Vision. Knowledge & Insights. The case for DC pension plans. In-depth analysis of a major pension or benefits issue of long-term significance

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1 Knowledge & Insights Vision In-depth analysis of a major pension or benefits issue of long-term significance Volume 18 Number 1 April 2015 The case for DC pension plans By Fred Vettese, Chief Actuary In its December 2014 Consultation Paper, the Ontario Government proposed that defined contribution pension plans would not be deemed comparable plans for purposes of gaining an exemption from participation in the proposed Ontario Retirement Pension Plan (ORPP). The irony is that DC plans are the only type of pension plan where membership is growing in the private sector and that have proven their sustainability through challenging economic conditions. DC pension plans will continue to play an important role in providing retirement security for many years to come. Such plans could be further improved if better decumulation options were available, something which the provincial governments, including Ontario s, could make happen.

2 In a perfect world, every worker would participate in one defined benefit (DB) pension plan for an entire career. DB plans provide a predictable stream of retirement income, shield vulnerable retirees from longevity risk, and outperform other types of plans in terms of cost-effectiveness thanks to professional investment and risk management. The trouble is the working world is far from perfect. For more than 20 years now, private sector employers have been coming to the realization that DB plans entail more risk than their shareholders are prepared to bear. Funding requirements have been too volatile, largely due to the exigencies of dealing with solvency deficits and even if the solvency problems could be made to go away (which they could), DB pension costs for accounting purposes would continue to pose a serious and possibly insurmountable problem. This is why defined contribution (DC) pension plans have gained so much popularity. Over half of all pension plan participants in the private sector are now covered by DC plans, most of them DB plan refugees. As for the remaining DB plans, over 50 percent are now closed plans (i.e. closed to new members) and will gradually sink into oblivion as the last members retire. It is expected that over 75 percent of all DB plans in the private sector will be closed plans within 5 years. Labour will argue that the popularity of DC plans has been achieved on the backs of workers, since such plans transfer virtually all of the investment and longevity risk to the member rather than being borne by the employer. This claim is largely true but ignores two important facts. The first is that employees and employers combined contribute significant amounts to DC plans each year, and risky or not, the participants of such plans can definitely count themselves among the haves in a society where the majority of private sector workers have no workplace pension at all. The second fact is that DC plans are naturally portable and hence well-suited for a mobile workforce. Assuming a conservatively low 5 percent annual turnover rate, there is only a chance in three that a 25-year-old employee will still be with the same employer at age 45 and a smaller chance again of retiring with that employer. The typical DB plan does not do a good job of addressing the needs of employees in the first half of their careers. Enter the Ontario Retirement Pension Plan (ORPP), the retirement vehicle proposed by the Ontario government to supplement the Canada Pension Plan. In its current iteration, it would differ from the CPP in that workers who participate in comparable pension plans in the workplace would not be required to enroll in the ORPP. This is highly commendable since it avoids double coverage and minimizes the disruption of the third pillar that would occur if thousands of plans had to be modified to accommodate the ORPP. The trouble is in the proposed definition of comparable plan. While the situation may yet change, Ontario has deemed that DC plans are not to be considered comparable for purposes of gaining an exemption from participating in the ORPP. Ontario would consider only DB plans and Target Benefit Multiemployer pension plans (TB MEPPs) to be comparable, primarily because only those two plan types pool longevity risk. If the government chose to do so, similar pooling of longevity risk could be made a feature of DC plans at virtually no cost. (This is explained below.) It is therefore unfortunate that the only type of pension plan that continues to thrive in the workplace would be excluded in this way. Incidentally, Ontario did cite a second advantage of excluding DC plans from the definition of comparable. They noted that doing so would increase the number of people participating in the 2 Morneau Shepell

