The keys to DCs

Many organizations, especially in the private sector, are moving to defined contribution plans. How do you make the most of these plans — both as an employer and an employee?

There's a huge shift going on in Canada, but it has nothing to do with tectonic plates. It has to do with the steady move from defined benefit (DB) to defined contribution (DC) retirement plans.

For much of the 20th century, employer-sponsored plans were of the DB variety. Under these plans, employers took on the responsibility — and risk — of ensuring a fixed retirement income for their plan members. But about 30 years ago, things started to change. While many employers remained active in contributing to retirement funding, the responsibility for ensuring an adequate retirement income was transferred to employees. This was the beginning of the DC era.

According to a 2010 StatCan survey, 16% of registered retirement plan members in Canada are in DC plans and 85% of these are in the private sector. Meanwhile, 74% of registered plan members — and 96% of registered plan assets under management — are still in DB plans. But the move is well underway, and most new registered plans are DC plans.

“Several factors contributed to the change,” says Nigel Branker, a partner and leader of Morneau Shepell’s pension consulting practice in Ontario. “The shift actually began in the 1980s, but things gained momentum after the year 2000. Among other factors, markets were underperforming and pension liabilities were going through the roof due to very low interest rates. You couldn’t find a worse combination: plan assets were declining while liabilities were rising.”

While they may be less challenging overall, DC plans nevertheless bring their share of responsibilities — for both employers and employees. For their part, employers have to look after the plan design and investment policy as well as communicating information on the plan to contributors. And employees need to make sure they are retirement ready. They have to make the right financial choices to ensure they have enough for retirement — a task that involves managing their own investment portfolio and facing the inevitable ups and downs of the market.

If you are an employer looking to set up a DC plan or a potential member, it’s useful to remember that these plans have a relatively short history, so some of the risks inherent in their design are only beginning to appear (see “Unexpected risks” below). For both employers and employees, preparation is key.

THE RIGHT DESIGN

Unlike group registered retirement savings plans (RRSPs), DC plans must be registered not only with the federal government, but also with the employer’s provincial pension regulator. DC plans also have more restrictions than RRSPs do.

“There are two major restrictions associated with DC registration,” says Michel St-Germain, an actuary at Mercer. “The funds in each individual account must remain locked in until retirement and, upon retirement, the plan member must use the accumulated capital solely for retirement income [not to buy a house, for example].”

In designing the plan, the employer needs to focus on three key elements: contribution rates, categories of members and investment options available. According to Branker, deciding on the right rates means striking a balance between the need to ensure the company’s financial health, the need to help employees reach their retirement goals, and the need to maintain a competitive recruitment policy.

Canadian employers typically contribute 3% to 6% of an employee’s salary, with matching contributions from employees. But any combination is possible, says Kim Anto, senior retirement consultant at Towers Watson in Montreal. “It depends on how the plan is set up. Among other things, the employer can make the plan mandatory or optional or set a minimum contribution threshold for employees.”

According to St-Germain, beyond the established threshold, most employers offer an incentive formula: for example, for each extra dollar an employee contributes, the employer will contribute 50¢ or $1 or even more.

Contributor categories are based on the types of positions in the organization. One DC plan might have only three categories, while another might have eight. “These categories cannot be established on the basis of gender or age — only on the basis of job classification,” says St-Germain.

However, employers can have higher contribution rates for different categories. For positions that are more difficult to fill, for example, they might contribute 7% of salary. They can also establish eligibility criteria — for example, they can require employees to have at least six months of service before joining the plan. Finally, they must decide on how to deal with exceptions, such as employees on maternity leave.

Apart from the plan sponsor, four types of service providers are involved in pension plan administration: the plan custodian, the investment manager, the record keeper and advisory support. According to Branker, historically in Canada it has been popular to “bundle” the plan — that is, to entrust the entire plan to one provider, often an insurance company. If this option is chosen, it’s important to have at least one outside expert who can independently assess the plan’s performance. As DC plans become more widespread, larger sponsors are tending to “unbundle” and build their own plans and support structures.

INVESTMENT OPTIONS

Choosing an investment lineup can be complicated. First, how many funds should be included? Some employers have only three or five, while others offer 30 or more. “Today, in 69% of cases, the number ranges from five to 14,” says Carl Wiseman, senior investment consultant at Towers Watson in Montreal. The employer also needs to decide how much of the lineup will be in actively managed funds as opposed to index funds with minimum management fees.

Then there are the investments themselves to consider. Apart from the basics, such as Canadian equity funds and government bond funds, what should be offered? Should you stop at large cap international stocks or venture into emerging market equities and alternative asset funds?

It all depends on the plan members. While Canadian balanced funds might be a good choice for some employees, others might want to see more complex investments — even hedge funds — in the lineup (although this option has been gaining traction only recently).

