Sustainable Target Benefit Plans
Historically, industry conversations around pension plans have revolved around single-employer defined benefit pension plans (DB) and single-employer defined contribution programs (DC). Much of the provincial and federal pension legislation focuses on these two end-points in the spectrum of programs that can be reasonably be called a pension plan.
Target benefit plans are a hybrid DB and DC arrangement. Benefits are promised on a DB basis and contributions by employers are fixed just like DC plans, often through a collective agreement. This best of both worlds design is afforded with one slight modification to the rules that apply to traditional DB. In a TBP, if there are insufficient assets in the pension fund then plan trustees can reduce benefits. Reducing benefits is not an option in traditional single-employer DB until you travel all the way to the Companies’ Creditors Arrangement Act which is not a happy place for anyone – except the lawyers, accountants and actuaries charged with the cleanup.
I have not spent much time on target benefit plans (TBPs) during my career. This is because when I joined Mercer, working on these plans had largely been ceded to a different tier of consulting firms dominated by governance consultants rather than actuaries. My distance from TBPs was also a conscious choice because in the early 2000s I started to see that these plans were going to have struggles managing their funded status following what was accepted actuarial practice at the time and I didn’t have the diplomacy to nudge trustees to the level of conservatism that made me comfortable personally. Beyond letting down plan members, I also worried that if benefits had to be reduced then actuaries might be blamed. My work in expert evidence shows that this is sometimes the case.
As I anticipated, over the past 20 years, many TBPs have faced financial pressures on funding pension promises and, in many cases, benefits have been restructured (cut), contributions increased, or both. It should be no surprise that plan members and sometimes trustees are taken by surprise when plans are forced to change. Some plan members and trustees have taken on this challenge intelligently – others have gone to the courts looking for someone to blame. As it is with traditional DB, it is hard to blame one group for the failure to predict today’s economic landscape. You will be hard pressed to find any articles from lawyers, accountants, actuaries or economists from the 1980s predicting that 30+ years down the road the world would be facing negative interest rates.
In my time working with trustees, the fundamental argument for not funding conservatively was one of inter-generational equity. If you are too conservative today, you unfairly withhold assets from today’s retirees and enrich the next generation when it becomes clear that the ‘extra’ reserves were not needed. When faced with the opposite problem of what to do with future generations if reserves were insufficient one trustee said to me ‘we will worry about that problem when it happens’. My friend and former co-worker Robert looked at this situation around 1990 and decided that it was a no-win situation and he is now responsible for a multi-employer pension plan that is 99% DC with a small legacy DB promise.
The language of inter-generational equity has started to transition to the language of sustainability. Sustainability is the idea that any pension plan, regardless of whether its DB, TBP, or DC, needs to have a plan design and funding policy that can reasonably assure the long-term survival of the plan and the delivery of its promises.
In the past 30 years, much of the private sector has moved from DB to DC. Retroactively, it is fair to say that this has been a move to more sustainable pension plans since the 1990s helped us see that sustaining a DB plan would require either a conservative investment policy or a sponsor with a stomach for unpredictable contributions. I am more than willing to criticize the design of many of today’s DC plans, but it is hard to knock them on the sustainability axis.
A recent CD Howe paper by Barry Gros and Barbara Sanders looks at The Quest for Sustainability in Contingent Pension Plans. I love the word ‘Quest’ in the title. This paper is interesting because rather than a quantitative academic paper – it is a survey of 30 key experts in the pension industry. What did they find?
“Many view sustainability as a balancing act between the needs of the present and the needs of the future. In fact, there is a strong intergenerational equity component that appears to be tied up in the definition of sustainability, and this is emerging more and more in discussions of contingent pension plans. When asked about what needs to be in place for a plan to be, or to become, sustainable, respondents surprised us by identifying a wide range of other factors in addition to financial measures, including the design and nature of the plan, governance, and communication with stakeholders.”
I wasn’t included in the panel, but I am heartened to see that ‘communication with stakeholders’ is on the list. In my time working with TBPs, I have always pushed for transparent communication to all stakeholders.
When it comes to sustainability, there are two competing approaches. The first approach is to put a ‘expected return’ liability on promises, smooth contributions as much as possible and only reluctantly reduce benefits or increase contributions once the ‘writing is on the wall’. The idea in this approach is that over the long-term, fluctuations will level out and each generation will get a reasonable pension at a fair price.
In contrast, the second approach is to put a ‘guaranteed value’ liability on promises and then take any gains from investment risks to provide additional benefits. The problem with this method is that initial benefit promises are perceived to be low relative to the contributions being made, because you don’t get to pay benefits based upon expected investment gains but rather must wait until those investment gains are earned before the money is paid out to members. The most common form of benefit in these types of arrangements is contingent indexing.
The multi-employer pension plan industry of the 1980s and 1990s largely used the former ‘expected return’ model, and while it has worked for some plans it has failed for many plans as interest rate declines have pushed liabilities up faster than the investment gains on the other side of the balance sheet have grown.
In my mind, the latter ‘contingent benefit’ approach is the better model for TBPs which doesn’t rely on actuarial magic to smooth everything out in times where reality doesn’t line up with fantasy.
I do think that there is a bright future for TBPs and its cousin the shared-risk plan. However, we must make sure that if we are going to fix contributions as they are in the DC world, then workers need to understand that future benefits will be contingent upon future investment returns and we shouldn’t let the managers of their pensions count their nest egg before it’s hatched.