3 new ORPP. If this is important, then why exempt DB plans and TB MEPPs? Many, if not most, employees who participate in such plans will terminate employment before retirement age and receive a deferred pension with a lesser value than had they remained in service. The thousands of employers who sponsor DC arrangements need some re-assurance that they are on the right track and that their plans measurably enhance the retirement security of their employees. They also need a response to pension pundits who have long argued that DC plans are ticking time bombs; popular now but once such plans have been in operation long enough, their flaws will become self-evident. The best possible response, perhaps, is to ask the naysayers to consider the situation in Saskatchewan, which adopted DC plans for a large number of public sector employees back in This is described in the feature story. Innovation in plan design From the 1970s until the early 1990s, DB pension plans used to be a hotbed for innovation. A partial list of the changes that contributed to the evolution of DB plan design is given below: Early retirement benefits Shift from career-average to final average earnings plans A change in pension formula from government offsets to step-rate formulas Flexible pension plans DB plans stopped evolving by the mid-1990s, around the time that employers came to realize the implications of pension accounting rules as well as the fact that funding had become solvencydriven (and hence more volatile) rather than going-concern driven. We would be remiss in neglecting to mention Shared Risk Pension Plans (SRPPs) which mark the next step in the evolution of pension plans. (We regard Target Benefit pension plans or TBPPs as a special version of SRPPs.) Apart from New Brunswick, however, it will be a while yet before SRPPs fulfill their promise because the provinces have been so slow to roll out enabling legislation and regulations. In their defense, the federal government will also need to play a role to ensure the Income Tax Act is harmonized to accommodate SRPPs. As important as SRPPs might turn out to become, they will not be a viable option for smaller employers because of the intensive governance regime they entail. There will always be a place for DC plans. The same is not necessarily true for DB plans. Unlike DB plans, DC plans have evolved considerably in recent years. For example, one of the most difficult problems with DC plans has been to educate members to make good investment choices. To a large extent, this hurdle has been side-stepped by the proliferation of Target Date Funds which ensures that the majority of members will have an asset mix that takes into account their investment horizon. As another example, the importance of investment management fees is more widely recognized now. As a result, service-providers are doing a better job of providing cost-effective investment options. Web-based self-service tools are becoming more readily available to DC participants. Such tools are also more user-friendly and more useful in helping members to understand better whether they are on track to meet their retirement income target and what measures to take if they are not. With the help of stochastic modeling, considerable work is also being done on refining investment and savings strategies to improve the odds that members will meet their retirement goals. More will be reported on this development in a future Vision. Morneau Shepell 3

4 The Saskatchewan DC experiment DC pension plans have overtaken defined benefit DB plans in the private sector in terms of active participants but they are not without their detractors. The biggest criticism of DC plans is that the benefit is too unpredictable for such plans to be suitable for the average individual. The proponents of this view contend that DC plans are ticking time bombs, a fact, they say, that will become more evident once DC plans have been around long enough for participants to retire in large numbers. This is why Saskatchewan s experiment with DC plans is so intriguing. It was in 1977 that the government closed its DB plans to new hires and established DC plans for its public sector workers. We do not have to theorize about whether DC plans are sustainable over the long term; all we need to do is study the Saskatchewan experience. Saskatchewan was able to introduce DC plans in the case of its public sector employees whose pensions were not subject to collective bargaining. If one looks at the transcripts of the time in Hansard, it is interesting to note that the main reason given for adopting DC plans was not related to risk management but rather to better serve the members. As reported in Hansard, over 80% of all Saskatchewan public service employees terminate their employment before retirement age. This was true in the 1970s and it is still true today. Where turnover is high, DC plans are better suited to meet the needs of plan participants than are DB plans. Today, about 90,000 Saskatchewan s public service employees are members of DC pension plans. The MLAs also participate in a DC plan and have been doing so since With the exception of the decumulation options, Saskatchewan s DC plans operate much like any DC plan in the private sector. Basic contributions are 5% on the part of both employees and employers though individual employers can establish a higher contribution schedule for their own employees. Many do and currently, the average combined employer/employee contribution rate in Saskatchewan is about 15% of pay. Members have a number of investment options. This is a fairly new development as member choice didn t exist before The default options are a series of balanced funds in which the equity weighting declines by age group. There is a different fund for each 5-year age group, right up to 65. Anecdotal evidence across Canada suggests increasing awareness of the importance of keeping fees low within a DC plan since it is the members who pay the fees. For every 100 basis point (1%) increment in annual fees, the amount of retirement income that can be generated over a lifetime reduces by 15% to 20%. In the case of the Saskatchewan DC plans, fees are relatively modest. The average annual fee for record-keeping and investment combined is 57 basis points. Compared to the 250 to 300 basis points that retail mutual fund investors pay, Saskatchewan DC members are doing fairly well. As for the decumulation stage, members have more options than one typically finds in a private sector DC plan. They can withdraw their account balance at retirement and transfer it to a Locked-in Retirement Account or use it to buy an annuity from an insurance company. They also have the option of buying the annuity directly from the plan (actually the Saskatchewan Pension Annuity Fund or SPAF for short) in which case they will receive a fixed monthly pension from the SPAF for life. The SPAF annuities are generally comparable to what members can obtain from an insurance company. Another option is the Variable Pension Benefit (VPB) which allows the member to retain control of his or her investments and withdraw whatever amount they want, right up to 100% of their account balance. Now that these DC plans have been operating for over 35 years, we can start to gain a good idea of the type of retirement income employees have been drawing from the plans. The average gross replacement ratio is currently 75% of average final salary including CPP (but not OAS); the average employer and employee contribution rates needed to generate this ratio are 7.21% and 6.31% respectively. A 75% gross replacement ratio is impressive as it translates into a net replacement 4 Morneau Shepell

