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A study of Canadian and U.S. defined benefit pension plans by the credit rating company DBRS finds that two-thirds of plans are underfunded by a significant margin.
The report says the alternative will be defined contribution plans which effectively shift the risk of investment performance to employees.
However, a recently released paper from the Association of Canadian Pension Management suggests that “hybrid” plans which combine the features of both defined benefit and defined contribution plans are gaining traction because they can achieve a better balance of employer and employee risks.
Defined benefit plans are based on a formula that typically combines years worked for the employer multiplied by a percentage of average salary over the last several years of work. Here’s an example: Suppose an employee earned $100,000 in the last five years of a 35 year career. If the formula is 2 per cent per year times 35 years of services his annual pension will be $70,000 ($100,000 x 70%.)
In defined benefit plans, employers and employees may be required to contribute to a defined benefit plan, but the employer is ultimately responsible for covering any shortfall, based on actuarial calculations revised every three years.
With low interest rates and volatile investment markets, the obligations of defined benefit plan sponsors have significantly increased, in many cases at the expense of their core business. DBRS does not expect full funding to be achievable until 2014 at best.
In defined contribution pension plans, employees contribute a percentage of their salary, often with an employer matching amount. The problem is that in a defined contribution plan the retirement benefit is dependent on how the portfolio performs without guarantees about how much income the retiree will receive.
In target benefit plans, employer and employee contributions are fixed according to a pre-determined rate (or formula) that is expected to be enough to fund benefits according to a defined benefit-like formula (i.e., the target benefit).
Accumulated benefits can be increased or reduced from time to time if the funded status of the plan turns out to be too much or too little to provide the target benefits. Another variation is that if the pension fund is under water, instead of employers bearing the full cost, employee contributions can be increased or contribution increases can be split 50-50.
Target benefit plans can provide a higher expected benefit at the same cost as defined contribution plans for several reasons:
- Members do not have to over save for the possibility of living longer than expected or face the risk of outliving their defined contribution account balance.
- Investment risk is also pooled. Studies show that average plan members investing on their own significantly underperform professional investment programs.
This innovative plan design is far from new in Canada. A 2012 guide to target benefit plans released by consulting firm Aon Hewitt notes that similar principles have existed for years in traditional multi-employer plans.
The UBC Staff Pension Plan is cited as an example of a plan where the target benefit approach has succeeded for over two decades. More recently, Resolute Forest Products opted for a similar plan design when the company restructured.