Discussions about pension plan de-risking tend to focus on minimizing—or at least managing—financial risk for DB pension plan sponsors. Across the spectrum of pension risk management strategies, plan sponsors often consider a DC plan to be a low-risk, or no-risk, solution, particularly if they previously provided a DB plan. In fact, when DB plan sponsors talk of de-risking, that is often “code” for converting their plan to a DC arrangement. DC plans certainly mitigate plan sponsor financial risk: there is little danger of having to make higher sponsor contributions to account for market volatility or increased longevity, as is possible in the case of a DB plan.
From a plan member perspective, on the other hand, DC plans are fraught with financial risk. Typically, members decide how much to contribute, what investments to make, and how and when to receive their savings in retirement. If they don’t contribute enough, make the wrong investment choices or take too much too soon, these pensioners may not have enough retirement income to last their lifetime.
What constitutes de-risking, then, is clearly in the eyes of the beholder. The question arises, however, as to whether plan sponsors have been lulled into a false sense of security by defining risk in purely financial terms. When sponsors consider risk more broadly, is a DC plan not as risk-free as they assumed? Might DC sponsors have unintentionally taken on more risk than if they’d opted for, or stayed with, a DB plan?
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Quantum of risk
Measuring risk is tricky, since risk takes on various forms and has different owners with various tolerance levels. One way of thinking about pension risk is to consider the overall system and its objectives. At a very high level, all pension programs—whether DB, DC or hybrids such as target benefit plans—share the same core characteristics. Money is set aside during an individual’s working career, invested and ultimately used to fund retirement income. In such a structure, risk comes from uncertainty: uncertainty in the length of a working career, uncertainty of investment returns and market conditions, uncertainty of retirement needs and longevity, and uncertainty of expectations.
Considered this way, the sources of risk are no different in a DB or DC plan. However, DB plans have evolved more mechanisms for managing risk than have DC. For example, DB plans allow for effective pooling of longevity so that members with short retirements subsidize the benefits of those with longer retirements. DB plans also often have active management of their investments over a long-term horizon, resulting in better risk management and generally higher returns than DC plans. Viewed this way, given that DC plans do not benefit from the same risk mitigations as do DB programs, it’s likely the quantum of risk in a DC system is actually significantly higher than in a DB plan, as inherently many risks reside at the individual member level.
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Beyond financial risk
Quantum of risk is only part of the story; key differences between DB and DC plans lie in the nature and ownership of those risks. While the primary risk of DB plans vests in the plan sponsor and the requirement for the sponsor to mitigate any market or demographic surprises through additional contributions, the principal risk of DC plans has been transferred to the plan members in the form of uncertain and often insufficient retirement income. This represents a transfer of primary risk from the sponsor to the member but does nothing to de-risk.
Moreover, the nature of this risk transfer actually creates new risks within the pension system. Compared to DB plan sponsors, the onus on DC plan sponsors may, in fact, be heavier in some of these cases. Consider the following:
- Attraction and retention — A DC plan is less likely than a DB plan or hybrid model to have a positive impact on attracting and retaining employees. Many employees have a good understanding of the difficulties they face in saving for retirement under a DC plan. A plan sponsor that provides a DB plan may hold a competitive advantage.
- Workforce planning — If, when they reach retirement age, employees find their savings are inadequate to support the post-career lifestyle they envisioned, they may simply decide to keep working. Older, long-service employees may have higher pay relative to productivity, and delayed retirement can have a significant cost to the plan sponsor if compensation is not decreased to reflect reduced productivity. Moreover, the cost of benefits for these employees may also be higher. DB plans can offer early retirement windows to encourage older workers to leave voluntarily.
- Legal liability and damage to reputation — If DC plan members won’t, can’t or don’t understand the financial risk employers have transferred to them—or the extent of that risk—has the risk transfer actually occurred? Do plan sponsors retain responsibility in this situation? While these questions have yet to be determined definitively, there have been court cases (Dawson v. Tolko Industries Ltd. and Weldon v. Teck Metals Ltd.) that have asserted the transfer of risk to plan members via a DC plan is, at best, a grey area unless members fully understand what they are taking on. Even if disappointed plan members don’t sue, media attention can harm a company’s reputation.
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De-risking DC
Given a broader definition of risk that goes beyond financial considerations, DC plan sponsors should be assessing these risks and looking to implement risk management strategies, just as their DB plan counterparts do.
Risk mitigation starts with developing a better understanding of the DC deal, the risks and the structure used to deliver it. The perception of DC plans as being risk-free has, in many cases, led plan sponsors to rely totally on bundled DC providers to handle all aspects of the program—in many cases, with far less oversight or understanding of the details than they would have applied to their DB plans. This should be an immediate warning sign, since the discrepancy in the level of ongoing due diligence over a DC plan, where member money is at stake, versus a DB plan, where plan sponsor money is involved, may indicate that risk is being ignored.
In particular, any discussion of de-risking in a DC context should begin with the premise that the primary risk—to member and sponsor—revolves around the ultimate level of retirement income a member receives from the arrangement. Defining objectives in these terms will help both parties understand how the plan is tracking and, in turn, make more informed decisions on how to use existing levers, including level of contributions, investment allocation and decumulation options (e.g., how much to self-manage versus annuitize).
Opportunities certainly exist to reduce and manage risk in DC plans leveraging technology, governance practices and investment solutions. These approaches reflect innovative work being done by certain players in the DC space to add transparency and control to a system that has become opaque and confusing. It all starts, however, with plan sponsors asking the right questions and viewing DC plans with a holistic risk perspective and a clear focus on the ultimate goal: helping members attain efficient and sufficient retirement income.
Nigel Branker is a partner and leads the Ontario pension consulting practice, and Idan Shlesinger is managing partner, DC pensions and savings plans, with Morneau Shepell. The views expressed are those of the authors and not necessarily those of Benefits Canada.