Protecting Retiree Pensions
One of the things I like about writing through our blog forum is that the time between an idea in my head and sending an email to our readers is somewhere between two hours and two weeks. Sometimes however the ideas are more complex, take longer to think through, and require more than a two-page overview.
I am pleased to share my recent work with my co-author, Serge Charbonneau, Protecting Pensioners of Traditional Defined Benefit Plans: A New Approach to Solvency Funding and Benefit Reductions on Plan Wind-up. Serge is an actuary who spent all his career in a major consulting firm practicing mainly in Quebec. While both of us have practiced in pensions for many years, our client experiences are very different. With this background I was pleased to find that Serge and I shared one key viewpoint: that retirees are the most vulnerable constituency in defined benefit pension plans and the group least able to manage reductions to their pension income when a pension plan is wound-up with a deficit and without a solvent employer to top up the pension fund.
This shared view led us down the road to the paper published last week by the Canadian Institute of Actuaries. Although the CIA published the paper, it is not an official statement by the CIA and is simply the views of the authors, fine-tuned after peer review from several actuaries. The CIA wants to increase its role in publishing the viewpoints of actuaries to help contribute to public policy discussions. There is a small disclaimer on the back page saying the statement may not represent the views of all CIA members. I would have preferred if the disclaimer was on the front page so that all readers understood that we were sharing ideas and not rigorous solutions endorsed by all CIA members.
What’s the problem?
Good papers start with a problem that we are trying to understand or solve. In our case it was the simple observation that when underfunded pension plans are wound up and pensions are reduced, no one is happy. Not only is the worker or retiree that loses a portion of their pension promised not happy, elected governments are not happy that the system allowed a sub-optimal outcome for these taxpayers/voters, actuaries are not happy and perhaps embarrassed that the system they support failed, and usually the folks in HR at the employer are not happy as they deliver the bad news.
The question to be answered: Is there a better way to organize funding of private sector defined benefit pensions plans to create better outcomes?
What is the thesis?
We identified two key levers for a plan member to ‘recover’ from lost pensions.
- The first is to increase the investment risks taken with their transferred value (and potentially other savings) in the future in the pursuit of greater returns – since the transfer value is based on the yield of provincial and high-quality corporate bonds, the individual could invest a portion of their transferred value in some equities in the hope of earning more than the bond yields. Obviously, this involves some risk, but when you have a long-term horizon, poor investment return years can be compensated by good investment return years. It is our thesis that older workers and retirees have a shorter time horizon for taking investment risks compared to younger workers. As for retirees, they cannot benefit from this lever at all if they do not receive a transfer value.
- The second is to make up the lost pension from future employment earnings as well as additional savings from those earnings. Although plan members may have no control on the loss of their pension, they may have some control over their future employment and thus try to use this as a lever to offset their pension loss. For young members, future employment earnings represent a much larger source of their remaining lifetime income than future pensions, but older members have fewer years of earnings, while for retirees it may be impractical to return to work at all to earn income.
In a nutshell, as we age the levers lose their power to help us recover lost pensions.
The fact that many defined benefit pension plans have started to look at the demographics of their plans as they set investment policy, growing more conservative as the plan’s membership ages, is a confirmation that our thesis is not pulled out of left field.
What is our solution?
The reason I say, ‘our solution’ is that we are not presenting it as ‘the solution’. There are many ways to go about reducing pensions in under-funded pension plans including the status quo of reducing every pension by an equal percentage based upon the funded status of the plan at wind-up. As noted earlier, we don’t think this is the best approach.
Our approach comes in two parts. First, recognize that older workers need greater protection from pension cuts and develop an approach to funding which requires greater funding levels based upon the age of the worker/retiree. Second, when it comes time to wind-up a pension plan, mirror the higher funding requirements when determining what benefits need to be cut.
You can read the paper for the detailed math – but in its simplest form, we encourage a new solvency funding regime that targets funding 100% of the promised benefit for the oldest retirees and grades down to something less such as 75% funding for mid-career workers. This contrasts with the current rules in Ontario that targets 85% funding for all plan members regardless of age. When it comes time to reduce benefits in case of wind-up, then the same preferential scale would be applied.
The paper discusses other ideas such as allowing members to top up the funding of their pension back up to the promised level with their personal savings, as well as ways to implement guarantee funds. I have written before that I am not a fan of Ontario’s Pension Benefit Guarantee Fund, which is at best a very poorly organized insurance scheme and at worst just another tax on employers. One thing is clear to me: if governments are going to run guarantee funds, the only benefit that should be guaranteed is one that the government expects an employer to actually fund. In Ontario right now an employer needs to fund only up to 85% of the solvency liability but the PBGF still guarantees 100% of the benefit (up to certain dollar limits). In my opinion, this makes no sense.
This paper is not the end of the journey – it is the beginning of a discussion. Serge and I are hoping to engage policy makers in a conversation about the flaws in the current system and how changes can be made to create better outcomes. Of course, ‘better’ is a beauty in the eye of the beholder viewpoint and it will be interesting to see what level of support our proposal receives.
I encourage you to join the conversation.