The old system of defined benefit pensions won’t meet the needs of tomorrow’s retirees. Here are three ways we can evolve
Retirement has changed. People are living longer, and lower interest rates make investing for the long-haul harder. Fewer young workers are available to back-fill retirement attrition, and suddenly, today’s retirees are looking at a world unlike that of their parents.
If companies could once reasonably be expected to offer a pension program that provided a fixed income for the rest of a former employee’s life, financial demands and the changing workforce are compelling organizations to shift gears.
What’s more, a handful of very public bankruptcies affecting thousands of pensioners have made companies skittish when it comes to offering retirement programs. For instance, Sears’ bankruptcy is causing headaches for its former employees, while Nortel workers have waited years to learn the fate of their pension’s shortfall.
Today, most organizations have stopped offering defined benefit programs, opting instead for defined contribution pensions where companies top-up or match employees’ retirement savings, explains Sebastien Betermier, an Associate Professor of Finance at McGill University. Over five short decades the entire world of pensions has shifted dramatically, causing many of tomorrow’s retirees to be ill-prepared for their golden years.
“Defined benefits programs force employers to take on all the risks,” he says. “Yet defined contribution shifts that risk onto employees, many of whom don’t understand enough about investment or aren’t saving enough to see them through long retirements. We’re shifting between two extreme models, while there might be a more sound solution somewhere in the middle.”
Lessons from the Canadian model
First, Betermier makes the case that defined benefits don’t need to disappear completely. In what he calls a “uniquely Canadian approach,” organizations should look to a number of quasi-public/private funds that have seen tremendous success in recent years, and which are often made up of a homogenous group of employees (e.g. the Ontario Teacher’s Pension Plan, the Healthcare of Ontario Pension Plan, and the Canadian Armed Forces Pension Plan).
Each was set up within the past 30 years, and they’ve been quicker to adapt to changing demographics than their older counterparts, Betermier says, and importantly, they’ve operated more like a business than a public entity. For starters, this means these organizations have well-established governing bodies that can consider the long term, and these funds tend to pay better-than-average salaries, which makes it easier to attract top talent in the investment industry.
But, most important, because these funds consist of large groups of homogenous employees, they’re able to take the long view, often investing in illiquid assets, such as real estate or other businesses, which may not yield instantaneous returns, yet tend to be cheaper investments that pay out more over the long term.
The size requirement and homogeny are key factors in their longevity, says Betermier, though firms that want to replicate the successes of HOOPP or OTPP shouldn’t feel that they’re too small or too diverse. Betermier points to a group of small municipalities in Quebec that have pooled their resources and tasked a local asset manager to oversee their investments. “They’ve created a big player out of a bunch of smaller players,” he says.
The hybrid model advantage
The biggest challenge to today’s pensions is longevity—simply put, we’re living longer than ever before.
For many organizations, their knee-jerk reaction was to shift to defined contributions from defined benefit plans. From an accounting perspective, it’s easier to understand exactly how much money needs to be contributed, based on current levels of employment, than to budget given the uncertainty of how long each former employee will live.
But this approach places all the risk on the workforce, Betermier says, and even the staunchest saver can make some bad investments that will leave their long-term retirement fund feeling the pinch.
Instead, Betermier forecasts growth in the popularity of longevity insurance options.
Instead, Betermier forecasts growth in the popularity of longevity insurance options. The insurance industry has long provided these programs. Traditionally, upon retirement, an employee pays a lump sum to an insurance provider in exchange for a guaranteed-for-life income. Should the person pass away the following year, that money is locked into the insurer’s pool.
Companies could (and some already do) offer a similar service. Think of it like health insurance: For an individual, insurance that provides medical and dental services can be costly. Amortized over a large group, it becomes affordable. Betermier is not suggesting that employers put all their retirement plans into this basket. Rather, he suggests they could take a hybrid approach, using these forms of insurance that pay out a set amount each month (akin to benefits) as part of a broader retirement program administered by companies.
“From the employer’s perspective, acting as the coordinator for pooled longevity insurance isn’t costly—you act as the administrator, while the insurer bears the risk,” Betermier says.
This is a particularly effective approach for companies that have fluid workforces, he adds. “It doesn’t matter if you stay or leave the firm. You’ll always have that bit of insurance coverage from the years you worked there.”
Even small changes can have long-term impacts
Regardless of the type of pension planning organizations undertake, the most important thing is to get people to start saving today. But it’s hard to get people to think so far down the line about their futures – competing priorities like children, house purchases, and education always seem to take priority.
Part of the solution is nudging employees: Betermier points to a well-cited study which found that having employees opt in to retirement savings plans resulted in poor adoption rates – less than 40% signed up during onboarding. In comparison, when the terms were changed to one allowing new employees to opt out, adoption skyrocketed, with more than 85% enrolment.
“Today’s employees aren’t saving adequately for their retirement,” he says. “Most retirees are still benefiting from the old system and we’ve not seen people fail out of the new pension system yet. Companies can play a key role in safeguarding the workforce for the long term before that happens.”