October 2009

In the future, who will take care of our retirement?

With the announced disappearance of defined benefit pension plans, the way everybody sees their retirement is about to change radically. Even those who didn’t have such a plan!

Quiz question: who’s responsible for the following quote?

Pensions and like benefits will be “extravagant beyond reason.”

No idea? It’s Alfred P. Sloan Jr., former president of General Motors… and it dates back to the 1940s. Seventy years later, GM finds itself on the brink of bankruptcy and owes its survival to government intervention. Thousands of employees and retirees just don’t know what will happen to the generous pension funds and employee benefit programs they were counting on.

What happens now?

Although, in 2008, the shortfall in GM’s pension fund amounted to $4.5 billion, attributing the fate of the company to these pension plans alone would be going too far. But the example is striking because it shows just how much defined benefit plans, which companies use to guarantee a retirement income for their employees, can be a heavy burden for employers to bear. 

A burden, precisely, that they would like to get rid of.

Transfer the responsibility…
Transfer the risk …

It’s important to note that there are two types of employer pension plans:

  • Defined contribution plans (DCPs)
  • Defined benefit plans (DBPs)

In both cases, a pension fund is set up using payments made by the employees and by the employer. However, in the latter case, the employer assumes another commitment, that is, undertaking to provide the employees with a pre-determined retirement income, regardless of the return on the plan’s portfolio.  As such, it is up to the employer to replenish the fund in the event of a shortfall. In so doing, the employer is assuming two major risks:

  • the risk related to the portfolio’s performance
  • and the risk related to the life expectancy of the retired employees.

It just happens that, in the past few years, both these risks turned up at the same time. Long-term yields are lower than they have been in decades and, since retirees are living longer, they are drawing from the plan’s capital for many more years. Now, many North American pension funds are finding themselves in deep trouble – including those of large cities and States.

This is why many employers want to transfer these risks to their employees by limiting access to DBPs  and/or converting them DCPs. 

That changes everything!

This is a radical change for employees who hoped to benefit from defined benefit plans, as did their elders. It means they won’t be able to count on their employer to replenish their fund in the event of a bad performance. They themselves will have to make choices they didn’t have to make before to ensure that they and their household have sufficient income to last them until the end of their life.

Anyone who doesn’t depend on an employer pension plan, like independent workers, knows just how much trouble this can mean. And this will become increasingly true if the entire workforce ends up having to “manage uncertainty.” Can we really expect everyone to learn to manage what actuaries call their Retirement Sustainability Quotient?

Obviously, nothing could be further from the truth. And, suddenly, governments are becoming aware of this.

Towards a new retirement system

Problem is, for fifty or sixty years, defined benefit plans was a pillar of Canada’s retirement system. It’s true that, depending on the province, only 20 to 40% of workers benefitted from them. But, for these workers, a big part of the problem was solved by these plans, which meant there was less pressure on the other two components of the system: individual plans, like RRSPs, and public plans.

If the first of these three pillars goes, many analysts worry that the entire system will have to be revamped. The C.D. Howe Institute1 is already predicting that only one-third of all Canadian households are saving enough to cover the current spending they’ll have in 2030.

This is why, over the summer, both levels of government deliberated this issue in view of implementing new plans or new funds to ensure a better income for Canadian retirees in the future.

In the meantime, regardless of the future of our retirement system, one fact cannot be ignored: with the help of their financial security advisors, an increasing number of Canadians will have to plan their financial future by assuming more responsibility in ensuring their retirement income. 

And this is one of the most important challenges we’ll all have to face over the next few years.

1 The C.D. Howe Institute is a Canadian public policy think tank that promotes the application of independent research to major economic and social issues.