When it Comes to Pensions, Plan for the Worst and Hope for the Best

If you’re one of the fortunate individuals that has a defined benefit pension plan, I predict that your employer may consider changing that to a defined contribution pension plan sometime in the next couple of years.

Before I go on, let’s review the difference between these two types of pensions.

A defined benefit pension is where the actual pension amount is defined (say $2,500/month). The actual dollars that have to be invested to pay out the pension is not determined up front, and the risk of running out of money is borne by the employer.

A defined contribution pension is where the annual contribution amount is determined in advance (for example 6 per cent of your gross earnings). What you’ll receive as a monthly amount in retirement depends on how well your investment performs. With a defined contribution pension, the employee assumes all the investment risk.

Over the last few years most defined benefit pension plans have been “under-funded.” That means that the amount in the actual fund, along with the current contributions, has been insufficient to pay out current and future obligations. Employers have been forced to make up these differences and, in some cases (Nortel as an example), have had to reduce benefits for current and future retirees.

Due to the uncertainty around the future funding obligations of defined benefit pension plans, many employers have switched to the more predictable defined contribution plans.

When investment returns are bad, as they were in 2007 – 2009, and employers are faced with funding shortfalls, they are usually hesitant to make a change to their pension plans. Now, thanks to the strong investment performance of the last five years, most large pension funds are either fully funded or close to being fully funded. This provides an opportune time for these employers to make a change.

When a pension is changed from a defined benefit to a defined contribution, the current pension benefits are frozen and new contributions are directed to the new plan. Current employees can keep what they have up until the time of the change, but new employees only have access to the new pension plan.

As an employer, I prefer a defined contribution plan because it limits my liability to a specific contribution amount that I pay now and can budget for. As an employee, I much prefer a defined benefit pension because I don’t have to worry about how my investments are performing when I retire.

Right now in Canada, most employees do not enjoy the benefit of a pension because of the cost of such programs. Of those that do, there is a sense of security because they feel their retirement is taken care of. This security could soon be shattered for a lot of people if my prediction comes true.

How would these changes take place? Would they have the ability to eliminate entire pension obligations? For a number of companies that have been burdened by these large pension obligations without the means to make payments, bankruptcy has been one of the only routes. The courts can then make specific changes to the pension payments in order to ensure that the company remains solvent; some of the changes that can be made include eliminating indexing, reduction of bridge benefit amounts, or incentivizing late retirement.

I’m not saying that everyone will lose their pensions, but I do think that we’ve grown complacent with our own retirement security. We should all be trying to take care of our own retirement planning, which includes making sure we’re saving a sufficient amount. This includes those who have pension plans and those who don’t. I think a reasonable amount of money to save is about 15-18 per cent of your gross income (which would include contributions to pensions, CPP and RRSP); however, determining savings amounts really comes down to how much you spend in retirement.

I always tell people that those who plan ahead stand a better chance than those who don’t. Don’t risk being blown off course by a sudden change in the wind. As sailors say, “plan for the worst and hope for the best.”