Unable to bear the costs associated with traditional pensions, employers have been moving away from defined benefits (DB) and towards defined contribution (DC) plans for years. However, the risk in DC plans lies entirely with the members, who must choose their own investments and no longer know how much of a retirement income to expect. Does it have to be a zero sum game? Is there a way to offer predictable retirement income but spread the risk more evenly between employers and employees?In a panel discussion at the Chartered Financial Analyst Society of Toronto’s annual pension conference on April 16, several experts considered the history, advantages, and difficulties of shared risk pension plans. Also known as “target benefit” pension plans, these plans aim to provide retirees with a set level of income, but make no iron-clad promises.
Malcolm Hamilton, an actuary and former partner at Mercer Consulting, began the session by describing target benefit plans as what you get when you remove the parts of a defined benefit plan that do not work well; they offer economies of scale and the prospect of a predictable income for pensioners, but they free the sponsor from bearing all the risk and they free individual plan members from making investment decisions that they may be unwilling or unable to make for themselves.
“Instead of having all the risk [of paying benefits to retirees] go to the pension plan sponsor, you find a way to share that risk, not just with the active employees but with the retirees as well,” explains Hamilton. “You have a target benefit but there is no guarantee that this is what they will receive. The benefits could surprise or disappoint.”
Jim Leech, the retired head of the Ontario Teachers’ Pension Plan, spoke next on how target plans came into being as a result of the crisis that erupted on the east coast several years ago. A number of pension plans in New Brunswick had sailed dangerously close to the wind in the 1990s and 2000s, making poor management decisions and racking up investment losses. After the financial crash of 2007, Leech said that the pension plans for two pulp and paper mills, the province’s health care workers, and even the City of St. John were so badly underfunded that they faced the prospect of being unable to pay full benefits to their retirees.
A task force established by Premier David Alward’s Conservative government and chaired by pension lawyer Susan Rowland helped to avert disaster and devised a new pension framework for New Brunswick, one which allowed risk to be shared more evenly. Contributions from current employees of the troubled pension plans had to go up, as did the retirement age, but the province also amended its Pension Benefits Act and introduced regulations which allowed retirees’ benefits to be altered depending on how the pension performed. “Adding the retirees to the equation was the revolutionary part,” said Leech. “The model captures many of the advantages of a defined benefit plan, but you do have the ability to reduce benefits.”
David Long, senior vice president and chief investment officer at the Healthcare of Ontario Pension Plan (HOOPP) pointed out that as traditional defined benefit pension plans grow, increased contributions from current employees can only have a limited effect on the overall health of the plan. Especially in today’s low-interest rate environment, DB plans often need to take on more risk in order to deliver benefits to a large pool of retirees.”You need some kind of compensating mechanism when those risks don’t run in your favour,” he explained.
In the case of his own defined benefit plan, Long said this safety valve comes in the form of inflation indexing. For service acquired after 2005, cost of living adjustments for HOOPP retirees are not guaranteed; the pension board votes annually on whether they can afford to increase benefits in tandem with inflation. He noted that, for pension service after 2009, the Ontario Teachers Pension Plan has also made inflation protection conditional on plan performance.
Are the advantages and flexibility of target benefit plans attractive enough to woo the private sector back from DC plans? Malcolm Hamilton thinks it is unlikely that shared risk plans will become popular with big business any time soon. “My expectation is that the private sector will remain overwhelmingly defined contribution,” he commented. “The place where it might work is where there is a union pension plan that is defined benefit and the employer can’t find the energy for the fight to move it to DC. Then they might get target benefits.”
However, if the concept can be tested and proven effective in the public sector, Hamilton suggested that in another couple of decades some larger corporations may begin to consider target benefit plans. “There is no place in the world where you can find a long-standing, successful target benefit pension plan,” he said. “It’s going to have the feel of an ongoing experiment for some time.”
The panel members agreed that shared risk plans also come with their own set of challenges. There is, for example, the question of how to communicate to beneficiaries the magnitude of the risk that they may not receive the targeted level of income. “You don’t want to panic members and make them think that their retirement is in peril,” commented Long. “It is even challenging sometimes to communicate risks to boards.”
There is also the problem of internal governance, and how the interests of the employer, the employees, and the retirees can all be accommodated. For example, Hamilton suggested that retirees may be more inclined than current employees to delay addressing funding issues. “If you’re retired, you’re always in favour of putting things off since you’ll be dead,” he said. “Regulators have a key role to play, because no one else is as well-positioned to advocate for future generations.”
As for Jim Leech, he gave every member of the audience a copy The Third Rail, the book he wrote along with Jacquie McNish about the state of the Canadian pension industry. It contains an impassioned plea for offering employees pension plans that are something more than glorified investment accounts.
“Shifting Canada’s defined benefit pensions to defined contribution plans is no solution to our retirement savings crisis,” reads the final chapter. “Followed to its logical conclusion, it would replace a mandatory and efficient fund regime with a fragmented, non-compulsory, expensive, and risky savings system that would leave retirees with less income. The loss of defined benefits would also spell the erosion of the large pension plans that supply so much of Canada’s long term capital. This strategy saves us nothing in the long run. In fact, the Canadian taxpayer and economy will end up paying more. There is a better future for defined benefits.”