Five years ago, defined benefit (DB) pension plans were in trouble. Fast forward to 2007 and it’s as if a miracle has taken place.
Statistics Canada released a report in June 2002 announcing that, as they sold off sinking stocks in an effort to rebalance their portfolios towards bonds, Canadian pension plans had managed to lose more than $3.5 billion dollars. A month earlier the Association of Canadian Pension Management (ACPM) noted that private and public pension plans were short about $225 billion, an amount roughly equivalent to 20 per cent of the country’s gross domestic product.
"We’ve managed risk in these plans by the seat of our pants," said Keith Ambachtsheer, who was ACPM’s president at the time. "We need a sea change in getting rigorous about defining the risks in the system and managing them."
Funding levels recover
The situation has now taken a turn for the better. This past July, Watson Wyatt issued a press release saying that for the typical pension plan, the pension funded ratio (the ratio of plan assets to plan liabilities) had increased to 102 per cent at the end of the second quarter, up from 86 per cent at the beginning of 2006. "This news provides a welcome respite from the last few years, when most pension plans had deficits," says David Burke, retirement practice director of Watson Wyatt’s Canadian offices. "Now, plan sponsors not only expect next year’s budgeted pension expenditures to be lower, but it looks likely that the markets will help the cash side of their business operations. We are now moving back towards a world of pension surpluses."
The following month the Dominion Bond Rating Service (DBRS) released its own upbeat research paper, in which analysts denounced the funding crisis as a "myth" for 90 per cent of the defined benefit plans they had reviewed in both Canada and the United States. While weak stock markets, falling interest rates, and reductions in actuarial assumptions had helped to create a "perfect storm" for pension plans between 2000 and 2003, subsequent strong equity performance, higher contributions, better regulation and more conservative planning have paved the way to recovery.
Sponsors risk averse
But not every defined benefit plan has emerged from the tempest unscathed. Some jumped overboard. Worried about the size of their funding obligations, a number of CEOs and CFOs decided to either scrap or restrict entrance to their DB plans and switch employees over to defined contribution plans. It was a way to manage their risk exposure and put a cap on their liabilities. In a money purchase plan, the employer is only responsible for contributing a fixed sum, and it’s up to the employee to make all the investment decisions.
If sponsors needed any encouragement to get out of the defined benefit plans, they got it from Justice Elleen Gillese on June 5, 2007. In Kerry (Canada) Inc. vs. DCA Employees Pension Committee, the Ontario Court of Appeal overturned a Divisional Court decision and ruled that employers who wanted to convert from a defined benefit plan to a defined contribution plan could use DB surpluses to make contributions to the DC plan. One of the biggest obstacles on the road away from defined benefit plans now appears to have been swept aside. But does that mean employers should go down it?
In a speech at the Pensions Summit in Toronto in May, Bank of Canada Governor David Dodge listed the many advantages of defined benefit plans, and warned against throwing the DB pension baby out with the funding bathwater. He noted that defined-contribution plans can only reduce, not eliminate, risks for employers. "Because of market risk, this type of plan can fall short of the goal of ensuring adequate retirement income for all employees," he said. "The retirement incomes of two people with identical work histories can differ greatly, if they retire at separate times when the prevailing market conditions are very different." Employers who convert from defined benefit to defined contribution plans aren’t completely free and clear. They may still be sued by plan members who feel they got short shrift.
Bruce Cohen, a financial journalist and co-author of The Pension Puzzle (see Q&A page 14), says that while he’s not aware of any lawsuits involving DC plans or group RRSPs currently before the courts, he knows they are a very real possibility. "As lawsuits are filed and pressed, then the whole issue of the employers’ responsibility and the employees’ responsibility will be on the table." He suggests that Canadian pension industry could have learned from American lawmakers who offered employers a basic level of comfort and encouragement in their Employee Retirement Income Security Act.
"Basically, the U.S. Congress said to the country and employers, ‘These are our standards for giving your employees a fair chance to establish a reasonable retirement fund. If you meet those standards, we will substantially protect you from lawsuits by unhappy employees down the road.’" This strikes Mr. Cohen as a reasonable measure, and one that the Canadian pension industry should have emulated, but did not. "In their wisdom the Canadian regulators, when they developed the CAP [Capital Accumulation Plan] guidelines, decided not to offer employers any form of safe harbour. I don’t think that’s right."
The road ahead
So what’s the best choice today, defined benefit or defined contribution? Neither, says Keith Ambachtsheer. In his book, Pension Revolution, the director of the Rotman International Centre for Pension Management at the University of Toronto says that people shouldn’t assume that there are only two answers to the pension conundrum. Both models have serious flaws, he says.
Defined benefit plans don’t make it clear how, and by whom, risks will be borne. This means squabbling over who "owns" pension surpluses and deficits is inevitable. Defined benefit plans may eliminate ambiguity about risk bearing and asset ownership, but they’re not perfect either. Mr. Ambachtsheer cites research in behavioural finance that suggests most people are inconsistent or even irrational decision makers. Even if they are able to construct a decent investment portfolio on their own, high management fees can erode their returns. "Surely we should not expose the many millions of retirees around the world to the material risk of outliving their money," he says.
Mr. Ambachtsheer’s solution to the problem is a design he calls The Optimal Pension Solution (TOPS). The model addresses human foibles through auto-enrollment and auto-pilot mechanisms that adjust contribution rates and investment policies for each plan member based on his or her age. To deal with longevity risk, the TOPS plan purchases deferred life annuities for plan members over time. Since the annuity portfolio would be priced and managed according to insurance company principals, he says there "will be no fist fights over the ownership of any balance sheet surpluses or deficits." To handle conflicts of interest and to keep costs down, the TOPS pension plan is run by an arms length, expert co-operative.
Too good to be true? Not according to Mr. Ambachtsheer. He says the Teachers Insurance and Annuity Association - College Retirement Equities Fund (TIAA-CREF) in the United States is an example of a successful TOPS plan already in operation.
Instead of clinging to old pension designs, the industry needs to become more creative if it wants to look after tomorrows’ retirees. "It has been a sad experience to watch some of the finest minds in global ‘pensiondom’ earnestly attempt to ‘fix’ DB plans so that these arrangements will become not only management and sustainable, but wildly popular as well," says Mr. Ambachtsheer. "It is hard to imagine a more futile exercise."