By: Bob Adams
Events of the last decade or so suggest that neither the Defined Benefit (DB) nor the Defined Contribution (DC) pension arrangements are totally satisfactory. This article proposes a hybrid approach that could overcome many of the current criticisms while also eliminating the estimates and assumptions that complicate pension accounting for DB plans.
DB plans have had the worst press lately as equity markets and bond yields plummeted, generating pension fund deficits. Employers faced the reality that they ‘owed’ and had to make good these deficits producing concerns about the potential drain on cash flows and future profits.
Almost simultaneously, employers learned from the Monsanto decision that the playing field was not level. Employers did not necessarily own any pension surpluses and surpluses might have to be shared with employees.
As bad as all this was, employers were criticized for the financial statement distortion caused by the flexibility of assumptions used in DB pension accounting.
Earlier, in the heady stock market days of the ’90s, many employees demanded a switch to DC plans thinking they could easily beat the staid conservatism of their DB fund’s management. But employees’ attitudes changed with the markets. The DC praising chorus faded away and the pendulum swung back to favouring the relative safety of DB.
In between these periods, new employers offered DC plans from the outset and some existing employers began giving employees a choice or made only DC plans available to new employees.
There is no denying the appeal of DC. It is simple and straightforward and produces admirably clear accounting as well as more equitably determined benefits for both employee and employer.
The inequity in DB benefits does not receive a lot of attention. This is due, in part, because the DB approach to benefits reflects a long-held paternalistic philosophy that many accept without thinking about. DB benefits are typically based on final average salary and years of service. They are paid periodically over the retiree’s remaining life and often continue, discounted, for the life of the spouse.
DC benefits are annual contributions from the employer based on the employee’s salary. Unlike the DB benefits, an employee’s marital status, gender, and general health have no influence on the DC benefit.
Changing social attitudes are broadening the definition of marital status and we are starting to hear arguments by single employees in favour of naming nonspouses as beneficiaries. These issues reflect the muddled thinking that our paternalistic philosophy creates. We are combining a pension benefit for the employee with the employee’s responsibility for his spouse and others.
But, as attractive as DC plans may be to employers in this environment, they aren’t a perfect panacea. DC plans transfer the investment risk to the employee and bring a new set of headaches for the employer. These include:
- employee education
- providing an appropriate array of investment choices
- choosing and overseeing an administrator
- possibly facing law suits if employees wind up at retirement with inadequate returns or investment losses
The DB structure offers a better combination of professional investment management and adequate scale for costeffectiveness and diversification.
Why not combine the best of DB with the best of DC into a hybrid? Such a hybrid could retain the equity of the pension promise as well as the accounting clarity of DC with the superior investment management of DB. Such a hybrid could promise employees an annual percentage of their salary that incorporates both the employer’s contribution and an investment return. These annual amounts could accumulate in the employee’s name to be paid in a lump sum on termination or retirement. In the meantime, the employer would carry the accumulating amounts as a liability and manage the investment of the assets in a segregated pension fund.
The lump sum payment would cure many problems with DB plans. Pension benefits would be more just and equitable. Each employee would receive a benefit based entirely on their length of service and compensation during that service. The money would be paid to them all at once, to be invested within an RRSP or in an annuity with any beneficiary arrangements they wished. This would eliminate the inequity that currently exists when a retiree dies soon after retirement with no spouse or without having provided for the spouse to receive a reduced pension. It would also eliminate the inequity when an employer must continue to make pension payments to former employees and/or their spouses who live well beyond normal mortality. And it would make it possible for a single retiree to bequeath any unused portion of their pension benefit to anyone they chose.
Certainty About Pension Expense
Finally, I propose that investment returns on the accumulated assets, actual or estimated, be divorced from the accounting for pension expense. This proposed hybrid approach would produce much greater certainty about pension expense and the pension liability than DB plans do currently. It would largely eliminate the need for actuarial valuations. And, it should end the controversy over the ownership of pension surplus for non-contributory plans.
The idea is simple. Its implementation would not be. Pension documents would have to change, as would, probably, legislation. Widespread adoption could devastate actuaries’ pension business. Some retirees would make bad investment choices or have the misfortune to outlive their money. But, the benefits seem worthy of serious consideration:
- greater equity for employees and employers
- greater clarity and accuracy in corporate financial statements
- professional investment management In addition, changing employers midcareer would not incur the vagaries of interest rates and commuted valuations. Spouses would be less likely to be left stranded financially and retirees’ estates could keep any unspent portion of the pension benefit.
Bob Adams is a retired senior manager of the Bank of Montreal Pension Fund.
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