The plan should also include a default fund for plan members who don’t want to choose. According to a Towers Watson 2014 report, 67% of employers offer target date funds (TDFs) for this purpose, and TDFs are the default fund for 61% of plans. That is up 18% from 2012. Wiseman says these funds include both stocks and bonds, with the relative weighting changing as the contributor ages. A 35-year-old might have 65% stocks and 35% bonds, while for a 55-year-old, the mix might be 45%/55%. Despite the wider use of TDFs, Wiseman still says it is best to diversify all investment options, even for those members who don’t want to choose their own.

Management fees can significantly undermine fund performance, so every effort should be made to minimize them. One way to do that is to find the right split between index funds and actively managed funds. Another is to choose the right investment manager. “Over the past couple of years, the market has become extremely competitive,” says Wiseman. If you shop around, you can find very attractive rates. According to Wiseman, index fund fees range from 0.15% to 0.6%, while target-based fees range from 0.3% to 0.9%. It all depends on the size of the company.

THE EDUCATIONAL IMPERATIVE

Employers need to explain the workings of a DC plan to employees, especially in cases where they are converting from a DB to a DC plan.

Unfortunately, many employers fall short in this area. According to Dany Dumas, senior communication and change management consultant at Towers Watson in Montreal, the firm did a survey where 75% of employers said they had communication tools in place. But those tools were often extremely text heavy. As a result, “only 23% said their employees understood the savings options offered.”

To boost the education effort, it’s worth enlisting the help of digital media. According to Dumas, it’s possible for a company with dozens of locations across the country to produce plenty of brochures and training materials, but with a well-built website it can also include measurement and feedback tools. The best approach, he says, is actually multimedia: digital videos, e-mags, interactive brochures and websites as well as direct face-to-face meetings or presentations and printed material.

THE CONTRIBUTOR’S ROLE

Since DC plan members are responsible for ensuring their retirement readiness, they must take on a significant amount of risk. For example, imagine the market plummets by 30% six months before an employee retires. With a DB plan, the employee’s pension would probably not be affected. But with a DC plan, he or she would have to make a choice: either retire on the planned date, but with reduced income, or postpone retirement until the markets bounce back. If you are a DC plan member, you must do everything you can to find the best mix for your portfolio, while considering your risk tolerance and retirement expectations. Some plan members enlist the help of a financial adviser to do this.

If you find your DC plan does not allow you to save as much as you would like, you can invest in an RRSP. However, remember that the total amount that can be invested tax-free cannot exceed 18% of your income from the previous year, or $25,370 for the 2016 taxation year. Another option is to contribute to a tax-free savings account (up to a maximum of $10,000 a year in after-tax income as of 2015).

The most important thing, according to experts, is to take advantage of all the options offered, including matching contribution and other programs. Unfortunately, too many employees fail to do this. “This is free money that they are leaving on the table,” says St-Germain.

Diversification is an important element of any plan, and one that is generally built into premixed funds such as TDFs. Research conducted in the US by Morningstar shows that in their first 10 years of existence — a decade marked by a major financial crisis — TDFs yielded an average annual return of 6.13%, in third place behind sector equities (7.18% per year) and US equities (6.49%).

A plan member’s responsibilities don’t end at retirement — far from it. When you reach that stage, you’ll have some tough questions to answer: for example, should you manage your withdrawals yourself? Or should you purchase an annuity, even if that means giving your capital to an insurance company? When should you sell your house to boost your capital? And what are the tax implications of all these options?

“Personally, I find all the decisions you have to make when you retire extremely complicated,” says St-Germain. That’s why he has one cardinal rule: hire a financial adviser when it comes time to retire. “Especially a good, independent adviser,” he says.

UNEXPECTED RISKS

The issues raised at retirement highlight a new risk that many employers had not anticipated. When DC plans were introduced, few contributors had reached retirement age. But now that some are starting to retire, “employers are becoming concerned about the impact of situations where employees leave without having enough savings,” says Dumas.

Employers are also wondering about some related issues. For example, should they continue managing employees’ funds after they retire? Should they provide financial planning services? “Employers are looking to offer services and advice that do not bind them legally,” says St-Germain. “No one has found the perfect solution yet.”

Since it has taken more than 30 years for some of the risks involved in DC plans to rise to the surface, they cannot be removed overnight. But as sponsors gain more experience with these plans, they are likely to come up with new ways to temper the risks for employees without putting more pressure on employers. In fact, this is already starting to happen (see “A fine balance” below). Let’s just call it DC in evolution.

A FINE BALANCE

Some employers are trying to strike a balance between defined benefit and defined contribution plans. According to Michel St-Germain, an actuary at Mercer, some of the newer alternatives include target benefit plans, member-funded pension plans and cost-sharing plans. The distinguishing factor of these plans is that the risk is transferred from individual contributors to all plan members. Although benefits are not guaranteed, they are at least targeted. That means if the market crashes three months before an employee reaches retirement, he or she does not have to postpone retirement indefinitely. Members can still retire, although with a little less income, since the plan takes on the risk of rebuilding the assets of the group portfolio in the years to come.

About the Author

Yan Barcelo


Yan Barcelo is a journalist in Montreal.

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