Even an actuary like me knows that starting a discussion about pension plans at a social gathering is a conversation ender. And yet, two of Canada's largest unions went 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 (you get a pension that pays you, say, $1,000 a year in retirement for every year of employment, so if you have 30 years of service, you get $30,000 a year). Or it can pay out a percentage of your salary just before retirement (you get a pension that pays you, say, 1.5 per cent of your final average pay for every year of employment, so if you have 30 years of service, you get 45 per cent of your final average pay). Thus, in a defined benefit plan, you know what annual benefit you will receive in retirement, and 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 current 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 (at 4 per cent, say, versus 8 per cent). 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 - that is, they owe more money to their employees than they have in the plan.
Third, people are living longer; this means they collect pensions longer and company costs go up. Adding to the concerns is the ratio of retirees to active workers. 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's 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 say the employer will contribute 5 per cent of an individual's pay into the plan. But once the employer makes the contribution, that's 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 his own. Just imagine the difference between retiring in 2007 versus 2009.
It's 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, for example, 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 per cent 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 try to pass the pension risks over to the workers by using defined contribution plans, and workers will try equally hard to retain their defined benefits.
That's the reason for all the fuss.
Robert Brown was a professor of actuarial science at the University of Waterloo for 39 years and is a past president of the Canadian Institute of Actuaries. He is currently an adviser with EvidenceNetwork.ca.
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