Wednesday, August 19, 2009

Defined Benefit Plans

Defined benefit pension plans are having a rough go of it. Watson Wyatt reports that half of British companies with defined benefit pension plans expect to close them to all employees by 2012. Similar activities are occurring in the United States, including some states increasing the retirement age on their plans to age 68. Canada is a little slower but the issues are the same. Many plans simply cost much more than their sponsors expected. That is not to say that defined benefit plans deliver poor value - they don't - the issue more relates to sponsors expecting high equity returns would keep the costs low. Dollar for dollar, defined benefit pension plans deliver more pension than defined contribution plans. But, defined contribution plans automatically adjust to lower benefits in a poor economy and defined benefit plans don't.

Employers and unions need to assess what level of benefit they can afford and make changes. The timing is good - new accounting rules will highlight all costs for both private and public sector plans and there appears to be a sea change in economic thinking.

A good starting point for change is to determine the size of current liabilities and costs using a near risk free discount rate. In other words, eliminate anticipation of an equity premium. There are a few reasons for doing this:
  • pension plans are paring their equity exposure - some by 10% to 20% of assets, some by more - it's hard to say what will be considered reasonable equity exposure in the future.
  • equities inject more risk into a plan than was once thought - the view that volatility is mitigated by time is being questioned.
  • the efficient market hypothesis which encouraged equities for portfolio optimization is flawed (this is part of the economic sea change), but financial models have yet to find a suitable replacement other than scenario planning.

Continue to invest in equities, just don't count on excess returns ahead of time.

Once costs are assessed, determine a level of benefits at a cost the sponsor can live with. Here are some suggestions:
  • focus on the pension level/retirement age combination. If the plan is currently 1.5% per year of service at age 62, perhaps 1.3% at 65 would work.
  • avoid integration with the CPP/QPP. These benefits are likely to change in some fashion and the change may affect the plan's liabilities. Plan integration is also hard to communicate.
  • initially leave ancillary benefits out of the equation - benefits such as early retirement, spousal coverage, indexing, etc. can always be offered via a side fund paid for by employees who want the benefits.
  • look at a benefit change date far enough ahead to avoid employment issues such as constructive dismissal. For existing employees, grade the current benefits into the new benefits from the change date. For new employees, start the new benefits immediately.

As a trustees, keep in mind that the current economic conditions may substantially alter the employer covenant and the funding of deficits. In this context, security is itself a benefit and as such has a cost – extra security in funding may lead to lower benefits.
Don't be afraid to explain this to plan members.

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