Despite efforts at reform, the number of DB plans in Canada is still falling in favour of DC plans. Are the investment risks just too great to ignore? Or can DB plans be designed differently to address the inherent mismatch between liabilities and assets? Malcolm Hamilton weighs in. Read Ian Markham’s thoughts on the topic, in the second part of this series.
The traditional DB pension plan is best viewed as a noble experiment that failed. The goal was to deliver safe, adequate, affordable pensions—to insulate plan members from risk in an uncertain world. This was to be accomplished by investing DB pension funds in securities that, while risky and volatile in the short term, were thought to generate high, reliable returns in the long run.
The argument for DB plans is similar to the case for investing retirement savings in common stock, as articulated in Jeremy Siegel’s 1994 classic book, Stocks for the Long Run. Over long periods of time (25 years or longer), equities will usually outperform safe investments such as bonds, treasury bills and GICs. Those with long investment horizons can turn this to their advantage by investing heavily in equities and patiently waiting for the superior returns to materialize.
Individual retirement savers grow old and retire. As they age, their investment horizons contract and their ability to bear risk diminishes. Thus, while it makes sense for young investors to emphasize equities in their retirement portfolios, they are well advised to de-risk as they age.
DB plans, on the other hand, were thought to be “forever young.” Generations would come and go but the DB plan would remain, perpetually investing for the long term, able to weather the temporary ups and downs of capricious stock markets. The DB plan’s presumed ability to ignore short-term investment risk conferred upon it a significant competitive advantage in the provision of pensions. In a world where safe investments deliver, say, a 2% real return, a decent DB plan supported by safe investments might cost 15% of pay—more than most Canadians are prepared to save for retirement. However, by investing in risky assets, the DB plan might reasonably expect to earn an additional 2% per annum on its investments, enough to reduce the cost of the plan to a more affordable 10% of pay. The key to delivering pensions that were both affordable and adequate was to invest in assets that, at least in the short term, could not be relied on to deliver the expected returns.
But what of the risk? Can DB plans really deliver safe pensions supported by risky investments? In a sense, the DB plan was an experiment in risk management—an attempt to see if the investment risk inherent in retirement savings plans could be managed in such a way that, over the long term, it essentially disappeared.
DB advocates hoped and believed that the investment risk would prove to be of little consequence as long as the plan continued as a going concern. From time to time, the stock markets would disappoint but, as night follows day and summer follows winter, the markets would soon recover and the plans would return to good health aided, perhaps, by a small, temporary increase in contribution rates. Patient equity investors would be rewarded for their patience.
Viewed from this perspective, the DB plan is an early example of financial innovation. Prior to the 1980s, pension assets and liabilities did not appear in the financial statements of corporations. The risks were invisible to shareholders. Pension contributions did appear in the financial statements, but they were stabilized by actuarial techniques that made pension costs appear predictable and firmly under control.
Economic failure
Legislation, regulation, plan design and poor governance are often cited as important contributors to the decline of the DB plan, but they are not the root causes. As important as it is to improve in these areas, no amount of improvement will return the DB plan to the position of prominence it once enjoyed or cause the next generation of companies to establish new DB plans. The failure of the DB experiment is, first and foremost, an economic failure. It cannot be fixed by legislation or regulation.
The DB experiment failed because the economic foundation on which it was built proved faulty. The concept, while plausible, did not work as advertised. It did not work because equities can, in unusual circumstances, underperform safe investments for decades. It did not work because, in the private sector, neither pension plans nor their sponsors can be relied on to continue perpetually as going concerns. It did not work because shareholders, aided by investment analysts and accountants, came to realize that the pension risks they were bearing without compensation were real, large and expensive. Most important, it did not work because DB plans, even plans that continue perpetually as going concerns, are not forever young. They, and the organizations that sponsor them, do not grow old in the same manner as people do, but they age nonetheless.
The symptoms of pension plan aging are well known to those who have experienced them. The pension fund grows large relative to payrolls and corporate profits. The ratio of retired to active members increases, first to 0.5, then, for some plans, to more than 1.0. The proportion of the pension fund held for those who are at or near retirement moves well past 50%. The operating cash flow (the excess of contributions over benefit payments) becomes decidedly negative (i.e., the pension plan pays $2 or $3 in benefits for each $1 of regular contribution). The process is gradual but irreversible and, as it proceeds, DB plans become less able to tolerate and bear investment risk.
