Hybrid pension plans: a hard sell

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When Dave Schaub scans the business headlines, the news about a corporate pension crisis is strikingly familiar.

"Where most plans are today is where we were in 1992," says Mr. Schaub, chairman of the Pulp and Paper Industry Pension Plan (PPIP), which invests the pension money of 18,400 forestry workers and retirees.

Back then, the plan was facing a dire funding crisis. Its assets were worth just 50 per cent of liabilities, a chasm that was the result of generous improvements to benefits and weak investment returns that made those commitments impossible to fulfill. Without major changes, thousands of workers who relied on the plan faced the risk of having their future pensions slashed.

The solution was tough medicine: A new lower-risk structure, a change in the way benefits are paid, and a requirement that employees begin contributing to the plan. It still took years of improved investment returns to make up millions of dollars of shortfalls. But today, the plan is in a healthy surplus, its assets "virtually unaffected" by last fall's stock market meltdown.

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"When we look back at what we've done, it's been very beneficial to the employers and the plan members," Mr. Schaub says.

If the fix at the PPIP was both long and arduous, it also holds out hope that creaky pension plans can be put right. Indeed, the debate in Canada's executive suites is now over just what sort of fix holds out the best hope of providing for adequate retirements without crippling employers.

The proposed solutions range from the simple to the radical. One school of thought is that the answer lies in Ottawa, with less onerous federal rules on funding traditional pension plans. At the other extreme is a movement to get rid of those plans entirely, end the era of defined-benefit pensions, and transfer the responsibility for funding retirement to the shoulders of employees by giving them defined-contribution plans.

In the middle are a variety of alternatives that, not surprisingly, are dubbed hybrid plans.

No matter which route is taken, hard choices lie ahead - for companies, their employees and for government policy makers.

The great debate

Many Canadian companies with pension plans have been hit by a double whammy of low interest rates over the long term and a dramatic drop in stock markets in the short term. The combination has knocked the daylights out of returns, typically leaving plans currently with assets equal to about 80 per cent of liabilities. Traditional pension funds in Canada's private sector currently have a solvency deficit of about $50-billion, according to pension consulting firm Watson Wyatt.

As companies weigh alternatives for the future, a crucial choice comes down to a pair of innocuously simple-looking bits of shorthand: Will the future be DB or DC? Those four letters house a world of difference.

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Traditional pension plans are DB, defined benefit. A retiree covered by the plan is guaranteed a given level of income. If the plan falls short, the employer is on the hook.

The new model, increasingly favoured by employers, is DC, defined contribution. In this approach, the employer's responsibility is limited to making a certain ("defined") contribution to the employees' pension plan. Contributions made by both the employer and employee go into an individual account for the employee, who makes his or her own investment choices. If the plan falls short, the employee is on the hook.

The crisis notwithstanding, not every employer is ready to give up on DB.

"Maybe I'm being a bit paternalistic, but I'm not sure DC is the right solution if the end result of that is just to expose the entire population to market fluctuations for their retirement savings," says David Bryson, chief executive officer of mining giant HudBay Minerals Inc., whose unionized work force has a traditional DB plan.

"I think that defined-benefit pension plans are a very, very good vehicle to address the need for pension security," says Canadian National Railway Co. executive vice-president Claude Mongeau. "From the standpoint of employees, it is a great vehicle." The CN plan, with $14-billion in assets, is one of Canada's largest private-sector plans.

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Even for employers, Mr. Mongeau says DB pension plans are beneficial, because they help them to retain workers. But he argues pension plans are being strangled by the federal government's excessively tough funding rules, which have made their financing far too volatile.

For that reason, CN and six other major companies - Air Canada, Bell Canada, Canada Post, Canadian Pacific Railway Ltd., MTS Allstream and Nav Canada - have banded together to quietly lobby Ottawa for reforms to the rules.

In a submission to the Department of Finance, the companies warned that their ability to maintain defined-benefit plans "will be seriously challenged" without permanent changes to the rules.

The group's biggest complaint centres on the volatility of the contributions they're required to make to keep assets aligned with liabilities. Under current "unnecessarily onerous" funding rules, they say they collectively would have to contribute $3.5-billion annually from 2009 to 2013, a huge increase from $1-billion in 2008 and $800-million in 2007.

The seven companies want more time to make up their pension shortfalls. And they want the government to adopt a less-conservative formula when calculating how well-funded a plan is.

Mr. Mongeau says the current system already requires pension plans to be funded on the "hypothetical" assumption the companies are going to go out of business immediately and become insolvent, and the additional restrictions make funding requirements unsustainable.

"We cannot put our heads in the sand," he says. "There is a big problem."

Consultant Keith Ambachtsheer, one of Canada's most prominent pension reformers, argues that funding requirements actually should be toughened.

Mr. Ambachtsheer, who consults to many pension funds and is director of the Rotman International Centre for Pension Management at the University of Toronto, says the private-sector pension system is "fundamentally unsound" because most plan sponsors do not allocate enough money to fund their promises, and instead hope for large returns from higher-risk investments like stocks.

