Pension plan design and funding were at the heart of two high-profile labour disputes in Canada this summer (Canada Post and Air Canada). The landscape of pension plans is shifting dramatically, in light of expected regulatory reform and an aging population. Issues of solvency relief, sustainability, and benefit security are coming to the fore. As well, on 10 June 2011 new draft reforms of IFRS accounting standards affecting pensions were tabled.

To give an overview of current thinking, Ian Markham of the HR consulting firm Towers Watson kicked off the Toronto CFA 2011 Pension Conference on June 6. His presentation on new approaches to today’s issues was based primarily on results from the eighth annual Towers Watson pension survey of 153 organizations. The respondents were broad-ranging: 40 percent publicly-traded, 25 percent private companies, 24 percent public sector, and 10 percent non-profit organizations. It covered DB (defined benefit), such as FAE (final average earnings) DC (defined contribution), CAP (Capital Accumulation Plans), and hybrid plans (a mixture).

Balancing competing goals

An effective retirement plan should maximize the efficiency of employer contributions. It must be financially sustainable for the sponsor yet be competitive in the talent marketplace. It should meet workforce management goals of reaching benefits adequacy and enhance the financial literacy of the employees. Whereas pensions used to be primarily in the HR domain, what’s changed is that the maturing of DB plans and their expanded size relative to corporate liabilities means that CFOs must now play a leading role in managing DB risk. Large swings in bonds and equities have played havoc with pension deficits. Now pension plans must maintain a precarious balance between the CFOs, who worry about the level and volatility of costs, and HR, who worry about attracting and retaining a dedicated labour force. “HR keeps the CFOs honest,” deadpanned Markham.

Funding shortfalls and volatile markets

Pension liabilities are considerable for some companies. Of 126 publicly-listed Canadian companies surveyed, one-quarter had pension liabilities that are 50 percent to 270 percent of the size of their corporate liabilities. Mature plans are of particular concern. At certain auto manufacturers, the pension liability is so great it’s like selling every car “with a free pensioner in the back seat.”

The current DB pension plan landscape in Canada is changing particularly rapidly. Out of the private sector companies that sponsor a DB plan, only one half still offer DB accruals to all employees; 37 percent have closed DB plans for new hires, and 13 percent have stopped all plan members from accruing a DB pension. Meanwhile three-quarters of public sector and not-for-profit organizations offer DB to all; 12 percent have closed DB plans for new hires. The rate of changeover to DC/CAP plans has not slowed down this year, despite regulatory changes being imminent.

The Towers Watson pension survey revealed that for DB plan sponsors, volatility is seen as the greatest danger to be managed over the next three years. The second priority is to reduce the total amount of funding or pension expense overall. Financial risks are long-term because even a frozen DB plan’s liabilities will not materially decrease and therefore will require financial management for many years. The actual savings from conversion to a new design are not large for several years. Markham speculated that among many DB sponsors, there is nevertheless a “wait and see” attitude regarding regulatory changes.

The losses of 2007-08 are still having to be accounted for in many DB sponsors’ 2010 actuarial valuations, and this is heightening the attention on funding. Markham pointed out an intriguing paradox in the area of plan conversion. When funded status is low (such as post-2008 crisis), the desire to reduce pension risk is high. However, the ability to de-risk is low (higher costs). In good times, funding status improves, but the desire to implement de-risking measures is low. For this reason, he recommends that companies institute a “journey plan” or exit strategy for DB plan sponsors— and stick to it.

Attracting and retaining employees

Employers are well aware that their boomer employees value their DB plans. However, the message is also seeping through to younger employees. Three out of ten Gen-X employees are now taking pension plans into account. Competitive retirement benefits ranked fifth on the 2010 list of key attraction drivers. Two years ago, said Markham, these benefits did not even rank among the top ten.

Even as employers are moving to DC plans as a cost saving measure, “it behoves sponsors to promote employee understanding of their pension plan,” said Markham. Some sponsors do not make employees aware it is in their best interest to maximize DC contributions. “They should,” said Markham, not just from a legal standpoint but because ethically, “it is the right thing to do.”

The average maximum employer contribution (MEC) appears to be geared only to what competitors are doing. For example, in the U.K., the average MEC was 8.5 percent around 2005 but has risen to 11 percent, whereas in Canada the average is stuck at 5 percent, excluding the oil and gas sector where competition for talent is red-hot. It is unsettling that only 13 percent of plan sponsors believe plan participants will have enough retirement assets to support their income goals, according to the 2010 Towers Watson survey of DC plans. Three-quarters of respondents believed that employees have unrealistic expectations of what their DC plans would provide.

For this reason, two-thirds of DC/CAP sponsors believe litigation will increase in the future. The top three grounds for litigation are predicted to be: low retirement income, poor investment performance, and inadequate communication and education provided.

Possible solutions

When trying to balance competing priorities, the pension plan design spectrum can be parsed according to how the risk is shared between employer and employee. (See chart below) Markham said that “target benefit” plans are “not a panacea, but they are of great interest.” Target benefit plans, which have single-employer sponsors, and are similar to pure DC but mitigate employee risk somewhat, may be tough for governments to establish a regulatory framework for.

Markham noted that one reason to change pension plan design is to manage retirement patterns. With DB plans, the pattern of retirement is much more predictable than under DC plans, which tend to have more erratic departure patterns. DB plans favour those who retire over those who quit; therefore they are geared to long-term employment and retention of experienced employees.

Not only is there a move to DC/CAP conversion, but plan sponsors are implementing (or considering) material changes in investment strategy in half the organizations surveyed. DB plans both large and small plan to decrease the amount of equity assets – and move into more fixed income and longer duration fixed income assets.