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Defined Benefit versus Defined Contribution Pension Plans

A version of this commentary appeared in the Globe and Mail, Winnipeg Free Press and Montréal Gazette

Even an actuary like me knows that starting a discussion about pension plans at a social gathering is a conversation ender.  And yet, recently two of Canada’s largest unions (Air Canada and Canada Post) were on strike to save their Defined Benefit pension plans against the wishes of the employer to switch new employees to Defined Contribution plans.

What are these plans all about and why all the fuss?

As the name implies, a Defined Benefit pension plan promises to pay you a Defined Benefit when you retire.  This can be a flat benefit plan (e.g., you get a pension that pays you $1000 a year in retirement for every year of employment — if you have 30 years of service you get $30,000 a year).  Or it can pay out a percentage of your salary just prior to retirement (e.g., you get a pension that pays you 1.5% of your final average pay for every year of employment — if you have 30 years of service, you get 45% of your final average pay).  So, in a Defined Benefit plan, you know what annual benefit you will receive in retirement and, thus, you have a very good idea of how much more you need to save on your own to be fully secure.

The funding risks of a Defined Benefit plan are carried by the employer (although in the long term, higher pension costs could force wages down).  And the present environment packs a triple whammy of bad news for these employers.  First, interest rates are very low.  So the value today of retirement income to be paid many years in the future is not as significantly discounted (e.g., at 4% versus 8%).  Second, because of the financial crisis of 2008/09 and the mediocre recovery, pension plan assets are worth less than they were expected to be and pension plans are in the hole — i.e., they owe more money to their employees than they have in the plan, (Air Canada has a $2.1B deficit and  $3.2B for Canada Post).  Third, people are living longer and this means they collect pensions longer and company costs go up.  Adding to the concerns is the ratio of retirees to active workers that is now about 1 to 1 in both Air Canada and Canada Post.  This matters because the cash flow needed to pay benefits must come from worker contributions and investment returns.  With the growing ratio of retirees to workers, the plan becomes more dependent on investment returns that are low today.

In these Defined Benefit plans, the worker has a defined benefit and increased costs are the responsibility of the employer.  This is bad news today.  Of course, if the economy improves and investment rates are up, good times for the employer could return.

The opposite is true for Defined Contribution plans.  Again, as the name implies, in a Defined Contribution pension plan, it is the contribution that is defined with no commitment to how much will be paid out in retirement.  For example, the plan may provide that the employer will contribute $1 to the pension plan per hour of work.  Or it could state that the employer will contribute 5% of an individual’s pay into the plan.  However, once the employer makes the contribution that is the end of the employer’s responsibility.  If the stock market crashes or interest rates on investments are low, the worker will have a lower asset pool at retirement and, thus, lower income post retirement.  Thus, the worker has no idea until very close to retirement what income to expect and how much more to save on their own.  Just imagine the difference between retiring in 2007 versus 2009.

It is further true that even if investments work out as hoped for, the new Defined Contribution pension plans being offered by Air Canada and Canada Post should not be expected to result in benefits as large as the Defined Benefit plans they want to close.  For the level of benefits now promised to Air Canada and Canada Post workers, employer contributions in excess of 10% of pay would be expected in today’s climate.  One would not anticipate the new Defined Contribution plans being that rich.

So, the benefits being negotiated are important and real.  Management will continue to attempt to pass the pension risks over to the workers by using Defined Contribution plans and workers will work equally hard to retain their Defined Benefits.

That’s the reason for all the fuss.

Robert Brown was Professor of Actuarial Science at the University of Waterloo for 39 years and a past President of the Canadian Institute of Actuaries.  He is currently an expert advisor with EvidenceNetwork.ca, a comprehensive and non-partisan online resource designed to help journalists covering health policy issues in Canada.

June 2011

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