5 ratio of over 100% for most participants, meaning they can look forward to a better standard of living in retirement than they had while they were working. Mind you, these estimates of replacement rates are based on the member taking a non-indexed annuity so there will be some erosion in purchasing power over time. Not all public sector workers are covered by DC plans. One notable exception is healthcare workers who have participated in a DB plan since the 1960s. Another exception is the Saskatchewan teachers who are also covered by a DB though not a typical DB plan by any means. The teachers bargained for a DB plan back in but it is not a run-of-the-mill DB plan: the employer contribution as a percentage of pay is fixed, which makes it a defined contribution plan from the government s perspective. To the extent costs in the teachers plan will vary, it is the members who make up the difference. It will be interesting to see how this plan evolves in the years to come and whether it can avoid the problem experienced by mature DB plans. Such plans are becoming unsustainable because retirees are shielded from any risk which exacerbates the volatility in contributions required from active members and this volatility grows as the size of the retiree population increases. The other major exception is the 14,000 municipal employees who are covered in a DB plan. The rationale for this exception is that they are not paid directly by the Saskatchewan government. One would have expected that the average retirement age would have risen under the DC plans since the 2008/2009 financial crisis and this is precisely what has happened. For retirees who chose the in-house annuity option (SPAF), the average retirement age in the 3 years following the 2008/2009 financial meltdown was 2¼ years higher than in the 3 years that preceded it. To some, this might be viewed as a weakness of DC plans. To others, it shows the resiliency of DC participants who understand the risks of DC plans and are prepared to cope with adversity. An ongoing challenge within Saskatchewan s DC plans, as with most DC plans, is employee engagement. Getting employees to take an active interest in their plan is probably as much of a problem in DC plans as it is in DB plans. One way around the problem is to mandate a fairly high contribution rate. Another is to ensure that the default investment option is broadly appropriate for a range of employees in different circumstances. Saskatchewan has taken both these steps. Lessons learned 1. DC plans are sustainable over the long-term, partly because much of the short-term volatility is smoothed out over long periods and partly because participants are resourceful enough to make adjustments to cope with market fluctuations. DC plans should work even better in the future with better online education and modeling tools, age-appropriate default options and a greater focus on keeping investment management fees low. 2. Anyone who saves at least 10% of pay each year in terms of combined employee/employer contributions and who is given good investment options is likely to have a reasonably secure retirement; this is in spite of the inherent volatility of retirement income from DC plans. 3. In any jurisdiction where pensions are not negotiated, the government is probably able to effect a conversion to DC with minimal political fallout. Morneau Shepell 5

