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Business Commentary The employee argument against defined-benefit pension plans

Michael Armstrong is an associate professor at the Goodman School of Business, Brock University.

Employers like Canada Post want to rid themselves of defined-benefit pension plans because they pose clear long-term financial risks. But perhaps we employees should think more about the less obvious risks on our side, too.

Pension plans are basically promises to employees. With defined-contribution plans, employers simply promise to invest a certain amount of money each year. Their promises are short term, just a year at a time. The eventual payouts depend on how the investments perform.

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With defined-benefit plans, employers also promise to top up the accounts if the investments don't perform well enough to cover the agreed payouts. That is reassuring for us as employees.

However, those top-ups may be needed years or even decades later. If I start work at 25 and retire at 65, my first pension cheque won't arrive until 40 years after my first paycheque. That's a very long-term promise, and it consequently presents two risks for employees.

The first risk is that the pension payout money might not be there when needed. Defined-benefit plans should pay better than defined-contribution plans during economic downturns. But downturns are precisely when employers are least willing or able to top up their plans.

For the private sector, 40 years is roughly six economic cycles of boom and bust. Will your employer even survive that long?

For example, look at the defined-benefit plans of U.S. Steel Canada, previously called Stelco. The company entered bankruptcy in 2014 with an $838-million pension fund shortfall. Or think about Nortel, the once-mighty telecom firm that went bust in 2009. Both groups of pensioners are still waiting to see what they'll receive. The only thing definite about those pensions is that they'll be smaller than originally promised.

Public sector plans face equivalent risks. Forty years implies about 10 election cycles. Will all those politicians keep their predecessors' promises through thick and thin?

They didn't in Detroit. To escape bankruptcy in 2014, city officials cut existing pensions by 4.5 per cent and eliminated other benefits altogether. Some cuts were even retroactive – retirees had to give money back.

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And they didn't in Rhode Island. In 2011, that state realized it had saved only 56 per cent of the money needed to fund its pension promises. To avoid disaster, it spent four years overhauling its plans. Retirees past and future lost some of their supposedly "defined" benefits.

The second risk with defined-benefit pensions is that employees might not be there to receive them. The pension formulas typically set thresholds for calculating payments, based on age and/or years of service.  If you stick around long enough, you receive the full defined payout.

But if you quit too soon, you get less.  Depending on where you work, you may get only the accumulated contributions back, plus some interest.  In effect, the defined-benefit plan degrades into a defined-contribution one.  Or you may eventually receive a deferred pension, but calculated from your salary at the time you quit, say 20 years ago at age 40, rather than from your potentially much higher salary at the time you retire, say at age 60.  So it's "defined" to be smaller.

This is why defined-benefit pensions are sometimes called "golden handcuffs." They penalize people who switch employers.

Of course, in reality many people do switch. Successful professionals jump to new openings that advance their careers. Less-fortunate workers struggle from one temporary contract to another. One study found that 50 per cent of workers in their 40s change employers within two years; that jumps to 78 per cent for workers in their 20s. For them, defined benefits are no better than defined contributions.

This is not to say that employees should race to give up their defined-benefit plans. They are still valuable, especially where employers are financially stable and payouts are economically realistic.

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But perhaps workers and their unions should stop thinking of them as risk-free sacred cows to protect at all costs. In at least some cases, they could be better off directing their bargaining efforts toward benefits that they are more likely to actually receive.

Editor's note: An opinion article in Report on Business  about defined-benefit plans simplified the effect on an employee who resigns early.  Depending on the jurisdiction, the pension remains vested, and the former employee becomes a "deferred member."

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