The Negative Impact Of PAs On DB
By: Patrick Longhurst
In 1990, after years of debate, the federal government introduced a new system of Pension Adjustments (PAs) and Past Service Pension Adjustments (PSPAs). The intent was laudable, a level playing field for all Canadians when it comes to saving for retirement.
However, I believe that the actual result was to take private sector Defined Benefit pension plans down a road from which they may never recover.
The fundamental PA approach was to give all Canadians an annual window for tax-sheltered RRSP contributions equal to 18 per cent of their previous yearʼs earnings, subject to a dollar maximum. Canadians, who were members of a Registered Pension Plan (RPP), would have their RRSP room reduced by the Pension Adjustment from the previous year.
While this was a straightforward calculation for Defined Contribution pension plans and for Deferred Profit Sharing Plans, it was more obtuse for DB pension plans. Here the calculation was nine times the pension earned in the previous year, less $1,000 (subsequently changed to $600). A PSPA was calculated on a consistent basis for some past service enhancements. Unused RRSP room could be carried forward indefinitely.
‘Nine Times Factor’
Members of DB plans in the public sector were largely unfazed by these developments. Given the rich ancillary benefits in many of the larger plans, the ʻnine times factorʼ was quite appropriate. In addition, the existence of the plans was so firmly entrenched that it was highly unlikely these plans would be amended.
However, in the private sector, individuals who had been members of DB plans for years suddenly realized that membership in the plan was significantly cutting into their beloved RRSP room. Frequently, the ʻnine times factorʼ provided a gross over-statement of the value of the plan to them.
Many plan members responded by demanding that they be released from the pension plan so that they could maximize their RRSP contributions. This even happened where the offending DB plan was non-contributory! Employers of the day had differing opinions on the situation and responded in a number of ways:
- Designing the pension plan around a tax provision is akin to the tail wagging the dog; the plan stays.
- The plan is expensive and hard to administer, so if the members donʼt value it, the solution is obvious. Kill it!
- Most creatively, how can we redesign the plan so that it still meets our goals, but it also accommodates the membersʼ concerns?
The second of these reactions helps to explain why participation of private sector employees in DB plans has fallen from 28.9 per cent in 1992 to a pathetic 20.4 per cent in 2005.
However, it is the third reaction that is actually more insidious. Employers looked to their consultants to find ways of restructuring their DB plans so that they were more acceptable to plan members. The wisdom of the day was to reduce the unit benefit and enhance the ancillary features, thus creating equal value for a smaller PA.
At the same time, many career average plans were converted to final average, once again with a lower unit benefit. In some cases, sponsors introduced flexible pension plans, which allowed the members to purchase enhanced ancillary features without increasing their PAs.
There were two problems with these ʻnew eraʼ pension plans.
First, employers discovered that many plan members rate their pension plan based on the level of the basic benefit. In their minds a ʻtwo per centʼ plan has to be better than a ʻ1.5 per centʼ plan and discussion of enhanced features is just a smoke screen for downgrading the plan.
Secondly, when the ʻPerfect Stormʼ hit, which plans were best able to withstand the impact? It was good old simple career average plans, which did not include contractual commitments to link the benefits to final earnings and to index them after retirement. However, by then, many of them were gone.
So, in summary, I believe that PAs have failed to provide the fairness they were supposed to create. In fact, this approach has made DB plans in the private sector less viable and has exacerbated the divide between private sector and public sector coverage.
Patrick Longhurst, an actuary and a certified financial planner, is president of Patrick Longhurst Advisory Services Inc. As well, he is the speaker for the CPBIʼs 2006- 2007 National Speaker Program.
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