Pension Plans Worth Striking For

The Air Canada and Canada Post strikes were about who takes on the risk in retirement pensions.

Even an actuary like me knows that starting a discussion about pension plans at a social gathering is a conversation ender. And yet, recently, two of Canada’s largest unions (Air Canada and Canada Post) went on strike to save their defined-benefit pension plans, against the wishes of the employers, who wanted to switch new employees to defined-contribution plans.

What are these plans all about, and why all the fuss?

As the name implies, a defined-benefit pension plan promises to pay you a “defined benefit” when you retire. This can take a number of forms: It can be a flat-benefit plan (e.g., if you have a pension that pays you $1,000 a year in retirement for every year of employment, and you have 30 years of service, then you get $30,000 a year), or it can pay out a percentage of your salary just prior to your retirement (e.g., if you have a pension that pays you 1.5 per cent of your final average pay for every year of employment, and you have 30 years of service, then you get 45 per cent of your final average pay). So, in a defined-benefit plan, you know what annual benefit you will receive in retirement, and, thus, you have a very good idea of how much more you need to save on your own to be fully secure.

The funding risks of a defined-benefit plan are carried by the employer (although, in the long term, higher pension costs could force wages down). Unfortunately, the present environment packs a triple whammy of bad news for these employers:

1. Interest rates are very low. This means that, because employers have to pay out a “defined benefit” either way, the retirement fund may not earn enough in interest to cover the payments owed to retirees.
2. Because of the financial crisis of 2008-2009, and the mediocre recovery, pension-plan assets are worth less than they were expected to be worth, and pension plans are in the hole, as companies owe more money to their employees than what they have in the plan. (Air Canada and Canada Post have deficits of $2.1 billion and $3.2 billion, respectively.)
3. People are living longer, which means they collect pensions longer, which means company costs go up. Adding to these concerns is the fact that the ratio of retirees to active workers is now about 1:1 at both Air Canada and Canada Post. This matters because the cash flow needed to pay benefits must come from worker contributions and investment returns. With the growing ratio of retirees to workers, the plan becomes more dependent on investment returns, which are low today.

In these defined-benefit plans, the worker has a set benefit, which means that increased costs are the responsibility of the employer. This is bad news in today’s economy. Of course, if the economy improves and investment rates go up, good times for the employer could return.

The opposite is true for defined-contribution plans. With these types of plans, it is the contribution that is defined, with no commitment to how much will be paid out in retirement. For example, a plan may state that the employer will contribute one dollar to the pension plan per hour that the employee works, or it could state that the employer will contribute five per cent of an individual’s pay into the plan. However, once the employer makes the contribution, he or she has no further responsibility. If the stock market crashes, or if interest rates or investments are low, the worker will have a lower asset pool at retirement, and, thus, lower income post retirement. As a result, the workers have no idea – until very close to retirement – what income to expect, and how much more they need to save on their own. Just imagine the difference between retiring in 2007 versus 2009.

It is further true that, even if investments work out as hoped for, the new defined-contribution pension plans that Air Canada and Canada Post are offering should not be expected to result in benefits as large as those in the defined-benefit plans they want to close. In today’s climate, employers would be expected to contribute in excess of 10 per cent of an employees pay in order to maintain the level of benefits now promised to Air Canada and Canada Post workers. One would not anticipate the new defined-contribution plans being that rich.

So, the benefits being negotiated are important and real. Management will continue to attempt to pass the pension risks over to the workers by using defined-contribution plans, and workers will work equally hard to retain their defined benefits.

That’s the reason for all the fuss.

Origin
Source: The Mark