Features of existing pensions plans and of a better, more sustainable, pension plan
The following table describes the features of existing Defined Benefit (D.B.) pension plans, Defined Contribution (D.C.) pension plans and the Canada Pension Plan. We then explore in a second table the features that a more sustainable and workable pension plan should have.
|Characteristic||D.B. Pension||D.C. Pension||Canada Pension|
|Ultimate Goal of the pension||To provide adequate funds for living expenses in retirement in combination with other sources of income. The specific target is often to replace up to 2% of the purchasing power of final earnings per year in the plan.Full inflation protection would be required to fully meet this goal.||To provide adequate funds for living expenses in retirement in combination with other sources of income. The specific target would vary by individual. Achieving full inflation protection would be required to fully meet this goal.||To provide adequate funds for living expenses in retirement in combination with other sources of income. The specific target is to replace 25% of income up to a maximum level. Full inflation protection would be required to fully meet this goal.|
|Pension pay-out amount||As high as 2% of highest five year average wages per year worked. (70% for 35 years worked)||No set pay-out amount.||Approximately 0.625% of final wages (up to a maximum wage amount) per year contributed. Maximum pension in 2013 is $12,150 per year and requires 40 years of contributing with earnings at or above the yearly maximum to qualify for that.|
|Inflation Protection||Usually there is partial but not full indexing for inflation.||The available pay-out is tied to investment market performance and not directly linked to inflation.||The pay-out generally rises to at least partially protect against inflation.|
|Age of Retirement||Usually 65, but sometimes younger There is often a 3% per year reduction for early retirement. Government plans often have a feature that forgives the early retirement reduction if age and years of service sum to a certain minimum “magic number”.||No set age. Retiring earlier reduces the amount available and reduces the safe withdrawal rate.||65 but with actuarially sound reductions for retiring and collecting as early as age 60 and actuarially sound increases for retiring as late as age 70.|
|Other benefits such as disability or survivor benefits for minor children||Typically not included||Typically not included||CPP includes disability benefits and survivor benefits for minor children|
|Ability to access the Commuted Value of the expected pension payouts||Very generous ability to do so. The commuted values are calculated based on bond interest rates and currently far exceed the amount that would apply if the expected return on plan assets were used.||Not applicable. Since there is no set pension amount, the concept of commuted value of the pension does not apply.||No ability to access the commuted value.|
|Contributions||Often shared 50 / 50 with the employer and sometimes the employer pays it all. Some plans now require as about 15% of wages or more from each of the employee and employer.||Employers often pay half of the contributions.||In 2013 employers and employees each contribute 4.95% of wages up to the Yearly Maximum Pensionable Earnings (YMPE).|
|Mandatory?||Yes, almost always mandatory||May not be mandatory||Yes, this is mandatory|
|Portability||There is some portability to certain other DB plans.||The money belongs to the employee but a new employer may not have a DC plan and if it does it may not allow the employee to transfer in existing amounts. In some cases these DC amounts could be transferred to a new employer with a DB plan.||Not an issue. The CPP pension is administered by the government and any new employer continues to fund each personal CPP account.|
|Risk to Retiree||Often no risk other than usually at least some inflation risk. Retiree has some risk in extreme cases where the plan sponsor goes bankrupt.||Highly risky, the retiree is at risk for market performance and inflation and must manage the investments.||No risk.|
|Value to Estate||No value to the estate after the death of the retiree and spouse||High value – the estate owns the remaining D.C. pension but faces income taxes.||No pension value to the estate after the death of the retiree and spouse. Does provide survivor benefits for minor children.|
|Longevity Risk||The “risk” of living for a very long time in retirement is pooled. Those who die early effectively subsidize those who live longer. This key feature means the plan only has to fund
(on average) for average lifespan not for maximum lifespan.
|The individual bears the “risk” of living a long time in retirement and must plan to fund for maximum lifespan rather than average lifespan. Therefore a larger pot of money is needed and
DC plans are inherently more expensive to fund than DB plans for that reason.
