DC Plans – A New Frontier Or Fatally Flawed?
The shift away from Defined Benefit to Defined Contribution plans (Money Purchase Plans ‒ MPPs) is well underway in both the U.S. and Canada. Employers view DC plans as a way of reducing the exposure to DB pension risks. As well, they are being enticed by lower administration costs and contributions. Sponsors, as the administrators, also have less onerous legal and fiduciary roles and responsibilities. DC plans shift the bulk of legal responsibilities from the sponsor and the pension funding burden from the employer to employees.
DC plans were introduced in the U.S. between 1978 and 1980, but became popular in 1994 when 'safe harbor' legislation, ERISA Section 404(c), was introduced. In Canada, the number of DC plans has increased as awareness of the perceived economic and competitive advantages increased. In 2008, approximately 23 per cent pension plans were DC plans. Sponsors are anxious to extricate themselves from DB plans because they are more costly, represent a potential financial risk, are heavily regulated, and are expensive to administer.
Each member has an account in a DC plan and must fund their own unique pension liability so it is a personal mini-DB plan. This is often not understood or ignored by most sponsors and DC service providers. Few DC members appreciate the subtly or understand the difficult and complex task of managing and funding their pension liability.
Retirement planning and education is presented as an exercise in managing (maximizing) returns rather than a difficult task of funding a pension liability. A benchmark indicating the funded status of each member's account is also often not provided or understood by members.
A 2007 study in the U.S. concluded that DB plans are less likely to generate very low retirement wealth than a DC plan and also noted that the impact of timing and the type investments used in a DC plan were difficult to assess. A study in the U.S. by Friedberg & Owyan (2002) concluded that DC plan member retirement age increased by two years and that elderly DC plan members were likely to outlive their DC assets. The documented and well known problems faced by many experienced administrators and investment professionals in managing DB plans are an indication of the challenges faced by the average unsophisticated DC member. It is, therefore, hard to understand why governments in Canada and the U.S. are encouraging DC plans as the pension program of choice for individuals given these hurdles.
DC plans also have features which inhibit a member from successfully achieving an equivalent level of DB income. These are:
- Members do not understand investment risks and the impact of volatility on returns.
- Members are not conscious of the impact of time and the concept of normally distributed returns with respect to funding.
- Members forget their retirement nest egg must be sufficient to cover themselves and their spouses.
- Members focus on achieving high returns versus adequate consistent returns.
- Members do not take advantage of other tax assisted savings programs such as RRSPs and TFSAs which can boost retirement income.
- Sponsor contributions in most cases do not adequately compensate members for the investment risk. A combined contribution of 15 to 18 per cent is likely needed.
- The risk sharing regarding time and investment timing available in DB plan is not available in a DC plan.
- Investment losses in a MPP cannot be made up rough additional contributions and tax deductions as is the case in a DB plan.
- DC members pay high fees from their plan assets which significantly reduces investment asset accumulation before and after retirement.
- It is difficult to make up for investment losses after retiring because of interest and equity risk.
- Longevity risk is borne entirely by the DC member.
- Members have to sell units of fixed income investments to create a monthly retirement income increasing the exposure to interest rate and equity risk.
- Investments by pooled (mutual) funds are limited (prospectuses) as to the types of investments that can be used. DB funds can invest higher yielding alternative/diversifying investments.
- Few DC plans include duration matching products such as long bond funds to minimize duration risk.
- Purchasing an annuity is an option but dependent upon a sufficient amount of savings and a favorable interest rate environment.
To recover investment loses or increase retirement income, MPP members, unfortunately, have little choice but to take on greater investment risk.
Test Of Time
DC plans have only been available in the U.S. since 1974. They have not stood the test of time in either the U.S. or Canada. Given the added limitations and investment hurdles presented to DC plan members, why is it assumed an individual will be successful in managing a funding their personal 'DB' plan?
The reliance being placed on DC type plans by governments and employers to generate adequate retirement incomes is perplexing. Perhaps this is just another example of grasping for a 'silver bullet' solution to a complex problem. Perhaps there is another underlying agenda? The question remains, are DC plans a new evolving frontier or, fatally flawed?
Gerry Wahl is senior partner and managing director at Ampersand Advisory Group.