What is a Sustainable Pension Plan?
A sustainable pension plan is one that can consistently deliver, through both favourable and adverse circumstances, an appropriate range of benefits within an acceptable range of costs.
There are three key concepts in this definition:
1. Acceptable range of costs — We must be careful to distinguish between sustainability and affordability. The affordability discussion is just one element of sustainability. Joint cost sharing solutions are examples of how stakeholders are addressing the affordability question. Plan stakeholders need to agree on an acceptable range of costs in order to define sustainability.
2. Appropriate range of benefits — The Canadian retirement system has several components: government sponsored arrangements (CPP, OAS, GIS), employer, union and association sponsored pension plans, and private savings. Employer, union and association sponsored pension plans are not intended to provide a complete retirement solution to members. However, stakeholders do need to agree on what they would consider an appropriate, or adequate, benefit level.
3. Balancing costs and benefits consistently through both favourable and adverse circumstances — Sustainability is not achieved by simply balancing the cost / benefit equation at a single point in time. A sustainable plan is able to maintain that balance "consistently" and "through both favourable and adverse circumstances". The whole point of sustainability is to have mechanisms that can deal with shocks to the system, and avoid severe corrections to either contributions or benefits. The objective is, at most, infrequent adjustments of low magnitude.
Included in the concept of an appropriate range of benefits — and, we believe, critical to the sustainability question — is the need for a focus on lifetime pension income. The amount of that income may need to vary, within limits, but individual members are generally unable to absorb the risk of outliving their savings.
Whether you agree with this definition, or prefer another definition, it is important for plan stakeholders to discuss and agree on what sustainability means to them.
What are Target Benefit pension plans?
The target benefit (“TB”) approach is similar to the DC model in that it involves fixed contributions, or a fixed range of contributions, which are set independent of the funded position of the plan. Benefits are based on affordability projections. Contributions and benefits are directly linked in a way that doesn’t currently exist in traditional DB and DC plans.
A target benefit pension plan has sometimes been referred to as a "pooled DC" plan or a "shared risk" plan, where members share the plan risks through adjustments to their benefits. The commitment of the plan sponsor(s) to the plan is their fixed funding rate. Once the funding rate is established and contributions are made, sponsors no longer have any direct interest in the plan fund.
Critical to a target benefit plan is the benefits/funding policy — the pre-determined guidelines for linking benefits to funds available.
The term “Target Benefit Pension Plan” is used quite differently by different people. What about “Shared Risk Pension Plans” — are they the same?
How you refer to this solution is not important. What is important is that three key elements be present: fixed contributions, formula benefits and affordability. These are what define the “Target Benefit Pension Plan” as we currently refer to the solution in Canada:
a- Fixed contributions (possibly a range), but what really makes it “Target Benefit” is that we begin with the contributions, and then determine how much benefit we can afford. This is very different from the Defined Benefit approach, where we begin by defining the benefit and then determine the cost.
b- Formula benefits, which are described in terms very similar to a Defined Benefit pension plan, with one key difference. In a Target Benefit Pension Plan, the benefits depend on what the affordability test reveals, meaning benefit levels can change in response to emerging experience.
c- Affordability test and risk management guidelines specify how the balance between contributions and benefits is tested, and how benefits and/or contributions will be adjusted to ensure that the balance is maintained.
These three elements are fully present in New Brunswick's “Shared Risk” plans. The main difference in the New Brunswick model is that the legislation provides detailed guidelines for the design of each element.
Why are sustainable pensions important?
We believe that sustainable pensions are essential for Canada's prosperity, especially considering the challenges of the aging population. The goal is to work together to combat old age poverty and help Canadians feel secure about their retirement years.
The topic is of especial importance given the inability of individuals to absorb longevity risk and the fact that current defined benefit and defined contribution pension design approaches are struggling to cope with investment and interest rate risk.
Radical change is not required. What is needed is more effective use of structures already in place, with a regulatory framework that permits flexibility in their application. The Target Benefit approach is definitely an idea that holds substantial promise for being a key contributor to the sustainable pension discussion.
How is sustainability achievable?
