The Defined Benefit Pension: An Endangered Species

On March 27, 2009 The Honorable Jim Flaherty released regulations designed to provide "temporary solvency funding relief for federally regulated defined benefit pension plans". The intent of the new regulations is to reduce the pension funding burden on organizations that are struggling during the current economic downturn.

The announcement was significant for two reasons. First, because it provided some temporary relief to firms struggling with the worst economic downturn in decades and second, because of why the announcement was necessaryóspecifically, what that means for defined benefit pension plans in Canada. It is worth noting that the funding relief applies only to employees in federally regulated industries, which includes telecommunications, banking and interprovincial transportation.

The Office of the Superintendent of Financial Institutions (OSFI) is responsible for the supervision of federally regulated pension plans. OSFI supervises some 1,350 pension plans or about 7% of all pension plans in Canada. Of the 1,350 pension plans supervised by OSFI, 446 are defined benefit pension plans¹.

However, this announcement begs a more important question: how long will any organization, other than government, be able to retain their defined benefit pension plans?

Pension plans come in two primary variations, these being defined benefit and defined contribution. Defined benefit pension plans pay benefits based on some ratio that typically includes years of service and the average pay earned during the last few years of service. From the employee's perspective, defined benefit pension plans provide certainty of income during retirement (although not necessarily certainty of purchasing power, unless the pension income is also indexed to inflation). From the employer's perspective, however, defined benefit pension plans represent a significant risk, as they are responsible for maintaining the plan with a sufficient level of funding to meet the actuarially determined liabilities of the pension plan.

Defined contribution pension plans allow the employee to contribute a usually fixed percentage of their income during their working lives, which may or may not be matched in some fashion by the employer. The real difference occurs at retirement. Whereas the defined benefit pension plan provides a relatively certain retirement income, based on the formula agreed to by both the employee and the employer, the defined contribution pension plan provides no such guarantee of retirement income. For those employees who are retiring today, during the depths of a major correction in equity markets, retirement looks significantly different than it did only a few months ago.

Defined benefit pension plans present significant risk to the employer; defined contribution pension plans present significant risk to the employee. Who should bear this risk and how should the risk be managed?

Based on the numbers, it would appear that employers have spoken and their answer is clear - most employers would prefer not to bear pension risk. Based on numbers provided by the Federal Department of Finance, there are slightly more than 19,000 pension plans in Canada. According to a study done by the Certified General Accountants Association of Canada in 2004 and updated in 2005, there are approximately 2,800 defined benefit pension plans in Canada. Stated differently, approximately 15% of all pension plans are defined benefit².

According to the CGA's 2005 update on the state of defined benefit pension plans in Canada, 59% of Canadian defined benefit pension plans were in deficit as of December 31, 2004. If indexation of benefits were to be included, 96% of plans were in deficit as of the same date.

Why would any employer willingly undertake the risks attached to a defined benefit pension plan in an era of volatile stock markets coupled with continuous pressure from Bay Street to increase the firm's EPS and share price? In an earlier age, there was an implied social contract between employers and employees, wherein employees were loyal to their employers and employers in turn assumed a more patriarchal role towards their employees. That era ended as pressure on management to deliver continuous increases in share price ramped up.

It is my contention that no private sector employer today would willingly undertake the risks associated with a defined benefit pension plan. Those plans that are in existence will be changed, as and when possible, to defined contribution pension plans. The result is a huge increase in risk exposure by individuals.

It is also my belief that most individuals are neither capable nor desirous of assuming this increased level of risk exposure. There are only two potential solutions:

One is for government to assume a larger role in protecting the pension income of all Canadians. The second is for the development of new technology around risk mitigation. While it is tempting to assume that government should provide cradle to grave security, the development of new and enhanced methods of risk mitigation probably holds the true key to certainty of pension income.

Robert Ironside, ABD, Ph.D. is a faculty member of The Knowledge Bureau and Professor, Finance School of Business, Kwantlen Polytechnic University