By sharing some risks, workers can achieve higher investment returns
A version of this commentary appeared in the Globe and Mail, the Huffington Post and Ottawa Life
In a speech in Toronto last week, Kevin Sorensen, Minister of State for Finance, introduced details of a new “hybrid” pension plan proposed for all federal workers and other corporations under federal pension regulation. He referred to these proposed plans as Target Benefit Pension Plans.
One can understand Target Benefit plans more easily by reviewing the existing polarized options for pensions in Canada: Defined Benefits (DB) Plans (common among the Public Service) and Defined Contribution (DC) Plans (common in the Private Sector if one has a pension at all).
In a DB Plan, the plan sponsor (for the Public Service that means you, the taxpayer) is responsible for all plan risks. These include investment risks (think 2008), longevity risks (everyone seems to want to live longer and longer), expense risk and so on. The worker is told up front in a clearly stated formula what benefit they will get in retirement (e.g., 2% of your final pay times years of service or $2350 per year of service). If the costs of such DB benefits rise, then the plan sponsor must pay the difference.
In many of these DB plans, the purchasing power of such guaranteed benefits is also guaranteed by having a Cost of Living Increase each year equal to the full change in the Consumer Price Index. Nice deal.
In a DC Plan, the plan sponsor makes a defined contribution to a Capital Accumulation Plan. It might be some percentage of pay or some set dollar amount per hour, but it is defined and set. All risks associated with pensions (investment risk, longevity risk and so on) are borne by the worker. So, if 2008 is repeated, you could easily lose 30% of your Capital Accumulation and have to work years longer than you ever imagined to attain retirement income security.
But, perhaps equally as important, when you retire, you have to decide how to “draw down” your accumulated wealth as monthly retirement income. This is a horrible dilemma for one individual facing two huge unknowns going into retirement. You can’t know for sure what rate of interest your funds will earn and you have no idea (or at least only a very foggy idea) of how long you will live.
Very few workers transfer this longevity risk to an insurance company by buying a life annuity, because, for a variety of reasons, annuities are very expensive today. Instead, most workers respond by moving to more conservative and liquid assets like bonds, which pay very low rates of return. Further, they plan their draw down to last longer than their expected lifetime so as not to fall into bankruptcy late in life. Both actions lower your monthly income.
A Target Benefit Pension Plan, as proposed by the federal government, mitigates most of these risks to a large extent making it a very good idea.
Your plan will be backed by a huge asset pool that can invest in more stable assets like private equity and infrastructure. If 2008 occurs again, you will feel an impact, but it should be somewhat softened and it should be temporary (by 2013, virtually all asset values have returned to their 2007 levels, if not beyond). Further, a large asset pool will not have to sell its assets in the middle of a severe down turn.
Equally important, you can now share your longevity risk with all members of the plan. This will allow the plan to remain invested in higher yielding assets such as stocks and private equity. And, you will be guaranteed a monthly income cheque for life.
The absolute amount of that cheque, however, is not fully guaranteed. A financial meltdown like 2008 might mean that benefits have to be lowered, even if only temporarily. And you should expect that any Cost of Living increase will be dependent on the plan funding being healthy.
But, you decide. Would you rather have a DC plan where you, as an individual, carry all of the risks? Or would you rather have a Target Benefit plan where you share the risks with your employer and all of the other participants in the plan? Or, more realistically in the private sector, would you rather have no pension plan at all?
With this proposed policy, the government is on the right track.
Robert Brown is an expert advisor with EvidenceNetwork.ca and a Fellow with the Canadian Institute of Actuaries. He was Professor of Actuarial Science at the University of Waterloo for 39 years and a past president of the Canadian Institute of Actuaries.