressive asset mix and willingness to have the benefits move up and down could push that slightly higher.”

Sustainability is another factor. Many DB plans have been forced to continue to increase active members’ contributions for existing benefits, including benefits that were improved permanently during boom markets. Active members may also see decreased benefits for future service. “How much can you charge the current generation to fund an existing deal?” asks Steele— especially since working members may not reap those benefits when they retire. The flexibility built into TBPs favours a more sustainable pension arrangement between generations, she explains.

Employer considerations

From an employer’s standpoint, TBPs offer workforce management benefits similar to DB pensions, says Dobson. “This includes the ability to attract and retain employees who see the value in a lifetime pension [and] the ability to retire employees gracefully, knowing they have a lifetime income source.”

Since TBPs pool employee longevity risk, they will be attractive to those who value models designed to deliver a pension for the employee’s lifetime. However, there are some key aspects of TBPs that employers need to manage.

Read: Do target benefit plans reduce costs and risk?

Member education – A new deal requires a new approach to communication. “As long as employees understand the deal, the concept works,” says Vettese. “The most important message is that there is some risk.” And the pension promise can’t be communicated the same way as in a DB plan. “The information on benefits and risks needs to be transparent,” says Dobson. “Employees need to see the retirement income target and scenarios so they can plan with some certainty.”

Joint governance – In the short term, employers may shrink from the prospect of a jointly governed pension plan with employee representation, but it’s critical to the long-term success of TBPs, says Dobson. “When employees are at the table, they are engaged; they understand and value the benefit and own decisions. This reduces legal risk, long term. You can pay dollars now for good governance or down the road to fight employee lawsuits related to the pension plan.”

Plan management – Managing TBPs is more complex than managing DC arrangements, since employers need to consider risk management and funding decisions, actuarial expertise and asset reserve management. An example is the primary risk management goal in the New Brunswick regime, which requires testing at certain times (including plan inception) to confirm at least a 97.5% probability of delivering the lifetime target pension amount.

TBPs need to make decisions balancing risk and benefits flexibility, says Vettese. Depending on the plan’s needs, “if you can tolerate greater flexibility on benefits, you can get by with a smaller reserve and adjust the asset mix for more growth potential.”

Read: The myths of target benefit plans

Reputational risk – “The majority of DC plan sponsors are concerned that individual employees are not qualified to make investment decisions and may make poor decisions,” says Vettese. But with a TBP, that problem goes away. Investment professionals make decisions on the pooled fund, and funding policies may include investment reserves to protect core benefits. This model also mitigates massive swings in DC employees’ retirement savings based on market events, such as the 2008 market downturn, and related reputational risks.

At the same time, TBPs can and will involve benefit reductions in tough economic times—even the core benefit of the lifetime pension. “If a benefit reduction is needed, the employer could wear that in terms of reputation,” says Dobson. For some potential variation in the benefit, the plan gains accounting relief and can deliver a more powerful benefit than a DC plan over time. Those issues need to be balanced when looking at the potential optics of target benefit changes, Dobson adds.

Alignment with plan type – For Jo-Ann Hannah, director of pensions & benefits with Unifor, TBPs can work when DB is not feasible, and they work best in a multi-employer environment. She cites the Canada Wide Industrial Pension Plan, sponsored by the Canadian Labour Congress, as an example, and the Canada Pension Plan with its 18 million members.

Read: Guidance on governance options for target benefit plans

Hannah says recent federal legislation on TBPs for federally regulated private sector employers overlooks a potentially winning idea: making multi-employer TBPs more accessible to small employers with DC plans or no plans at all. TBPs, she says, just don’t seem as feasible for an individual employer with a small number of employees.

Impact on members and retirees

Despite their advantages, TBPs can pose problems for members—particularly when a DB plan is switched to target, says Hannah. As in the case of the shared-risk plans in New Brunswick, making the switch may mean a member’s “entire DB accrual is moved into the target plan, meaning it becomes subject to future funding issues,” she says.

“The DB part is not frozen, as it would be if a member transferred from DB to DC. So there can be hardship if there are downward adjustments to the target benefits due to funding problems or market downturns. When accrued benefits become subject to being changed, you are really rolling the dice.”

Plan members also have to worry about tax treatment. Vettese points out target benefits are currently given the same pension adjustment (PA) treatment as DB plans, despite contributions being fixed. Tax law changes to allow PA treatment based on the DC model (aligning with the value of contributions versus the target benefit) would make the target option more attractive.

Read: Are target benefit plans the solution?

When moving from a DB plan to a TBP, can employers and employees really put themselves in the shoes of retirees affected by the change? After a long career of more than 30 years running pension plans in New Brunswick and the Cayman Islands, Cyril Theriault—now active with Pension Coalition NB—says moving away from DB to target benefit or shared-risk plans can have a negative impact on members and pensioners.

The change to shared risk has “really upset a lot of people,” Theriault says. “Pensions that people planned for— pensions they were told for years would be there for them—are changing.” And there was no consultation with pensioners on the switch. “They call it shared risk; we call it shifted risk,” he adds.

Retired N.B. provincial workers used to get a guaranteed cost-of-living increase each year equal to 100% of the annual increase in the consumer price index (CPI), to a maximum CPI increase of 6%. The new target for cost-of-living increases, says Theriault, is 75% of the CPI—if funds permit.

“So even if the funding target is achieved, you have lost 25% of your cost-of-living escalation,” he notes. “This makes a significant difference in planned income. Many of the pensioners have been out of the workforce and retired for 20 years, and the average provincial pension is only around $21,000. Lots of retirees live in seniors’ apartment complexes, and these people may have to walk dogs, babysit and do what they have to do” to preserve their spending power, he explains.

Read: More myths about DB and target benefit plans

The coalition has no quarrel with target benefit and shared-risk concepts on a go-forward basis. But “we believe it’s wrong to do it on a retroactive basis to pensioners who may have retired as long as 30 years ago,” says Theriault.

“Target benefit is an important pension design option,” Steele says. “At one end of the spectrum would be a final average earnings DB plan with all the bells and whistles. At the other end would be a DC vehicle. In between, there are many plan design options and variations on all of them. It’s important to have a range of options in the tool box, including TBPs.” And certain TBP features may appeal to some more than others. For example, a DC plan may wish to pool investment risk in one fund, but not pool longevity risk by changing to a target benefit.

Dobson identifies the top factors to support the success of a TBP. “If you have good governance, transparent funding policies, adequate asset reserves and robust risk management, you should not notice big differences between DB and target plans in the long term.” He believes joint employer/employee governance “is even more critical” in the case of a TBP, so both sides contribute to—and own—plan decisions.

Ian Kinross is a communications consultant with experience in the pension and health sectors, and Martin Biefer is a freelance writer and public affairs consultant with experience in the pension sector and news business. Feel free to contact Ian and Martin via LinkedIn.

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