Although pension plans and funds seem to be a taboo discussion topic, it looks like this is the topic our society is prepared to stand up for. A defined benefit pension plan is valued so much that two of Canada’s biggest unions went on strike to prevent employers from switching to a defined contribution plan. Robert Brown, former professor of actuarial science at the University of Waterloo, commented on the situation: “The benefits being negotiated are important and real. Management will continue to try to pass the pension risks over to the workers by using defined contribution plans, and workers will try equally hard to retain their defined benefits.”
The Defined Contribution Pension Plan
There is an increasing number of Canadians relying on this form of pension planning. Let’s clear up what the defined contribution plan means. The plan stipulates how much the employer contributes to the pension plan, either per hour of work or as a percentage of an employee’s payment that would be assigned to the plan. This is all the employer has to do. The rest is up to the market. If it destabilizes or the interest rates on investments decrease, the worker’s assets will shrink, reducing the income after a retirement.
The Defined Benefit Pension Plan
The defined benefit pension plan, on the other hand, doesn’t carry this risk. It sets the defined amount of benefits to be payed out when one retires. Once again, there are two options. For the first option, you get the fixed amount of money per year in service. Say your pension is $1,200 a year in retirement for every year of employment. For 40 years of employment, you get $48,000 a year. For the second option, you get a percentage of your final average salary multiplied by the years of employment. For example, 2% times 25 years of service gives you 50% of your final average salary.
However, the plan is not very beneficial for employers since they are the ones carrying all risks. Rapid increase in investment rates would be necessary to secure the situation. Currently, pension plan’s assets have high value and interest rates are low thanks to the financial crisis. This is bad news for employers who have to pay more than they’ve originally planned.
The final and most significant of concerns is the ratio of active workers to retirees. The amount of money needed to pay for benefits is divided between a worker’s contributions and investment returns. Currently, the defined benefit plan becomes increasingly dependent on investment returns that might easily fall through.
Is Pension Plans Funding Improving?
Some of the private sector pension plans funds report surpluses. Is this the first sign of upcoming increase in pension plans returns? RBC Dexia Investor Services Ltd., the advisory firm issuing the latest survey of pension plans, reports a slow recovery of the market. The survey covered 108 plan sponsors and pension plans with assets from $100-million up to $1-billion.
Yet pension funds sponsors are still concerned with interest rate and inflation. Inflation may cause problems for pension plans, depending on returns indexed to inflation in particular. Funds are transferring the investments into infrastructure and real estate assets to avoid the risk of inflation.
“Returns for pension plans have been double-digit territory for some time, and it’s been Canadian equities that have led the way,” said Scott MacDonald, head of pensions, financial institutions, and client service at RBC Dexia.