Many decades ago, pension plans were set up as a mechanism to ease older workers out of the workforce gracefully before they became a liability to their employer. In those days, pension plans typically fell within the purview of the senior human resource officer. As pension funds grew in size, and their risks—especially those of defined benefit(DB)plans—became better understood, increasing numbers of plan sponsors began to regard their pension plans more as a financial subsidiary of the employer than a critical element of the total compensation package, even though the fundamental purpose of sponsoring a plan has not changed. As a result, the Chief Financial Officer(CFO)began to assume the leading role in corporate pension decision-making, particularly as the funded ratios of DB plans plummeted earlier this decade.

Arguably, this may be set to change. Employers in both the private and public sectors have become gripped by the claws of labour shortages across the country. The human resource function is being increasingly drawn into critical organizational decisions, to the point that some senior human resource officers are being re-titled chief people officer(CPO)to put them on an equal footing with the CFO. With the aging of the workforce, the CPO is being called upon to play a leading role in developing pension strategy, as the organization struggles to provide the human resources necessary to create the goods and services to take to market.

In fact, there is an added dimension to the evolution of pension strategy these days—several jurisdictions in Canada are now studying the effectiveness of their pension legislation, especially as it relates to DB plans. If legislation is changed to better accommodate DB plans, it is possible that we will at least see a rekindling of the DB versus defined contribution(DC)debate, and who knows … we may eventually see a modest resurgence of DB plans in some sectors.

A major challenge for any organization, when reviewing its pension plan design, is creating a design that can be said to meet the needs of its workers. The generosity of a pension plan tends to have little influence on most employees’ job decisions until they are beyond age 45 or so, especially in the private sector. Somewhere around that point in their lives, they start to focus less on the amount of funds in their retirement savings accounts and more on the amount of pension that they might receive when they retire. Given the suitability of DB plans for matching the needs of those who want to be able to predict their retirement income, DB plans have always been a useful arrow in the human resource quiver when attracting and retaining older workers. In fact, according to the survey on pension risk conducted by Watson Wyatt and The Conference Board of Canada in early 2007, DB plans are considered significantly more valuable by CFOs and CPOs in attracting highly skilled individuals than other plan types and even more valuable in retaining high-performing employees.

Yet the painfully low level of knowledge exhibited by most workers with respect to pension matters makes it tough for an employer to demonstrate that its plan design does indeed meet its workers’ needs. Instead, employers design their plans to obtain the behaviours they are seeking from their workers, and create a communications program to influence these behaviours.

This is not to say that DC pension arrangements should not play a major role in providing retirement income. However, if a DC plan is to be an employer’s primary vehicle for providing retirement income to its employees, it is important that the employer takes into account the ability of the plan to provide a reasonable pension. Unfortunately, unlike DB plans where members(with a bit of help)can figure out what pension they might get as a percentage of their final pay(known as their income replacement ratio), it is very uncommon to find a member of a DC plan who is actually able to estimate their ultimate pension. To do this they need skills and confidence in using compound interest and annuity rates, but few members are so equipped. And it is a rare person indeed who understands the effects of volatility in market returns and annuity rates on the DC pensions they will ultimately receive—few active members of DC plans realize how swiftly their ultimate income replacement ratio can change over a period of just a few months.

Frankly, some DC plan sponsors may be taking advantage of this lack of knowledge, by contributing low amounts to their pension plans, usually defended on the grounds that these amounts are “competitive within their industry.” It seems that there are relatively few DC plan sponsors who, even for internal purposes, perform projections of typical plan members’ income replacement ratios. Those that do these projections today are likely to be shocked at the extent to which recent changes in future market expectations, in today’s low interest-rate environment, will lead to much lower projected income replacement ratios than projections made just five years ago. DC plan sponsors in the United Kingdom seem to have realized the need to increase their employer contribution rates—a Watson Wyatt survey of FTSE 100 companies reveals an average overall employer contribution rate(assuming members take full advantage of any matching contributions)of 9.8% of pay in 2007(up from 8.5% in 2004). In Canada the median such contribution rate has languished at 5% for the past few years.

How is this all relevant to the CPO? Lower pensions inevitably lead to postponed retirement. When workers postpone their retirement, there may come a time when their productivity decreases(depending on the nature of their work). However, in order to earn more pension, they need to keep working. This means that an organization must be particularly adept at providing the support and mechanisms required to ensure that the right workers are exiting at the right time.

Further, volatility in the starting pensions offered to workers inevitably causes fluctuations in the number of new retirees each year. This increases the employer’s difficulty in predicting the number of retirements during the following year, thus making the development of recruitment strategy and workforce projections even more challenging.

It turns out that many employers are keenly aware of the need to be able to manage the pattern of exits of older workers from the labour force. According to the Watson Wyatt/Conference Board of Canada survey on pension risk, survey respondents consider DB plans to be the best retirement mechanism for managing the exits of older workers. The percentage of respondents citing DB plans as very or somewhat valuable for ensuring orderly exits(73%)is much higher than the percentage who cite hybrid plans(50%), DC plans(40%), and cash compensation other than a pension plan(37%). Research has shown that DB plans help create retirement patterns that are fairly independent of the business cycle. On the other hand, with DC plans, workers can better afford to retire during an economic boom, which is precisely when their employer needs them the most.

This brings us back to pension strategy and the relative weights, in the minds of an employer’s decision-makers, of the two major risks—financial and human resource. The heavy focus on financial risks in recent years has been wise, and indeed rather late in coming. But in the long term, the human resource risks need to be an integral part of the equation—it’s a matter of managing it all together.

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I applaud Ian for writing a sensible, insightful and succinct summary of some of the forces at work in the pension industry over the last few decades. Every action and every decision has its consequences, however, because consequences in the pension world often appear only decades after the initiating event, it is easy to miss the underlying connections. Ian has shone a light on some key factors. I certainly hope sponsors and practitioners are paying close attention to his wise words.

Christopher Cartwright
Vice President
The Financial Education Institute of Canada

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