In the 1870s one of the first pension plans in Canada was sponsored by the Grand Trunk Railroad. Retirees could benefit from the plan at age 70 for a lifetime pension. Trouble was a Canadian’s average life expectancy was 55 years of age. This is what is called a pretend gift or empty promise.
Fast forward a century and a few decades and we see a somewhat similar problem. Employees are retiring earlier than 65 by choice or not, and there are many more upcoming retirees than at any time in history. Retirees are also living longer. A new term has entered the lexicon of financial terminology. That term is the unfunded liability.
Never mind that companies such as Enron or Nortel caused their retirees’ benefits to erode to the point of nil value. Those employees had the majority of their retirement savings in company stock. Their retirement dreams vanished, and many had to work longer.
Today’s problem is more insidious and subtle. That is because there is a long held belief in the value of pensions. It is like the golden egg the goose laid. A perk that many believe is a financial windfall. I have been asked more than once by clients should I buy back my pension benefits so I can remain in the plan?
An unfunded liability is a calculation done by a company or government to determine the health of its pension plan. If a pension plan has an unfunded liability it means that the contributions of the members and the investment return of the plan are less than the benefits the plan pays to present retirees. Unless the pension administrator is a level of government this presents s financial dilemma. In a private company shareholders’ interests come before pension holders. For the company to remain viable something must be sacrificed. When the pension administrator is a level of government they will simply get more revenue from taxpayers, namely you and I.
I have discussed the definition of risk in this newsletter before, but let’s refresh our memories in order to continue the pension discussion.
The definition of risk is the probability of harm or loss occurring from an action. If I go out and leave my front door wide open, I am exposing myself to risk of loss. If I drive at excessive and reckless speed around an icy corner that is risky behavior.
In the present financial world pension plans can present a risk to certain employees of certain ages and financial circumstances.
So why might that be? Let’s begin the analysis by looking at the two main types of pension plans.
Defined benefit(DB) plans used to be the type of pension that every employee aspired to and still does. DB plans are sponsored by the employer. It is basically a contract to provide a guaranteed lifetime retirement benefit to the employee based on years of service and salary. The employee has no control over the investments in the plan, and all investment risks are assumed by the employer. The benefit is based on a formula, and because it is employer sponsored is the most expensive type of plan. If a company has many retirees who each receive a pension indexed to the cost of living for their lifetime that can be a substantial hit to their bottom line. They are therefore becoming rare in the private sector and governments are also phasing them out. Also if the economy dictates that employers hold the upper hand due to high unemployment there is no need to offer any pension plan. Restrictions on commutation(taking it when you quit, retire or are laid off) are becoming more commonplace.
Defined contribution(DC) or money purchase plans(MPP) are replacing DB plans. DC or MPP plans are a combination of employer and employee contributions. DC plans allow for some choice of investments by the plan members. Therefore some of the responsibility for the rate of return of each member’s plan rests on good investment choices. This is fine if the member has access to advice as my clients do.
A DC plan is less expensive for the employer. DC plan members have true ownership of their plan benefits and if they leave the plan they are allowed to commute(take it with them) to invest in a Locked in Retirement Account(LIRA).
Plan members of DB benefit plans contribute a significant portion of their salaries to their plan. Often these contributions percentages are only negotiated at the end of contracts for the group, eg teachers. These contributions impact clients’ take home pay, which cuts into monthly cash flow for day to day expenses.
That would be OK if these increased contributions were going to directly benefit the contributors. But many working plan members realize that their contributions are supporting current retirees. They wonder out loud if there will be a plan for them when they retire. Their intuition is correct.
This may sound harsh and unconventional but I believe evidence supports that DB plans pose an unacceptable risk to anyone under 45 years old. No employee can project the health of the DB plan 20-40 years into the future. In a DB plan you cannot say with certainty that the 10-15% of your salary will provide you a benefit decades from now. Contracts can be reneged on or rewritten. Case in point: 40 cents of every dollar the city of Detroit brings in must go to pay pension benefits. They can’t turn on all the street lights or open all the libraries. Think that is far from home and doesn’t affect you?
Many large Canadian companies have declared unfunded liabilities. You work for the government you say? The Alberta government recently announced that the Local Authority Pension Plan or LAPP to be unsustainable if it continues on its present path. The most responsible companies are at least forewarning their plan holders so they can put together an exit strategy.
Long ago I set out these categories to determine whether a person could become financially successful. They are the spender, the lender and the owner.
The spender lives for today and does not think of the future. The lender lends their money to institutions that pays the lender a small honorarium for the use of their money to invest and make the institution rich. The owner has full control over their money and uses it for their financially successful future. At present, DB plan holders are lenders and DC plan holders are owners. So too are people who are taking responsibility to invest independent of their company benefits if indeed they have a work plan.
Canadian stakeholders need to ensure that the next generation of wage earners are not penalized for the mismanagement of the past. There is a discussion needed to reform the present pension system in Canada, so the young workers now are not burdened with supporting upcoming retirees.
Source:
- http://www.theglobeandmail.com/report-on-business/canada-post-to-push-for-worker-concessions-on-pensions/article15987182/?click=dlvr.it
- http://www.theglobeandmail.com/report-on-business/how-the-rhode-island-treasurer-slayed-her-state-pension-dragon/article15225383/?click=dlvr.it