All pension plans have three elements … three levers for achieving sustainability:
The challenge for sustainability is having access to all three levers. A defined benefit plan has limited access to the "benefit policy" lever, which means contributions can vary more than might be considered acceptable. A defined contribution plan has limited access to the "funding policy" lever, which means members' benefits can vary more than might be deemed appropriate.
A pension plan that can use all three levers, making small and infrequent adjustments, to keep the plan in balance has a greater ability to withstand shocks and achieve long term sustainability.
What is the advantage of a Target Benefit Plan?
The advantage is greater flexibility to deal with unforeseen events. One of the greatest constraints of current pension plan designs is lack of flexibility. In a DB plan the high degree of benefit certainty for members can come at a high cost and with significant contribution uncertainty for those funding the benefits. Furthermore, there can be significant intergenerational inequalities as retired members continue to receive benefits whether or not those benefits were adequately pre-funded. The reverse holds true for DC plans where the contribution certainty comes at the cost of complete benefit uncertainty.
Target benefits give plans greater room to manoeuver by allowing flexibility in all three elements of the pension plan: benefits, funding and investments, as well as by requiring greater attention to cost/benefit affordability. What the target benefit plan provides is the opportunity for a significantly better balanced risk management model than either traditional DB or DC plans can provide, and on a neutral basis concerning funding, accounting and tax standards.
Do you see Target Benefits as a better solution?
Target Benefits is one solution in a toolbox of sustainability options. Whether a Target Benefit Pension Plan is a better pension solution for your organization, or not, depends on your perspective and your objectives.
Different stakeholders have different concerns with both defined benefit and defined contribution pension plans:
• As an employer, you may prefer defined contribution – it is certainly simpler. And, it avoids the contribution volatility of defined benefit
• As a member, you may prefer at least some defined benefit, since benefits are more predictable.
Target Benefit Pension Plans can address some of these issues, but not all. Evaluation and selection of the appropriate design model depends on the objectives and priorities of the entire group of stakeholders. Target Benefit Pension Plans appear to be a viable and reasonable middle ground between defined benefit and defined contribution pension plans. One could actually argue that Target Benefit Pension Plans are less risky than either defined benefit or defined contribution pension plans. A Target Benefit Pension Plan may not be the right solution for every organization; however the concept is eminently workable in the right circumstances.
Will Target Benefit Pension Plans take off in Canada?
This will depend on how the legislative environment emerges in the various jurisdictions. If Target Benefit Pension Plans are to “take off”, the legislation would need to have a few common features, including:
• Permitting retroactive conversion
• Permitting sufficient flexibility in plan design, governance and management for a variety of designs
• Be consistent across the country – not necessarily identical, but flexible enough to accommodate a multi-jurisdictional plan
There will likely still be interest in Target Benefit Pension Plans without these features – this already exists today. However, it is debatable how much these plans might “take off” without such features.
Does Aon Hewitt advocate for Target Benefit plans?
No, Yes, and Maybe. Aon Hewitt is focused on sharing our knowledge and experience. We believe that Target Benefit Pension Plans provide one solution in the pursuit of sustainable pension plans. Target Benefit Pension Plans have great potential in certain circumstances and the principles upon which they’re based can inform any type of plan design. For these reasons, understanding these types of plans is important to anyone in the retirement industry.
Where else can I learn about Target Benefits?
The International Foundation of Employee Benefit Plans offers on-demand seminars online. Karen Hall and Troy Milnthorp of Aon Hewitt have presented two talks regarding target benefit plans:
• The Nov 2014 lecture explores how to set up a new target benefit plan. You will learn about the key elements of target benefit plans, their role in creating sustainable retirement for Canadians, as well as the latest legislation surrounding these plans. "What You Need to Know About Target Benefit Plans: How They Work & Recent Developments"
• "What You Need to Know About Target Benefit Plans: Part Two - Essential Communications" in January 2015, which discusses communication strategies for target benefits. You will the important role communications plays in sustaining the target benefits plan, experiences and examples of communicating a new plan, an ongoing plan and a plan change, and the emerging legal requirements.
Want to learn more about Target Benefits in Canada?
This site contains Aon Hewitt's research on Target Benefit pension plans as well as up-to-date information on current pension legislation as it applies to Target Benefit pensions. You can submit your contact information to receive notification of updates to the site.