From Defined Benefit to Defined Ambition?
Let’s run through some fun retirement-savings jargon: DB, for defined benefit, means a traditional pension plan. The monthly payout is defined from the start and guaranteed by the plan sponsor. DC, for defined contribution, is an individual retirement account such as a 401(k). The amount of money you put in is defined by you, and maybe your employer chips in a match. After that, good luck!I saw this article last week and wanted to briefly review it.
A lot has been written in recent years about the drawbacks of both systems. DB plans require providers to take on big, long-term risks, which private employers in the U.S. have generally decided they don’t want to do anymore and some state and local governments have done an awful job of managing. DC plans put all those risks on the shoulders of individual workers and retirees, with predictably mixed results.
It sounds like there ought to be a middle way, right? There is, and it’s being developed mainly outside the U.S.
A name I had previously heard for these middle-way schemes is collective defined contribution, which doesn’t exactly roll off the tongue and has an acronym that in the U.S. has already been claimed by the Centers for Disease Control. The Financial Times called them “target benefit” plans in an article this week on their possible rise in the U.K., but “TB” is already taken, too. So my new favorite term for these plans, which I learned Tuesday from John Kiff of the International Monetary Fund, is “defined ambition.” As Niels Kortleve, innovation manager with the Dutch pension fund manager PGGM, put it in a 2013 article in the now-defunct Rotman International Journal of Pension Management, DA plans usually start out looking a lot like DB plans, with a target benefit based on salary and years of service. Then comes the twist:
The main difference for DA contracts is that when asset value and longevity change, the benefits are adjusted downward in poor times and upward in good times. This should happen through well-communicated preset rules, such that all stakeholders know beforehand what will happen in each situation and how it will affect their contributions and benefits. If life expectancy increases, the retirement age can increase and retirees’ benefits can be adjusted accordingly. In the case of a negative shock in financial markets, the benefits can be lowered.Dutch pension funds were forced by their regulators to make such adjustments during and after the global financial crisis, although not exactly with “well-communicated preset rules.” The funds mainly just stopped adjusting pension benefits for inflation for a couple of years, although a few also had to make small cuts in nominal benefits. Since then the pension funds and the government have been working on better defining and communicating the rules. (1)
There are a few target-benefit plans in Canada, too, although a bill to encourage their wider use has run into lots of opposition. In the U.K., Royal Mail PLC, which recently froze its DB plan, is looking to shift its many workers to something along the lines of DA. In the U.S., a few union-run multi-employer pensions have moved in recent years to variable defined-benefit plans in which payouts are to some extent dependent on investment returns. But DA is as yet not a big theme here.
Instead, private employers have been moving to take at least a few DC responsibilities off their employees’ hands by automatically deducting money from paychecks (unless the employee opts out) and plunking it into target-date funds, while state and local governments that still offer DB plans have been under lots of pressure to shift workers at least partly to DC. At the national level, Social Security is a DA plan of sorts, but not an optimally designed one. That is, retiree benefits will under current law be reduced to match payroll tax revenue after the Old-Age and Survivors Insurance Trust Fund runs out of money, which is currently projected to happen in 2035, but most people assume Congress will step in and make changes before that.
The advantage of DA over DB is that it’s more sustainable. The advantage of DA over 401(k)-style DC is that pension funds generally achieve higher investment returns than individual retirement accounts. That’s partly because they’re run by professionals, partly because those professionals can make long-run illiquid investments of a sort not available in most 401(k) plans, and partly because the administrative costs are usually much lower. The administrative costs are kept especially low when, as in the case of the major Dutch funds, the pension funds are gigantic member-owned cooperatives. Two researchers for the Dutch central bank found in a 2007 study that “the administrative costs of collective pension schemes offered by pension funds constitute only a fraction of the operating costs of private pension schemes offered by insurers (over the last five years an estimated 4.4% versus 12.9% of the gross contributions).”
In the U.S., the shift to individual DC in the private sector is so far along that it’s hard to imagine how DA plans could gain much of a foothold there. But for troubled state pension funds, and maybe even for Social Security down the road, the idea of building in some flexibility while not giving up on the bulk provision of retirement income seems really sensible.
First, a little background information from the National Association of Federal Retirees, How do target benefit plans differ from defined-benefit pension plans?:
Defined-benefit pensions are plans where an employer or plan sponsor promises a specified pension amount upon an employee’s retirement. The pension is determined by a formula that is defined and known in advance, and usually based on the employee’s earning history, years of service and a multiplier. The formula typically does not change. Target benefit plans are exactly that – a target -- they provide a general sense of what the final pension amount will be. But that target can move if the pension plan does not perform well.You can also read more on target benefit plans in Canada from Morneau Sheppell here and here.
Most defined-benefit plans have indexation, to ensure retirees’ incomes keep up with inflation. Some plans provide full indexation based on, for example, the Consumer Price Index; other plans may provide a portion of indexing based on the Consumer Price Indexing. Some pension plans have an indexing formula based on average inflation over a set period of time. Target benefit plan indexing is typically conditional on positive plan performance. Further, some plans may have rules or limits on how much of the plan’s money can be used on indexing.
Defined-benefit plans are currently facing a new element of risk – rising costs due to difficult markets and shifting demographics. Target benefit plans may eliminate some of this risk by providing flexibility in the benefits that are paid, and in thereby shifting the risk of making up for shortfalls from the employer to the employees and retirees.
In recent years, it has been difficult to accurately account for defined benefit plans’ performance and make projections on their sustainability. As a result, we’ve seen many companies and governments, particularly in the United States and Europe, run into serious difficulties. Ideally, accounting in target benefit plans is based on contributions made, which is similar in practice to defined-contribution plans – in effect, a “real time” projection of the health of the fund and the benefits that can be paid from it.
