Defined contribution pension plans more costly, study finds

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Converting large public sector pension plans into defined contribution savings accounts for employees could cost governments up to 77 per cent more to provide the same retirement benefit for workers, a report argues.

A study sponsored by the Canadian Public Pension Leadership Council, an association of large public pension funds, says governments considering converting their traditional defined benefit (DB) pension plans would face higher administration costs because defined contribution (DC) plans cannot be run as efficiently.

DB pension plans pay workers a guaranteed level of income in retirement, while DC pension plans operate like individual savings accounts, paying out a retirement benefit that varies depending on the investment performance of the funds.

The pension council said it commissioned the study because there have been increasing calls by some provincial opposition parties and pension advocates for governments to shut down their large employee pension plans and convert workers to DC savings plans. Former Ontario Conservative leader Tim Hudak, for example, said in 2013 that the province should negotiate a transition to DC pension plans to reduce funding requirements, while the Saskatchewan New Democratic Party advocated in a 2013 study that more governments should shift public sector pensions to a DC model to cut costs for taxpayers.

"There's an attack on public sector defined benefit plans, and we wanted to substitute facts for impressions," study author Robert Brown, a pension researcher and actuary, said Tuesday. "We think it's a fairly overpowering argument."

Mr. Brown, a retired University of Waterloo professor, said DC plans are less efficient than DB plans because members must pay more for asset management and do not pool their risk of living longer than average; so they must each save enough to cover longer lives.

The result is that a hypothetical $10-billion DB plan would see the cost of providing the same retirement benefit rise by 77 per cent if it converted into individual-account DC plans.

Mr. Brown said DB pension benefits paid to workers are typically composed of 75 per cent from investment income and 25 per cent from contributions, which are typically split equally by employees and the employers. To achieve the same income from individual DC accounts, the study said investment returns would provide just 55 per cent of the final benefit, requiring workers and employers to cover 45 per cent of the cost.

The report said governments must also continue to manage the remaining DB plan that continues to exist after workers are shifted to DC, and have often found their liability soars because workers are not making any new contributions while the funding obligation remains and can grow.

Saskatchewan, which converted employees to DC plans in 1977, saw costs for its legacy DB plan climb in the first decades after it was closed, and will continue paying benefits under the plan for 90 years, the report said.

Two U.S. states – Nebraska and West Virginia – that converted employees into DC plans ended up partly converting back to DB because of a backlash about how low retirement income was for employees, the study adds.

The study also argues that governments do not enjoy the same savings as a private sector companies when they shift workers to DC plans because workers who end up with less retirement income can qualify for higher payments from Old Age Security or the Guaranteed Income Supplement for low-income retirees, so governments have to fund their pension costs through another route.

Mr. Brown said that if the motivation to convert to DC plans is to cut pension funding costs for governments, the outcome would be achieved more efficiently by modifying features of the DB plan – such as eliminating guaranteed inflation indexation – than by eliminating the plan entirely.

"If you're concerned about the level of costs, then let's talk about the level of benefits," he said. "But don't try to achieve cost reductions just by moving out of the DB delivery model, because it's the most efficient and effective model there is."