Are Defined-Benefits Pension Payouts False Promises?
By Mathilde Ngo Mbom
After the Second World War, employers have started offering defined benefits (DB) pension plans in order to attract the best employees. In DB pension plans, employees make contributions into the plan, and employers have to top them up in order to ensure that, when retiring, employees will receive a specific amount of income predetermined by the employees’ length of service and salary levels. DB pension plans are a good starting point for employees to fund their retirement. They also contribute toward strengthening the Canadian economy as concluded by a report produced by the Ontario Municipal Employees Retirement System (OMERS). However, various challenges have contributed toward considerably weakening the ability of employers to sponsor these plans and guarantee payouts. Judging by the many underfunded private DB plans, as seen in the recent example of Sears Canada where retirees got a 19% benefit cut, it is now questionable whether current DBP sponsors would be able to fulfill their full pension obligations to their member-employees.
Which factors have deteriorated the ability of private DB plans sponsors to guarantee payouts?
Gone are the days when pension payouts were ‘money in the bank,’ with some major reasons explaining this situation. Firstly, Canadians are living longer than expected and the proportion of Canadians over 65 has been increasing. According to a 2014 report from the Canadian Society of Actuaries, the life expectancy of male and female Canadians has reached 78.3 and 83.0 years, respectively, which is about 9 years more than the health adjusted life expectancy at birth. As a result, pension obligations are becoming considerably more costly to employers. Given that sponsors of DB plans hold 100% of the risk, employers might consider shedding their pension obligations since they cannot afford the retirement payouts in the long run.
Life Expectancy at Age 65 in Canada, Data for 1901 to 2012 and Forecasts for 2013 to 2075
Secondly, the weak return on financial assets has caused pension funds to underperform and therefore achieved lower returns than expected. To illustrate, the median annual return for Canadian pension funds between 2001 and 2011 was only 4.8%, compared to an expected rate of 7%. This situation was mainly caused by weaker interest rates set by the Bank of Canada, a monetary policy decision made in order to stimulate the economy after the financial crisis in 2008.
Thirdly, the evolving business environment makes it difficult for companies to always be on the top of their game: companies undergo many business cycles throughout their lifetime, and might be subject to bankruptcy like various retail chains that are currently struggling to survive. For example, in times of lower financial performance, private companies might not be able to contribute their share into the pension funds, therefore increasing the funding gap that is not necessarily compensated by profits during good times.
Which pension promises private employers are more likely to keep?
Given the plausible impossibility for many employers to fulfill their defined benefits pension obligations, difficult decisions have to be made despite dissatisfaction of unions but with the long-term benefit of employees in mind. Private employers should start offering a pension plan different than DB plans to either existing members and/or new members.
For instance, employers could revert to defined contributions (DC) pension plans. The payouts under this type of plan rely on the performance of the fixed contributions made by employees. This alternative is already proving to be quite popular, as seen through Statistics Canada's report of a 3.1% increase in membership of DC plans and a 7.7% decrease in membership of DB plans between 2014 and 2015.
Another option would be for employers to offer hybrid pension plans like the targeted benefit plans (TBP), which blends elements of defined benefit and defined-contribution plans. TBPs constitute of pension plans that would provide defined benefits to the participants but with fixed contributions. In situations where the plan gets underfunded, employers no longer carry the responsibility to fund the plan. As a result, the pension payouts get adjusted based on the performance of the participants’ contributions. Fred Vettese, chief actuary at Morneau Shepell, has written that “TBPs are promising because they eliminate the risk of rising costs inherent in DB plans while offering a better solution for most employees than most DC plans.”
The current challenges of DB pension plans make it difficult for companies to guarantee pension payouts in the long-run. As a result, companies should consider reforming their plans in order to make promises they are more likely to keep, rather than increasing employee dissatisfaction.