It’s Worse Than We Thought
By: Patrick K. Walsh
Whether a plan sponsor offers a Defined Benefit or a Defined Contribution pension plan to its employees, there are serious challenges they must address. Patrick Walsh, of SEI Investments Canada, looks at the challenges arising from both approaches.
What is the state of pension benefits today? The answer can probably be encapsulated by posing one simple question to Defined Benefit plan sponsors: “If your plan was fully funded today, would you terminate it?” While the human resources director might be aghast at the idea, many company boards and chief executive officers would answer with a loud “yes!” How did this happen? Most private sector plan sponsors feel like the bottom man in a football piling-on. Over the past two decades, sponsors have been held to increasingly higher standards of conduct in the management of pension benefits as a result of pension benefit legislation and subsequent regulations and litigation. The federal government, in a pincer movement, also limited the sponsors’ ability to fund their plans during good economic times by resuming tax deductibility for contributions to well-funded plans. In effect, sponsors are expected to continue funding plans while their organization is in financial distress, but not allowed to do so when times are good.
The accountants have been no help. Rules for reporting pension income and liabilities have made labour intensive businesses financially leveraged to the health of their pension plans. While many of us have questioned the sense and process of marking to market such long-term assets and liabilities, the result has certainly been to highlight the unattractive features of such benefits to a sponsor. It is also certainly no surprise that the number of DB plans in Canada has fallen by a third in the past decade, with virtually all the plan terminations coming in the private sector.
While DB plans will continue to be financially viable for private sector employers where human resources form only a small part of their costs and politically expected in the public sector, one has to ask the commercial logic behind it. Consider an analogy to operating a nuclear generating station. Expensive to construct, with unforeseen maintenance costs, and in the distant future an unquantifiable, but undoubtedly large, decommissioning cost, it is not surprising that private enterprise avoids them. Nuclear energy is well-established only where government has directly invested in it or provided a benign regulatory environment with financial protection for the private sector. Otherwise, operating such a long term business with open-ended liabilities is beyond the scope of private enterprise. And only their current under-funded status prevents many plan sponsors from seriously considering terminating their existing DB plans.
‘All You Can Afford’
Set against this background, the rapid growth of Defined Contribution (DC) vehicles for employee retirement savings is not surprising. Sold to small sponsors as ‘all you can afford’ and to large organizations converting existing DB plans, the siren song was simple:
- no governance or regulatory burden
- no long-term financial liability
- simple and easy to implement
- increased employee satisfaction
The time has come to evaluate these promises. What has the actual experience been?
Let’s start with the issue of governance and regulation. The DC market (which includes group Registered Retirement Savings Plans (RRSP) and Deferred Profit Sharing Plans (DPSP) has a checkered history driven by the inconsistent and incompatible regulation of multiple distribution channels. While a broker at an investment dealer who sells a group plan must meet the ‘know your client’ requirements for each member, the same group investing in an insurance product (often with the same underlying investments) has no such protection.
Cue the regulators to the rescue. The Canadian Association of Pension Supervisory Authorities (CAPSA), through the process of developing guidelines for employee savings plans, is attempting to establish a minimum governance structure for this fragmented business. While fiercely resisted by the insurance industry in particular, there is no question now that sponsors are indeed responsible to plan members for the proper operation of their retirement savings plan. They recognize this. In a survey conducted by SEI Investments1, 24 per cent of DC plan sponsors expected to be the subject of litigation within the next two years and 40 per cent felt that the results of that litigation would favour members over sponsors.
Given this reality, many sponsors are putting in place pension committees, performance measurement, manager searches – all the paraphernalia of a DB plan. So much for eliminating the need for governance! We anticipate that the regulatory burden on DC plans will only increase over the coming years, with parallel increases in the need for improved governance.
In many ways this also addresses the question of long-term financial liability. While it is certainly true that the plan sponsor’s cash cost is limited to current year contributions and operating expenses, those operating expenses will increase with the greater governance burden. What is impossible to quantify, yet is clearly a material risk, is the cost of making good in future to plan members for mistakes that have perhaps already been made:
- poor education resulting in bad investment choices
- lack of care in selection and oversight of investment options
- excessive costs charged to plan members. And this is only a partial list.
What do plan sponsors think of their risk? Educating members was very important in preventing litigation, said 53 per cent of sponsors surveyed. However, only 11 per cent would say they are doing a very good job. No wonder they expect litigation!
When it came to the monitoring of managers, the picture was the same. It’s very important preventing litigation say 48 per cent, but only 29 per cent rate their own performance highly in this area.
In fact, of the participants in this research, it was those from larger plans, and those who devoted the greater part of their time to pension management, who express the greatest level of pessimism on all these issues. If we assume a greater familiarity with pension matters in this group, things look grim. As far as financial liability, the past can’t be undone, but improving the DC governance process will go a long way to limiting future problems.