|As a specific example of a DB plan, the CPP pools longevity risk and only needs to fund for average lifespan, on average.|
|Market Risk to Employee||Employees face rising contributions when market returns are lower or deficits develop. But the risk is shared with the employer.||Employee is fully at risk for market performance.||Employees can face rising contributions when market returns are lower or deficits develop. But the risk is shared with the employer.|
|Market Risk to Employer||High risk, employers must raise contributions when market returns fall. Employers face unfunded liabilities appearing on their balance sheets.||Typically none.||Employers face the risk of higher contributions but do not have to worry about unfunded liabilities appearing on their balance sheets.|
|Multi-employer?||Sometimes yes, but typically it is a single employer and that sharply increases the risk to employees and requires the single employer to show any funding shortfall as a pension liability||DC plans are typically single employer but could be multi-employer.||CPP includes every employer in Canada. As a result employees face no CPP risk from bankruptcies of the employer and employers never have CPP unfunded pension liabilities on their balance sheets.|
|Market Risk Pooling||A DB plan typically expects to exist indefinitely. It can therefore pool the risk that the employment and/or retirement years of a particular employee cohort will feature unusually low average market returns.||No pooling of any risk is possible and a DC plan contributor should be conservative and plan for a market return that is at the lower end of the expected range.||As a specific example of a DB plan, the CPP pools market performance risk and can plan to achieve average market returns over many decades.|
|Cross subsidies and mathematical soundness||Cross subsidies can be high. Those with sharply rising salaries over their career are subsidized. Unreduced early retirement features are cross subsidized by those that do not qualify. Early retirement reductions are not as severe as they should be.||No cross subsidies as each plan is individual.||Little to no cross subsidies as benefits are based on contributions over up to 40 years. The maximum benefit requires one to have made the maximum contributions for 40 years. The reduction for collecting at age 60 is mathematically sound.|
|Investment Choices||Typically no restrictions but the plan will almost always follow relatively conventional rules for asset allocation and risk management.||May face restrictions such as having only a small family of mutual funds to choose from. Or on the other extreme, in other cases, there may be “freedom” to take huge risks and place
all the money in penny stocks if one wished.
|Little or no restrictions. The plan follows relatively conventional and contemporary asset allocation and risk management strategies.|
|Money management costs||Usually low due to the scale of the plans||Can be quite high and there may be no option to use low cost ETF products.||Low, due to the scale of the plan.|
|Capacity for Risk||Generally high because the plan has an indefinite life and can share market risks across age cohorts and there is (or used to be) some ability to increase contributions to make up for poor
|Generally lower because there is no ability to pool risks with anyone else or across time.||Higher risk capacity for the same reasons as DB and because the Canadian government does not face the risk of insolvency under any reasonably conceivable scenario|
|Equity Type Investment Proportion||Typically in the range of 60%||Totally at the discretion of the employee.||67% as of March 31, 2013|
|Funded Status||Varies but in 2013 many faced funding shortfalls||Not applicable since there is no promised pay-out amount||No funding shortfall was identified in its latest reports|
|Characteristic||D.B. Pension||D.C. Pension||Canada Pension|
Features of a more workable and sustainable Pension Plan:
It has been well documented that many Defined Benefit pension plans have developed unfunded liabilities due to low interest rates and poor stock market returns. And this is often in spite of
relatively massive increases in contribution levels. Many have concluded that the concept of a defined or guaranteed pension benefit is and always was mathematically unsustainable.
In summary a more workable, fair, sustainable and rational pension plan should: retain the group features of a DB plan and pool longevity risk since this lowers the funding requirements, be a group plan intended to continue indefinitely since this allows the pooling of market return risks across the lives of different employee / retiree age cohorts which reduces funding costs, be multi employer to reduce risks and increase portability, target full inflation protetion, provide a target rather than guaranteed pension since it is not feasible to shield retirees from all risks, have pension benefits that are directly and mathematically tied to the contributions of each year and to the time each year’s contribution has been in the plan since this will prevent unfair and unjustifiable cross subsidies.
The detailed features of a more sustainable and mathematically fair pension plan are summarized in the table below.