We might view the DB plan as a chess game played over decades. In retrospect, we spent too much time perfecting our openings, erroneously assuming that the game would never change—but it does, either suddenly when plans wind up or gradually as they mature. DB plan sponsors need a game plan—a viable way to wind up their plans and/or a viable way to sustain them through good times and bad after they mature. Without such a game plan, sponsors inevitably find themselves painted into a corner. They can no longer bear investment risks that have grown much larger than they were supposed to be, yet they cannot afford to abandon the high returns that were supposed to accompany these investment risks. They need the equity risk premium without the equity risk.
Improving investment returns
The most convenient way to address the DB challenge would be to find investment strategies that de-emphasize equities while delivering equivalent returns at lower risk. The most popular of these are alpha-seeking investment strategies and strategies that emphasize alternative asset classes such as private equity, infrastructure and commodities. These strategies may work for a while. However, unless there is a free lunch to be had in the investment world, they are unlikely to succeed in the long run. To seek superior risk-adjusted returns is understandable and commendable. To rely on the success of these strategies before they have, in fact, succeeded is foolhardy. At the very minimum, we need a backup plan.
Cutting benefits
Some employers address their DB problems through benefit reductions. If your plan costs 50% more than it was supposed to and, as a consequence, your compensation budget is 5% higher than it should be, the challenges are formidable: cut pensions by one-third; ask employees to contribute an additional 5% of pay; increase the retirement age by five years; or, alternatively, gradually reduce cash compensation by 5%. There are many options: none popular and none truly effective.
Cutting benefits addresses the symptom, not the problem. DB plans are expensive not because the benefits are unreasonably large (although sometimes they are) but because the benefits are guaranteed, and guarantees are expensive, particularly when interest rates are low. A DB plan costing 10% of pay may be affordable, but it is not money well spent if employees think that the benefit is worth less than 10% of pay. Employees would feel the same way about a DC pension plan where the employer’s 10% contribution was fully invested in long-term bonds and used to purchase an annuity at retirement.
Most employees, given a choice, would rather have the 10% added to their pay. Some don’t want to save. Others want to save less than 10%. Most would prefer to see their money in a balanced portfolio in which they can potentially earn higher returns—even if these potentially higher returns expose them to greater investment risks. Few would voluntarily buy annuities on retirement. Employees are interested in safety, but only to a point—and preferably when someone else is paying for it. From the shareholder perspective, providing guarantees that cost shareholders more than employees think the guarantees are worth is a losing proposition. DB pension plans, properly priced, are not value-creating compensation elements.
Shifting risk to employees
The most promising route for addressing the DB challenge is to shift the risk to employees, individually or collectively. DC plans do this, as do a number of established or emerging variations on the traditional DB plan. Multi-employer pension plans transmit risk to members through benefits and/or negotiated contribution rates. Many Dutch pension plans shift risk to members by adjusting pensions, typically through inflation protection that is contingent on the funded status of the plan. Ontario’s jointly sponsored pension plans share risk with members by adjusting contribution rates and, in some cases, through the conditional indexing of pensions in payment. These designs all share one thing in common—a commitment to sharing risk with plan members, both active and retired, in ways that are sensible, intelligent and fair.
There is no magic bullet here. In a world with negative real interest rates, central banks actively promoting inflation, competitive currency debasement and rapidly escalating risks of sovereign default, guarantees are an illusion. Neither employers nor governments have the resources to unconditionally guarantee the future prosperity of the large generation about to retire. No pension system can hope to insulate half of the adult population from the economic realities of our time.
DB plans cannot deliver safe, adequate, affordable pensions in a world without high, reliable, guaranteed investment returns. Employees do not want to receive safe, inadequate pensions. Shareholders do not want to provide safe, unaffordable pensions. The time has come to experiment with risky pensions, recognizing that the risk must be prudently taken, professionally managed and distributed equitably within and between generations.
We do not currently have the institutions, plan designs, governance processes or workforce needed to do this successfully. None of this will change overnight. Still, we have the building blocks needed to construct better DC plans, and we have some promising models for gradually converting traditional DB plans to jointly sponsored target benefit plans.
Pension conversions are seldom easy and never quick. All the more reason to get started now.
Malcolm Hamilton is a partner at Mercer.
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