6 Decumulation The one area where further evolution in plan design is much needed and relatively easily achievable is with respect to decumulation options. With respect to capital accumulation plans, decumulation refers to the ways in which a lump sum account balance at the point of retirement can be converted into an income stream. Judging from the spellchecker built into MS Word, decumulation is not yet considered to be a word, which may explain why governments have been so slow to act to improve the options that are available to DC plan participants. The current decumulation options under DC plans are admittedly sub-optimal. With a take-up rate of under 5 percent, annuities are not popular and in a world of low interest rates, they will not become more so any time soon. The Life Income Fund (LIF) remains the default option under a DC pension plan. A LIF enables retired DC participants to manage their own money and the income stream they derive from it, but LIFS have their own challenges. The LIF owners, now retirees, are now on their own without the plan sponsor to watch their backs. They may well have been unsophisticated DC participants without a good understanding of how quickly they can spend down their account balance in retirement, how they should invest it and what level of fees they should be paying. Now they are unsophisticated retirees with a large pot of money; the experts they might turn to for help have a vested interest in the investment options selected and may not have the retiree s best interests at heart. What is needed is a decumulation option that pools individual longevity risk among a large number of retirees, provides a reasonable and sustainable level of income and ensures that the remaining assets are invested prudently and cost-effectively. In larger DC plans, this could be accomplished by allowing the retiring participant to keep the account balance in the DC fund rather than transferring it out at the point of retirement. The retiree could then draw a monthly income from the fund. The amount withdrawn could be based on the life expectancies of the retired participants and thus eliminate the risk that an individual participant would outlive his or her monies. In smaller DC plans, the same end could be accomplished by pooling a number of smaller funds that are managed by the same service-provider. This mechanism would eliminate the fundamental flaw that was identified by the Ontario government as the reason why DC plans could not be deemed to be comparable plans. While some rules are needed about how the pooling can be accomplished, there is nothing about this idea that is difficult to implement or even novel. A number of large DC plans are pooling longevity risk now on a grandfathered basis. The average DC plan cannot do it, however, because the enabling legislation and regulations are not in effect in most jurisdictions. To finish on a hopeful note, the federal pension regulations have recently been amended to allow variable pensions to be paid out of DC plans on a monthly basis. It is hoped that the provincial jurisdictions will follow suit. 6 Morneau Shepell

7 Predictions If the CPP is enhanced or if the ORPP is launched in its present form, the following outcomes are likely: Canadians will save less in RRSPs. In the private sector, a number of marginal DC pension plans, group RRSPs and even small DB pension plans will be terminated. In collective bargaining situations, employers will have a fight on their hands if they try to reduce the future accruals in their workplace pension plans dollar for dollar to recognize the increased benefit from the enhanced CPP or ORPP. Even in non-union situations, the challenge in integrating an enhanced government-sponsored plan with existing workplace plans - DB or DC - will be greater than most people realize. Low-income Canadians who currently live in poverty before retirement but who will have much more income after retirement, will have even less income before retirement and even more after. DB pension plans will continue to be closed as plan sponsors migrate to Shared Risk pension plans in the case of larger employers or to DC plans in the case of smaller employers. The average retirement age will continue to rise though retirement will become an increasingly murky concept as more and more employees phase out of work gradually. In spite of the above outcomes, overall retirement security will improve, though not by as much as governments might hope. Morneau Shepell 7

8 Morneau Shepell is the largest company in Canada offering human resources consulting and outsourcing services. The Company is the leading provider of Employee and Family Assistance Programs, as well as the largest administrator of pension and benefits plans. Through health and productivity, administrative, and retirement solutions, Morneau Shepell helps clients reduce costs, increase employee productivity, and improve their competitive position. Established in 1966, Morneau Shepell serves more than 20,000 clients, ranging from small businesses to some of the largest corporations and associations in North America. With approximately 3,600 employees in offices across North America, Morneau Shepell provides services to organizations across Canada, in the United States, and around the globe. Morneau Shepell is a publicly traded company on the Toronto Stock Exchange (TSX: MSI). Morneau Shepell 2015 Morneau Shepell Ltd.