|Ultimate Goal of the pension||To provide adequate funds for living expenses in retirement in combination with other sources of income. Full inflation protection would be required to fully meet this goal.|
|Pension pay-out amount||The target payout should be some percentage of the inflation (or average market return) adjusted wages for every year worked. To get the math right and to avoid cross subsidies there should be a table of the percentage that applies to each year. It might be 3% of wages earned 30 years ago (Say 12% contributed – if that was the contribution rate 30 years ago – times five for average market growth times 5% of that equals 3%) and perhaps only 1% of wages from the last year worked. Say 20% contributed (which is a typical total contribution rate today) plus about 0% for growth times 5% of that equals 1%. The 5% is approximately the “safe withdrawal rate” for pooled pensions.|
|Inflation Protection||Full inflation protection should be targeted but not guaranteed.It’s only fair that pensioners be protected from purchasing power erosion. But only if the market returns on the funds allow it.|
|Age of Retirement||The normal age should probably be set at 65. Reductions for retiring earlier should apply in all cases and be actuarially sound and therefore fair. Increases for retiring later should also apply and be actuarially sound and therefore fair.|
|Defined Benefit Feature||Ideally the payout as calculated in the cell above would be fixed and known by formula but to mitigate risks there may need to be some ability to adjust the pensions (either up or down) to reflect market performance of the assets. Therefore it would be a target rather than a defined or guaranteed pension.|
|Other benefits such as disability or survivor benefits for minor children||Should not be included in the pension plan.|
|Ability to access the Commuted Value of the expected pension payouts||This should not be allowed. If it is allowed the discount rate should equal the expected return on plan assets rather than the more lucrative (to the departing employee) discount rate based on bond returns. Commuted values based on bond returns allow employees to remove risk free sums of money but leave the risk of asset performance with the plan and for that reason should not be allowed.|
|Contributions||Contributions, including contributions to a government pension plan like CPP should probably not exceed 10% from each of the employer and employee. Employers should be able to choose lower contribution levels and to choose whether they partially or fully match the employer contributions. Since the plan is meant to pay benefits directly in proportion to contributions, employees should probably be allowed to contribute additional amounts, if they wish.|
|Mandatory?||Employers probably should be allowed to set a minimum mandatory contribution level. The default option should be to opt into the plan with possibly the ability to opt out especially where there is no employer contribution.|
|Portability||Yes, should be portable to all other pension plans that allow incoming portability. Transfer values should be based on standardized return on plan asset assumptions, not on low risk bond returns.|
|Risk to Retiree||Unlike in DB plans there should be some ability to have retirees share the risk of lower market returns. Placing all risk on employers and and current employees has proven unsustainable in the face of persistently low market returns.|
|Value to Estate||There should be no residual value to the estate once the retiree and spouse are deceased. The savings from those dieing early are needed to pay those who live unusually long and this is one of the key features that is needed to make pension plans affordable.|
|Longevity Risk||A workable plan should pool longevity risk and the risks of low market returns in certain time periods. This allows the plan to fund for only average life spans rather than for maximum life span.|
|Market Risk to Employee||This will always be present but is mitigated by pooling the risk with many employees and across different age cohorts of employees and retirees.|
|Market Risk to Employer||This will always be present but is mitigated by pooling the risk with many employees and across different age cohorts of employees and retirees. These should be no requirement to show unfunded liabilities on balance sheets due to the multi-employer nature of the plan.|
|Multi-employer||A workable and sustainable pension plan should be multi-employer and at arms length from the employers. This reduces risks for all parties.|
|Market Risk Pooling||The pension plan should be an arms length multi employer organization that plans to exist indefinitely and can therefore pool market risks across different age cohorts.|
|Cross subsidies and mathematical soundness||As a principle, cross subsidies should be avoided other than pooling of longevity risks and pooling the risks of lower market returns in certain time periods. (Both of those lower costs on average and are required features). The discount for early retirement should be actuarially sound. There should be no unusual windfalls or early-retirement-without-penalty for reaching “magic
numbers”. The pension should be related to actual inflation- or average-return-adjusted salary over ALL years and not based on the highest five year average.
|Investment Choices||There should be few if any restrictions on the fund manager other than sound diversification.|
|Money management costs||Should be low due to scale.|
|Capacity for Risk||This plan will have a higher capacity for risk than a typical DB plan given the ability to share risks across multiple employers and employees (and even retirees) and the ability (like DB plans) to share risks across age cohorts and because the plan has an indefinite life.|
|Equity Type Investment Proportion||Given the capacity for risk and the higher expected returns from stocks there should be a high allocation to equities of at least 60%. Asset allocations should allow for reduced equity exposure during equity bubbles and reduced long-term bond exposure when interest rates are abnormally low.|
|Funded Status||These plans should target to be about 120% funded which allows a cushion for times when discount rates or expected or actual returns decline.|
Shawn Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.
June 15, 2013 (with minor edits through November 1, 2014)
See also our other pension articles