"What we've been calling defined-benefit plans aren't really defined-benefit plans," he says. "They're sort of 'wing and a prayer' plans, at least in the private sector."

He has no time for the argument that tougher rules would be a death blow to the DB system. A system that operates on a significant probability that funding promises can't be kept is not worth indulging, he says.

"Is it not more honest and functional to either put up enough capital to secure the promise, or tell plan participants up front that they are risk-bearers in this pension deal?"

Paul Gauthier, however, fears the debate about how to improve regulation for traditional pension plans is moot.

The recently retired CEO of one of Canada's largest corporate pension fund managers - Bimcor Inc., which manages pension money for Bell Canada - says better rules may help a few plans for a while, but the traditional plan is probably destined to die out. In a move typical of many companies these days, Bell has been closing its DB pension plans to new hires and is transitioning employees to a DC model.

"Saving the DB plan is like wanting to save the horse and buggy," Mr. Gauthier says. "We need a serious transformation of the system."

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A middle ground?

Experts, including Mr. Gauthier, are increasingly arguing that the way ahead is not simply tinkering with the rules of the game, but instituting new hybrid models that could provide better benefits than personal DC plans, while reducing the funding volatility and risk of DB plans.

Keith Elliott believes the Pulp and Paper Industry Pension Plan, which covers workers at companies such as Catalyst, West Fraser Timber, Canfor and Tembec, is already accomplishing both goals.

Mr. Elliott, director of human resources at West Fraser Timber Co. Ltd., says that since the PPIP plan was remodelled in the 1990s, it has taken an extremely low-risk approach to investing that is uncommon in Canada. The fund invests almost exclusively in long-term bonds.

"It was a hard sell in the early 1990s because the finance people said, 'You're giving up return.' But to do otherwise, you had a big problem."

That problem has been evident in recent years as many other pension plans have seen their equity assets decline sharply in bad markets. The PPIP posted a loss of just 1.6 per cent last year despite the devastating market crash, compared with an average 18-per-cent loss for a large pension plan in Canada.

Another key feature of the plan is that the member companies make a flat contribution on behalf of workers, set as a percentage of their wages. That is their only funding requirement: If the plan is short of money, employers don't have to cough up more to repay shortfalls. Instead, the plan has to cut benefits for workers or retirees.

"There's a significant contribution, but from an employer's perspective, the amount is limited," Mr. Elliott says. "There's no other obligation."

Benefits have been improved repeatedly over the past decade.

"Under the structure we have, we can't have a shortfall," Mr. Schaub says. "Unless we can fund plan improvements and guarantee them forever, we don't grant them."

The PPIP illustrates why many pension experts are keen on the type of hybrid dubbed a "target benefit" plan, which is already used in the public sector.

In this model, plans target a certain level of benefit payout that appears safely achievable. But if long-term investment performance makes that target unreachable, funding is not increased. Rather, the benefit level is lowered. Conversely, if investment returns exceed the target, the benefits can be increased.

Pension consultant Paul Forestell, leader of the retirement professional group at consulting firm Mercer (Canada) Ltd., says such plans are good for employees, despite that risk of reduced benefits.

Unlike individual DC retirement accounts, target plans allow large pools of assets to be combined and professionally managed, maintaining a strength of traditional DB plans. And for employers, the target benefit plans are more sustainable than the traditional DB plan in the long run.

"I think the change you need is something that makes DB less risky for employers," Mr. Forestell says. "And target benefit plans do that."

But the model is not going to be adopted overnight. Tax and pension rules in most provinces only allow a target benefit plan to be set up for plans sponsored by multiple employers, but not by a single employer. And the only plans that are allowed to unilaterally reduce benefit payments are those where workers get a say in their operations. That generally means the plan's board of trustees must have union representatives.

Another complication is that DB pensions cannot simply be shifted into a target benefit plan, says pension consultant Ian Markham, director of pension innovation at Watson Wyatt. Instead, a company would stop contributions to one plan, but continue to administer it, and then also start a new target benefit plan. "It gets cumbersome," he says.

Such practical complications are the main reason new models of pension plans are not evolving. Even hybrid models that are permitted under current regulations are not popular.

A hybrid may be better in theory, says pension lawyer Mitch Fraser. But once companies have opened up the highly charged issue of pensions, they figure they might as well go all the way and adopt defined-contribution plans, because they are the easiest model to administer. Companies don't adopt hybrids, he says, because they simply don't have to.

"I really hate to say it, but if a client called me and said, 'What kind of plan should I do,' I'd say, 'Establish a DC plan, of course. There's much more certainty.'"

Mr. Gauthier, who is now working with Montreal-based research centre CIRANO to develop reform proposals for the Quebec government, believes new pension models are most likely to be embraced by companies with no existing pension plans at all, especially if they can be crafted to allow smaller companies to band together.

"You create some big co-op type organization that can manage the pension plans of 3,500 smaller companies and their employees, and you set up a system that offers a lot more flexibility," he says.

"At some point people will say, 'Why don't I put all my employees into this?' And then everybody would have a pension plan that makes some sense."

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