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The Start – DB, DC, MEPPs

I started in the pension industry in 1986.  I was studying actuarial science at Waterloo and my first co-op job was working at the Province of Ontario helping calculate the liabilities for the Teachers’ Pension Plan and the Public Service Pension Plan.  Now when I say helping, I was helping sort through mountains of computer code only about half of which I really comprehended.  Nonetheless, this was my start in pensions.

Back then, there were defined benefit (DB) plans which were the dominant form of pensions for larger employers, defined contribution (DC) plans which were more common with smaller employers or as a supplement to a DB plan, and there were Multi-Employer Pension Plans (MEPPs) which were often a jointly sponsored plan between management and unions.  MEPPs lived in this wonderful world where employers paid a fixed contribution rate like DC plans, while members received benefit promises that looked like DB plans.

We in the actuarial profession knew that the only way to make a MEPP work was to agree that if the assets and liabilities of the plan became unbalanced with liabilities exceeding assets – then either higher contributions would need to be negotiated between employers and members or benefits would need to be reduced.  I don’t think many plan members understood this deal and it isn’t even clear what percentage of employers fully appreciated the negative outcomes that could arise.

The Middle – DB falls, DC rises, and MEPPs struggle

Through the 2000s and into the 2010s, the DB plan fell out of favor.  Falling interest rates drove liabilities higher and mixed investment performance meant that for most plans the assets did not keep up to the growing liabilities.  The result was ‘special payments’ to fund deficits, and these payments could sometimes be many times the cost of funding a year’s worth of benefits.  Employers were not happy with these unexpected and often unmanageable costs and these difficult times are one of the larger nails in the DB coffin.

At the same time, MEPPs found themselves in trouble with rising deficits and no way to fund them or even come remotely close to negotiating sufficient contributions to rebalance the promises.  The solution for some MEPPs was reduce benefits while for others it was to gain regulatory relief for solvency funding.  Essentially, government recognized that these plans were different than DB plans and imposing solvency funding would create intergenerational inequities as current generations would be forced to pay for prior promises.  The answer was to cross your fingers and hope that investment returns and rising interest rates would dig MEPPs back out of the hole.  It turns out that waiting 10 or 20 years is all that was needed.

The End – DB is rare, DC struggles, and rethinking TBPs

These days, setting up a new DB is rare, largely done when a company spins off a division and wants to maintain the DB promise for workers.  There is also the growth of the Individual Pension Plan market – which is technically a DB plan with one member, typically an executive or the business owner.

But with a solid 30+ years of DC plan experience, the industry is seeing that DC plans have their problems – most notably insufficient contributions by employers and members in total.  With DC plans generating an unpredictable and often insufficient retirement income, employers and workers continue to search for a better way to fund and deliver pensions to workers.

The answer has been a rise in Target Benefit Plans (TBPs) – which is the catch-all description of plans that target a level of benefits, but that promise is contingent on sufficient funding – insufficient funding results in forced reductions in benefits or forced increases in contributions.

Earlier this year I got in a little argument with a lawyer while being cross examined on a pension matter.  Counsel wanted to easily describe pension plans as defined benefit, defined contribution, and target benefit.  Unfortunately, it just isn’t that easy anymore.  Ontario legislation defines pension plans like CAAT and HOOPP as defined benefit plans – but these plans provide contingent benefits only available to members if funding provides for them.  To me, given the healthy margins these plans build up, they are more like a target benefit plan than what we think of as a defined benefit plan where all the benefits are guaranteed.

New Thinking

In June, the Canadian Institute of Actuaries published a new paper authored by George Ma.  For those that have forgotten or didn’t know, Mr. Ma spent many years as the Chief Actuary at the Pension Commission of Ontario which is now FSRA.  The paper has a great title – Balancing Act: Exploring Intergenerational Risk in Target Benefit Plans.  As usual, to spare my readers’ time, I have gone through the report and pulled out some key messages.  Let’s start with the conclusion:

“In summary, intergenerational risk in TBPs emerges from the desire to provide a more stable retirement income through collective risk-sharing. However, this approach also introduces complexities related to fairness and equity among different generations of plan members. Proper communication, transparency and thoughtful plan design are essential to address these complexities and strike a balance between the benefits of collective risk-sharing and ensuring fairness for all members.”

What this means, is that there can be sharing of gains and losses which most would consider equitable because you don’t know in advance whether you will be a winner or loser – think of longevity where the winners are those that live longer than average.  But it also means that when the sharing of losses is borne by one generation to protect the benefits of prior generations, the result can be an unfairness in who bears responsibility for investment risks.  Retirees with benefits guaranteed not to be reduced can benefit from indexing when the plan takes investment risk.  The retirees are playing a little bit of a ‘heads I win – tails you lose’ game with the money of active members.  The answer provided in the report?

“In Canada, New Brunswick introduced a shared-risk pension plan model in 2012, inspired by the Dutch system (New Brunswick, 2012). Under this model, both employees and retirees collectively share the responsibility of addressing pension shortfalls, with the option to increase contributions or reduce benefits in such instances. Several Canadian provinces, including Quebec, Alberta and British Columbia, followed suit by enacting TBP legislation and regulations between 2012 and 2015. However, the two largest pension jurisdictions, Ontario and the federal government, have not fully implemented these measures.”

New Modeling

George’s paper is not a light opinion piece.  George does the hard work of building a model and then testing assumptions and scenarios to illustrate outcomes.  The model runs for 160 years – with each year being a ‘cohort of members’.  40 years of build up with new members joining each year – 80 years of stability where new entrants match retirements – and 40 years of decline where no new members come into the plan.  With this paper, Boards of Trustees can see an entire lifecycle of a TBP and get a glimpse of a future that may not have yet unfolded in the plan they oversee (and maybe never will if new entrants are guaranteed – not true for the steel industry but probably true for government).

Without going into the more complex explanation in the paper – when a younger and older worker both accrue the same amount of pension benefit (as a percentage of pay) the younger worker is subsidizing the older worker.  In theory for this to be ‘fair’ there needs to be a cohort of younger workers joining the plan every year so that the population stabilizes.  So, what happens if a workforce declines, and younger workers don’t come on board as fast as older workers retire?

“When a TBP enters the declining phase, legislative policies should shift the focus towards protecting the benefits accrued by members. This phase typically occurs when there are not enough new members to replenish the retired, terminated or deceased members. As the plan has lower capacity for risk-taking and risk-sharing, policies should emphasize the importance of safeguarding the accrued benefits for members, especially those in the older generations. These may include other considerations such as options for transferring risk to third-party entities (e.g., the purchase of annuities from insurance companies) to ensure that members receive their accrued benefits even in challenging market conditions.”

Old Understanding

After you sort out all the modelling and math, you reach the same conclusion reached by sponsors of DB plans and members bearing the investment risk/reward construct in a DC plan – the older you get the less investment risk you can afford to take.

So, for sponsors of DB plans, the recent rush to annuitize benefits is a recognition that the end game for a closed DB plan is annuitization of benefits.

I have long argued that DC plan members should consider doing the same with some or all of their nest egg.  The headwind for annuity purchases by DC members is an investment industry that projects greater investment returns investing in equities than the member implicitly receives when buying an annuity.  But in my view, using some of the nest egg for an annuity allows DC participants to slowly unwind their risk taking and as Mr. Ma points out is a prudent conclusion when you are past the stage of generating more income.