‘Simple And Easy To Implement’
While the administrative demands of a DC program are certainly different from those of a DB plan, it was always a fallacy to say it was simpler. In both cases, a member- specific record is required. For DB, a simple salary record suffices. For DC, areas which are constantly being updated include contributions, matching, investment choices, switches, and potential vesting. What’s simple about that? Ask any plan sponsor who has contemplated, let alone executed, a change of record-keeper. Like a lobster trap, it’s easy to get into, but very hard to get out.
As to ease of implementation, I need look no further than two very large DC plans that recently transitioned their investments. One also made a change of recordkeeper at the same time. My admiration for these plan sponsors knows no bounds. With a precision and attention to detail rivaled only by the planning for the D-Day invasion of Normandy, both laid out and executed very successful transitions. The cost? Literally hundreds of multi-party planning meetings, employee enrollment and education sessions, and internal staff meetings (not to mention time and effort of their record-keeper and other specialist providers.)
Let’s pause and take stock. In examining the state of pension benefits today, very serious challenges face plan sponsors in both the DB and DC sides. While DB plans face a hostile environment, the promise of DC is different. Remember that many of these plans and conversions were done to satisfy a perceived demand from employees for more control over their retirement savings, along with portability and other features.
At the end of the day, employers offer a pension benefit to attract and retain a talented and productive workforce – to be a better place to work. If in fact employees are happier because of this benefit, then all the cost and effort is justified.
This is the true bottom line of a DC program: increased employee satisfaction. To take the measure of this issue, we recently surveyed more than 2,000 DC plan members across Canada2.
It’s worse than we thought.
Only six per cent of employees feel their pension plan will provide them with enough money to retire. Further, they don’t think they will be able to retire when they want to.Their planned retirement age is 61 years, while the average desired retirement age is 56.3 years.
These figures send a stark message. Regardless of whether these beliefs are factually correct, it is clear that the employees perceive that their retirement plans are unlikely to let them retire when they want to, with a pension that will meet their retirement needs.
At the same time, the pension benefit is highly valued. While 67 per cent agree that having a pension plan makes them feel valued by their employer, 39 per cent say it is so important that they would leave the organization if a pension plan were no longer offered.
Given that their pension is important, one might expect plan members to take full advantage of what they are offered. Not so! First, members do not know the basic features of their plan. They do not know if the plan is compulsory, whether they can make their own contributions, or whether the employer contributes to the plan.
Second, they do not take advantage of the education available to help them. Fully 52 per cent say they have never used it. This is consistent with the plan sponsor concerns discussed earlier. Regardless of the quality of the program, it has no value if no one uses it.
Finally, members lack investment knowledge. Worse, those who had participated in the education programs offered scored the same as those who had not. In a simple asset allocation test, only 16 per cent consistently allocated the same amount to stocks and bonds in two scenarios. Of employees who had used the education program, 17 per cent were consistent; of those who had not, 16 per cent. They diversified by investment choice rather than asset class and were influenced by the menu of funds offered. In another scenario, employees showed a tendency to chase ‘hot stocks,’ with 62 per cent being momentum chasers. Again, education made no difference in the results.
To sum up: employees don’t understand their plan, don’t understand investments, and make little use of what are evidently ineffective education programs. As I said, it’s worse than we thought.
Remember, the last thing that flew out of Pandora’s box was Hope. The objective of our research has been to understand these issues and develop insight into better ways to do things. It’s clear that the present process of DC plan management doesn’t work.
Formulated broadly, the key elements of a successful program will be:
- A governance process fully integrated into plan management. Plan sponsors need to go beyond the CAPSA guidelines and, in addition to adopting best governance practices, integrate them into the daily operation of the plan to ensure the highest possible level of monitoring, control, and compliance.
- An asset allocation solution. Employees need a guided process that will lead them to a personalized and appropriate asset allocation. This process will eliminate their current frustration with incomprehensive and ineffective education and lack of advice.
- Seamlessly integrated investments in life cycle asset allocation funds. The employee’s retirement savings should be integrated into an investment based on a life-cycle type fund which embodies their asset allocation and continuously manages their savings consistent with that allocation.
- Effective management information and educational outreach. The plan sponsor needs a reporting platform which will provide insight into employee behaviour and decisions and permit targeted outreach to plan members to ensure they are getting full value from the plan.
Despite the difficulties facing pension plans today, pensions have never been more important. Whether operating a legacy DB plan, or trying to improve their DC offering, sponsors should not lose sight of the importance and value of this benefit to plan members.
Patrick K. Walsh is president of SEI Investments Canada
1. DC Pension Plan Sponsor, SEI Investments, January 2004.
2. DC Pension Plan Members: Needs and Knowledge, SEI Investments, May 2004. Both can be downloaded at www.seic.ca
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