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Pension Reform: Time For A New Paradigm

By: Fred Vettese

While the decline of Defined Benefit pension plans is now getting attention, Fred Vettese, of Morneau Sobeco, suggests that the proposals now being put forward are certain to be too little, too late.

An estimated 28 per cent of paid workers in the private sector are covered by registered pension plans. The proportion covered by Defined Benefit (DB) plans is even smaller, just a shade over 20 per cent. This depressingly low coverage rate is the result of years of stagnation as many pension plans have been wound up while newly emerging companies have chosen to shy away from starting up a plan.

The good news is that the issue is now getting a lot of public attention. The bad news is that the proposals put forth are almost certain to be too little, too late.

Second Wave of Pension Reform

If we consider the first wave of pension reform to have occurred throughout the 1980s, it is fair to say that the second wave has now begun. Chart 1 summarizes the major consultation papers released in 2005.

The second wave is likely to be different in two ways.

First, the overall tone is more employer-friendly. Contrast this with the first wave which created a major headache for employers in a headlong rush to improve the rights and entitlements of pension plan members. While members got better vesting, survivor benefits, and portability, plan sponsors got stuck with additional pension administration and disclosure and reporting requirements.

The other major difference is that the second wave concentrates almost exclusively on funding issues and virtually ignores plan design issues. This is a serious oversight. A new round of reform will accomplish little if it does not eliminate the restrictions that pension legislation places on plan design. Even with the most intelligent changes to the funding rules, we can expect:

The underlying premise of the first wave of reform – that employers would keep their DB plans no matter how difficult governments made their lives – has proven to be erroneous. The implicit assumption behind the second wave – that employers will keep the DB plans that still remain and maybe start some new ones if the funding flaws are fixed – is also very likely to be wrong. A complete overhaul is called for and this means taking a harder look at plan design.

pension reform paradigm

A New Paradigm

Given that establishing a pension plan is a voluntary act by employers and that they may need better reasons to do so, a new ‘employer-friendly’ paradigm is needed, based on the principles:

Plan Design Innovations

Based on these principles, there are a number of plan design innovations. We believe these proposals have the potential to re-invigorate employer-sponsored retirement arrangements. The challenge is to persuade governments to agree as none of these ideas is acceptable under existing legislation:

This alone could save many a DB plan, especially those facing a funding crunch. Traditional annuities – bought from an insurance company to provide a level income for life – are becoming archaic. In the case of larger bankruptcies, they are no longer even viable. Had Air Canada gone under, the Canadian annuity market would not have been large enough to provide annuities to all members. The only requirement on plan termination should be to give a lump sum equal to the present value of the pension, based on a certain prescribed interest rate. The choice of the interest rate is the key. It might be based on long-term bonds averaged over several years to smooth out the peaks and valleys that have been causing the funding and accounting challenges.

Note this is different from the current actuarial practice of smoothing discount rates to determine a plan’s solvency position. This changes the actual entitlement on wind-up, not just the way the liability is measured. Had this provision been in place over the last five years, the funding crisis could have been avoided.

Currently, plan sponsors cannot change an accrued DB pension to an actuarially equivalent DB pension with different ancillary benefits unless the new plan is clearly better than the old one for every employee under every possible scenario. Consequently, many, if not most, DB plans have to maintain grandfathered formulas to deal with a previous plan re-design, plan merger, or acquisition. This makes plans difficult to administer and difficult to communicate. Plan sponsors should be able to ‘homogenize’ DB pensions by converting an existing DB pension into an actuarially equivalent DB plan or to split it into a DB and a DC piece. Of course, there would have to be some safeguards, but this proposal would go a long way toward simplifying plan administration and plan documentation, thus reducing operating costs.

Employers make mistakes such as introducing subsidized early retirement rights and then discovering years later that it has a skilled labour shortage. Employers in this predicament should be able to rescind the improvement and compensate affected employees with a lump sum or DB credit to cover the loss of the rescinded provisions.

Many employers would gladly share some of the investment risk in a DC plan if it would reduce their own potential legal liability should members suffer investment losses.

pension reform paradigm

For instance, a plan should be able to credit DC members’ account balances with the actual fund return subject to a minimum, such as three per cent per annum. If the actual return falls below the minimum in a given year, the employer would be allowed to contribute more to each member’s account balance (on a tax-deductible basis) to make up the shortfall. This idea is similar to a cash balance plan, a hybrid design which has been available in the U.S. for many years.

On termination of employment under current legislation, a calculation is needed of the employee’s deferred DB pension and the corresponding commuted value. This is a complicated calculation that requires extensive paperwork, time, and cost. It would be better if the termination benefit could be ‘decoupled’ from the DB accrual, say by defining it as a multiple of salary. This could be calculated easily and would be simpler for the terminating member to plan for. This almost exists now, but only after complex calculations to ensure that, in the rare case, the alternative DB benefit doesn’t have a greater value. Such calculations should not be required.

A principle underlying pension legislation is that a member should not suffer a severe penalty because they barely miss an age or service condition to be eligible for a pension. This needs to be applied in a more intelligent fashion. Certain pension plan designs are currently acceptable that shouldn’t be while plan designs that should be acceptable are offside.

For instance, DB plans exist in which a member with 29 years and 11 months of service receives a pension value on termination that is less than half what he would receive if he left a month later. Yet, a plan that provides a DC payout up to age 54 and the greater of DB and DC at age 55 is not acceptable, even if the increase in value at 55 is much less dramatic. (See Chart 2.) The reason for this anomaly is the inflexibility of pension legislation in dealing with DB/DC hybrids. This should be rectified.

These changes could revolutionize pension plan design. They would reduce both the cost volatility and the administrative burden enough to bring employers back to the table. The big question mark is whether governments will ever have the will to carry through major changes.

Long-term Scenarios

There are several paths that pension plans can follow over the long term.

The most likely scenario is that governments will continue to tinker with legislation and regulations, but not in a significant way. In the current round of reform some changes to the funding rules will be made. Significant changes – like eliminating surplus asymmetry – will almost certainly not occur. Decisive government action is elusive because different jurisdictions involve different ministries that rarely meet and that do not fully appreciate the urgency to take action. It has been suggested that a new ministry be established to deal with this, but this is unlikely to happen any time soon.

As a result, while employers will generally put up with whatever changes come along, the participation level in DB plans will continue to fall as participants in closed DB plans retire or quit and as existing DB plans are converted. The DB plans most likely to survive are union-negotiated plans, plans in capital intensive businesses where the size of potential pension deficits remains small relative to the business operation, and most government plans. Like global warming, this scenario could take decades to unfold.

pension reform paradigm

Less likely, but plausible, is some unseen external event that steers employers back to DB pensions. Perhaps the threat of litigation that currently hangs over the heads of DC plan sponsors may finally materialize in the form of a high profile class action suit where the sponsor is found liable for some astronomic amounts. Employers may then decide they can cope with the risk of DB plans after all.

However, even if the pendulum does swing back, pension coverage in Canada will almost certainly remain low.

As a result, the federal government may decide that retirement coverage needs to be improved and the system of voluntary, private coverage is not an effective way to achieve this. They might mandate an expansion of the C/QPP, but this is unlikely given other countries (such as the U.S.) are trying to pare down their social security obligations. More likely, but still improbable, they would do what Australia and Chile have done and mandate participation in a DC arrangement with compulsory employer contributions.

Least likely of all is that the plan design reforms proposed here will be acted upon. As mentioned earlier, the hurdles are significant, but we can always hope.

Fred VetteseFred Vettese is chief actuary at Morneau Sobeco.

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