A New Approach to Pension Design

In 2008 the Alberta/BC Joint Expert Panel completed its work on suggested pension reforms. Alberta passed Bill 10 implementing the majority of the suggestions and is expected to release the enabling regulations sometime this summer. There are a number of positive changes in the legislation, but the change that could transform the pension landscape across Canada is the introduction of the target benefit plan.

Pension plans have traditionally been defined benefit plans, which deliver known benefits to plan members, with contributions varying depending on plan experience. The longevity risk, interest rate risk, and investment risk are all borne by the plan sponsors. During the 90s when plans experienced significant return on assets plan sponsors were happy to continue with this arrangement. When the investment returns diminished and low interest rates lead to significant increases in liabilities the risks being borne by sponsors became far more apparent.

Numerous court decisions have also eroded the ability of sponsors to benefit in cases where results exceeded expectations, yet leave them responsible for providing additional funding to plans in cases where results were worse than expected. Plan sponsors in the private sector are understandably unwilling to continue sponsoring this type of arrangement.

The main deterrent from a company perspective is not the increased costs, but the increased volatility of costs, which is attributable mostly to the interest rate risk.

This led to the growth of the defined contribution plan, in which a sponsor provides predictable contributions towards a pension plan, but the ultimate benefit will depend on plan experience. The risks in this case are borne by the plan member. This works well for the plan sponsors but the consequences of the inadequate pensions provided by these plans are only in the infancy of being realized. DC plans do a poor job of mitigating longevity risk and have historically produced lower returns than DB plans.

Like so many other issues, the pendulum has swung from one position, of all DB plans, to the other extreme, in which new plans are almost entirely DC plans. What is required is a middle ground that mitigates the risks to plan sponsors, while not shifting the burden entirely to the plan member who is ill equipped to cope. The target benefit plan is designed to precisely that.

The target benefit plan aims to provide a defined benefit, however it does not obligate sponsors as a DB plan does. Instead, if needed, benefits can be reduced based on the funds available to provide the benefits. This shifts some of the risk to the plan members. This is not ideal for the members, however it is better than the alternative in which sponsors are unwilling to sponsor a plan. The new legislation includes measures to improve benefit security, such as stochastic risk based reserve calculations, that provide a high probability that the benefits will be provided, rather than forcing the sponsors to guarantee the benefits.

The death of the traditional DB plan has been evident for many years, but there has been no reasonable alternative. Some steps have been made towards introducing target benefit plans, but the Alberta legislation is the first that can be applied to any sponsor and will allow for innovative ideas to help restore the health of the Canadian pension system.

Ryan Wall