Toronto, July 14 2009. Logo of Globe and Mail's columnist Dan Richards, photo taken at the National Club on Bay St., Toronto. Photo by: Fernando Morales/The Globe and MailFernando Morales/The Globe and Mail
Dan Richards is president of Strategic Imperatives. He is a faculty member in the MBA program at the Rotman School at the University of Toronto. He also hosts a weekly conference call called Monday Morning Jump Start, which is about strategies for financial advisors. Advisors can see it GlobeAdvisor.com. He can be reached at richards@getkeepclients.com
Given markets over the past year and a half, we're seeing a modern day version of "hot potato" when it comes to who bears the risk of volatile markets on pension liabilities.
Quite simply, companies that traditionally took on the responsibility to guarantee retiree pensions are increasingly reluctant to do so - and in some cases are shifting the liability for risk to employees.
In my recent conversations with industry experts, there's broad agreement that the traditional "guaranteed pension" in retirement is broken - and we need fresh thinking on how to create a sustainable system that works for employees and employers alike.
The good news is that there is already a model out there that we can look to.
Before tackling the future direction of pensions, we need to first examine the $50-billion shortfall in pension assets on Canadian companies' books compared to their liabilities for guaranteed payments to existing and future retirees.
Firms with underfunded plans have some tough decisions. "You only have three choices when you're underfunded," says Scott Perkin of the Association of Canadian Pension Management, which represents companies with pensions. "You can increase contributions, take greater risk with the hope of improving performance, or reach agreement with employees to reduce future benefits."
What's caused the problem
Contrary to popular perception, it's not just the stock market downturn that has caused pension underfunding - low interest rates are also a culprit.
"When interest rates are low, pensions become very expensive," says consulting actuary Malcolm Hamilton of Mercer.
It comes down to the math done by the outside actuaries hired to evaluate how much firms need to set aside to fund pension obligations.
Let's suppose a company offers a pension plan that isn't indexed for inflation. When interest rates on government bonds were 8 per cent in the 1990s, an obligation to pay a retiree $10,000 in 20 years cost companies about $2,050. When interest rates are 3 per cent, as they are today, that triples to a liability of $5,600 - before the impact of longer lifespans is taken into account.
Deciding who bears the risk
Given low interest rates, the biggest issue for employers and employees alike is who bears the risk of funding future obligations. In the traditional defined-benefit plan, which guarantees a set payout, employees' contributions were generally fixed and employers assumed the risk should pension funds not perform well enough to meet future payments. That worked fine when companies could largely eliminate risk by buying bonds whose stream of income matched the future commitments to retirees.
As interest rates dropped, over the last number of years many companies have shifted to defined-contribution plans, in which both employees and companies make contributions and employees are on the hook should the pension plan underperform.
A shift away from the traditional plan
There needs to be a fundamental rethinking on this issue. Because of the level of risk in guaranteeing pensions, almost no new traditional plans are being created - and many companies with these plans are either moving away from them entirely or only offering them to existing employees, with new hires offered plans in which the company doesn't have all the liability in the case of underperformance.
One reason some companies switched away from traditional plans is because of court cases concerning plans with surpluses that were wound down, in which employees were awarded half the surplus.
Some CEOs responded by saying that if they bear all the risk on the downside but only get half the benefit on the upside, why on earth would they possibly have a traditional plan? In other cases, companies only contributed the bare minimum required by law to avoid a large surplus, meaning a cushion wasn't built during good markets.
Possible model for future
An interesting model is the one used by the Ontario Teachers' Pension Plan and some other government plans - in which employees and the government have joint responsibility for funding the plan. If it underperforms, then they both have to increase contributions or negotiate reduced benefits. It may be that a similar model needs to be considered for government employees not already in this kind of a plan and large company plans.
In part, this is for reasons of affordability, to ensure that both employers and employees share the risk and have a stake in the decisions that are made.
There are lots of hard decisions to be made around securing Canadians' retirements. As part of that, fresh thinking is needed to create a pension system that is equitable to both employers and employees, and sustainable over time.