In much of the western world, DB plans are on the endangered list. In some countries, such as Australia, these plans are virtually extinct. In the U.K. and the U.S., most private sector DB plans are closed to new entrants or even to all future accruals.
For a number of reasons, the trend away from DB plans has been slower in Canada. While Canada may be taking a more scenic route than these other countries, it is clearly heading in the same general direction.
There are valid reasons why private sector employers are abandoning their traditional DB plans. Volatile equity markets, combined with plummeting bond yields in the last decade, have resulted in DB plan costs increasing significantly and fluctuating wildly.
Looking forward, with little evidence that long-term government bond yields will increase in the near future, no end in sight for the eurozone crisis and the world economy seemingly destined for an extended period of slow growth, DB plan costs may settle in at uncomfortable levels for a long period of time.
In this environment, and with the aftermath of the 2001/02 and 2008/09 events still visible in the rear-view mirror, it is difficult for some organizations to continue to bear the bulk of the costs and risks associated with traditional DB plans. This is particularly true in industries in which employee compensation represents a significant portion of the cost structure or where the pension plans are mature and large relative to the size of the organization. As a result, many sponsors have taken or are taking steps to close their DB plans to new employees or even to future accruals.
The flip side is that the economic turmoil of the last decade has significantly increased employee appreciation of DB plans. Employees have come to love having a secure predictable DB pension, as they watch their RRSP balances and other savings stagnate or decline. Gone are the days of the consistent double-digit returns and high interest rates of the 1990s that had employees clamouring for DC plans.
DC Issues
In most cases, organizations that have moved away from DB plans are migrating toward the opposite end of the spectrum: DC plans.
Much has been written about the concerns with and inefficiency of DC plans from an employee perspective. Financial literacy among Canadians is generally low, and only a small minority of DC members would likely have the acumen to make appropriate investment choices. Fewer still take the time to monitor their performance and to adjust their investment mix as their risk tolerance changes.
Some DC members stay in ultra-safe low-yielding investments, while others continually chase the best-performing investments in the previous year, which, more often than not, end up being poor investments in the subsequent year. DC members are generally unwilling to buy annuities, particularly when interest rates are low. As a result, they continue to bear investment risk well into retirement. And members who forego a lifetime annuity need to plan for living well into their 90s or, alternatively, accept the risk that they will outlive their savings.
DC plans will alleviate the primary concern that employers have with respect to DB plans in the current low interest rate environment. Costs will become increasingly predictable as the legacy liabilities either decline, are de-risked or get transferred. However, the underlying economics that cause problems for DB plan sponsors have not magically disappeared. There are still risks that need to be borne. In DC plans, these risks manifest in the form of unpredictable member benefits. Even DC members who do everything right still have no guarantee that they will receive an adequate pension in retirement.
Consider, for example, a DC plan with a fixed 6% employer contribution rate. What kind of pension can a career employee expect to receive from such a plan?
To answer this question, we have estimated the projected replacement ratio that 30-year-old employees who join the plan in each of the years 1995, 2000, 2005 and 2010 could expect to receive at age 65. We have assumed that the four employees start out with an asset mix of 70% equities and 30% long bonds, and plan to move gradually out of equities as they approach retirement. At age 65, they intend to have 35% in equities and 65% in long bonds. The graph below shows how the projected age 65 replacement ratio for each of these employees has changed from the date they joined the plan until the end of 2011.
Note: The projected replacement ratio determined at the hire date assumes future salary increases at the breakeven inflation rate implied by nominal and real return Government of Canada long bond yields at the hire date, plus 2% for merit and promotion. Returns on the long bond fund are assumed equal to the current yield. Returns on equities are assumed to be equal to long bond returns, plus 3% per year. The replacement ratio assumes the purchase of a non-indexed annuity payable for life with no guarantee. The annuity price is determined using current bond yield, plus 80 basis points, in combination with the UP94 fully generational table. The updated replacement ratio in subsequent years is determined using the same methodology as above for the future but reflects actual past returns and inflation history.
With 10-year government bonds yielding more than 8% in 1995, the employee hired in 1995 would have expected a 50% replacement ratio when he or she first joined the plan.
Move forward five years to 2000, with government bond yields at slightly less than 6%. That employee would now be projected to have a 36% replacement ratio at age 65, despite having benefited from double-digit average returns.
Fast-forward to the end of 2011, with government bond yields at slightly over 3% and a decade of poor returns, that same employee, now age 46, is expecting an age 65 replacement ratio of about 20%. An employee joining the plan in 2010 could only expect to receive a replacement ratio of 16% at age 65 from a 6% DC plan.