June 25, 2007

Prescription for Canada's Ailing Pension System

Today, the Canadian Institute of Actuaries (CIA) unveiled a prescription for the country's ailing pension system at the non-profit Economic Club of Toronto. The 6 page report is quite readable and part of the Institute's desire to help guide public policy in Canada.

The prescription only addresses defined benefit pension plans.

Defined Benefit or Defined Contribution?
Fulltime employees in large companies usually get a pension through their employer. There are two common ways to convert savings into retirement income.
  • defined benefit: employer bears the financial risk of providing the benefits (e.g., 2% of your final average earnings per year of service)
  • defined contribution: employees bear the financial risks (the employer makes a contribution as you would with an RRSP and your pension depends on the growth of the savings)
Guess which type employers favour? Statscan reports that the portion of private sector workers covered by defined benefit plans has dropped from 29% in 1992 to 21% in 2003.

The Disadvantages
Defined benefit plans are not perfect. Employer funding requirements fluctuate, which makes corporate financial results more volatile. As a plan member, what happens if you change employers or are self-employed? Portability is a problem. If you leave employers during the first two years, your pension benefits for that period are lost (don't vest). Plans can still fail. Plan assets can be used for purposes you don't support, such as offering incentives to others for early retirement.

Asymmetry of Risks and Rewards
With defined benefit plans, the employer bears the risks and the employees get the rewards. If investment returns are poor, the employer must increase contributions. So if returns are favourable, shouldn't the employer be entitled to withdraw some of the surplus? If an employer tries, there's often an outcry. Hardly fair. Hardly an incentive for employers.

Where's the Outcry for Defined Benefit Plans?
There isn't one. Employees don't understand how much they lose. With defined contribution,
  • plan members bear the risk of poor investment returns
  • employers reduce their costs by 2% of payroll (which means costs have been shifted to plan members)
  • returns drop because of higher administration costs, less investment expertise and higher management fees than institutional investors
At retirement, plan members find that their retirement savings buy less of an indexed annuity than they expected. At this point, what can they do?

What's Next?
It wasn't clear what happens next. How will business owners react? Will politicians see a need to do anything? Do Canadians care? Are there other prescriptions that could help improve the defined contribution plans which predominate?



Unknown said...

Ur um, outcry? You don't live near anyone who works at Nortel now do you? Nortel is ending it's defined benefit as of December 31 2007, but this only effects anyone not 55 by that time.

There is screaming, the government doesn't listen and there doesn't seem to be a class action suit coming up yet. Stay tuned. --C8j

Promod said...

Thanks for the comment. Let's see what happens, now that the actuarial profession is speaking out :)

Promod said...

In the US, the number of Defined Benefit pension plans has declined rapidly.

1980: 114,396 Defined Benefit plans
2003: 31,135 Defined Benefit plans

Many are turning to annuities to fill the gap.

This information is from the Pension Benefit Guaranty Corporation.

Anonymous said...

Not sure where you got the idea that employers save 2% by providing a defined-contribution pension rather than a defined-benefit. I work as a pension administrator and the employer contribution rates for the DC are approximately 2 to 3% higher than they were for the previous DB plan. Agree that the responsibility for financial planning shifts to the employee.

Promod said...

Thanks for the comment, anonymous.

The cost savings for employers was mentioned by the speaker during the Q&A portion of the presentation. No source was mentioned.

Perhaps your plan has characteristics which lead to higher employer contributions, at least in the short term?