Target Benefit Plans 101:
Target benefit plans have their proponents and detractors. In 2014, Hassan Yussuff, President, Canadian Labour Congress wrote an op-ed for the National Post, Why there's no benefit in target benefit pensions:
Every child grows up learning the importance of sharing. It’s also fundamental to the labour movement. Unions bargain with employers to ensure that workers share in the fruits of their labour. This makes for a stronger, stable economy and a fairer society.Let me cut to the chase because I truly believe that defined-benefit plans are much better than target benefit plans but their future is based on two things:
Sharing is also at the heart of workplace pensions. Part of the wages and salaries that unions bargain get deferred until retirement, in the form of pensions. When our negotiated pension plans experience funding shortfalls, as they have in the last six years, unions have stepped up and agreed to pay more into the pension fund, even temporarily cutting back on benefit levels. In return, unions expect that employers will live up to their commitments and pay retirees the pensions they’ve earned over a working lifetime – the essence of the defined-benefit (DB) pension deal.
Even as our pensions return to health, however, employers are looking for ways to rid themselves of the cost and headache of pension plans altogether. And the federal government is lending a hand. In April, the federal government announced that it is proposing target-benefit plans or so-called “shared risk” pension plans in the federal private sector, and for Crown corporations.
In fact, so-called “shared risk” plans have nothing to do with sharing. Let’s look at some of the myths around these plans:
Myth 1: “Shared-risk” plans split the risk and rewards between employers and employees.
These plans don’t “share” risk; they dramatically reduce employers’ risk by shifting it onto plan members and pensioners. Employers would enjoy cost-certainty and strict limits on future risk, while plan members face an open-ended risk of benefit cuts, even when retired. Employers converting their existing DB plans would be able to turn promised pension commitments (once a legal obligation that could not be revoked) into fully reducible “target benefits” that may or may not be delivered.
Myth 2: “Shared-risk” plans strike a balance between worker-friendly DB plans and the defined-contribution (DC) plans that employers prefer.
For employers, switching to a “shared-risk” plan brings significant advantages: Employer contributions are capped, no pension guarantees of any kind are made to employees, and no pension liabilities appear on the employer’s financial statements. Plan members, however, experience a massive loss of security: The legal protection for already-earned benefits is taken away, and everything can be reduced, including pension cheques being mailed to retirees.
Myth 3: If benefits are reduced in a “shared-risk” plan, they will only be temporary reductions.
In fact, there is no requirement in a “shared risk” plan that benefit reductions only be temporary. Permanent benefit reductions are indeed a possibility in this model. This means, absurdly, that temporary shortfalls in the plan could lead to permanent reductions in benefits.
Myth 4: The “shared-risk” plan is a hybrid, in which some benefits are guaranteed and some (like inflation protection) are conditional.
Not true. There are no legal benefit guarantees of any kind in “shared risk” plans. All benefits (whether basic pension benefits, or additional benefits like inflation indexing) can be legally reduced without limit.
Myth 5: Unions have embraced the “shared-risk” model.
The vast majority of unions do not support the conversion of DB plans into “shared-risk” plans. Faced with the distinct possibility that their pension plan would be wound up, a small number of New Brunswick bargaining units supported “shared risk” plan conversions for a few severely-underfunded pension plans. By contrast, “shared risk” conversions are now being proposed for healthy and sustainable pension plans, across the country.
The fact of the matter is that the “shared-risk” approach is about one thing: reducing employers’ risk and cost. But Canadians cannot allow the conversation to be restricted to just employers’ costs. We have to talk about adequacy and security of retirement income, and in that respect, we’re not making progress. Access to pensions at work continues to dwindle as a share of the working population, and a growing number of families face a retirement plagued by financial insecurity.
Over 60% of working Canadians have just one pension plan at work: the Canada Pension Plan or the Quebec Pension Plan. These plans are truly shared, paid for equally by employers and employees. The Canadian Labour Congress calls on the federal government to expand the Canada Pension Plan and Quebec Pension Plan. The government’s misguided shared-risk initiative will only further undermine the retirement security of Canadians.
- World class governance where pension investments are completely separated from government and done in the best interest of all stakeholders; and
- A shared-risk model which involves inter-generational equity and temporarily reduces benefits when the plan experiences a deficit (typically, a small adjustment in the cost-of-living adjustment until the plan's funded status is fully restored).
Yes, OPTrust and OMERS still offer guaranteed inflation protection (not conditional inflation protection) but this isn't an easy promise to keep and it's simply not fair to ask your active members to continually subsidize retired members if the plan runs into trouble.
Recognizing this, OPTrust which is the only pension plan in Canada that is fully-funded and offers guaranteed inflation protection is now embarking on an innovative pension solution to increase its members and make the plan young through new members.
But the success of this initiative remains to be seen and even if it proves to be successful, there's no doubt in my mind that OTPP, HOOPP and CAAT are right to have implemented conditional inflation protection.
We have to stop the charade once and for all of guaranteeing retired members inflation protection no matter what the plan's funded status is. It's beyond ridiculous and it's grossly unfair to active members in mature plans where there are more retired than active members.
In short, we need common sense. This isn't rocket science folks. We need to think in terms of what works and what ensures the sustainability of defined-benefit pensions over the long run.
Again, read my comment on making OTPP young again. Below, a brief clip on how small adjustments to inflation protection for OTPP's retired members ensure the plan's sustainability over the long run.
In my opinion, conditional inflation protection is one element which is critical to ensuring a plan's sustainability over the long run. The sooner we recognize this, the sooner we can stop talking about target benefit and defined ambition plans. Stick to DB plans and introduce the right governance and shared risk model.
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