How Big Is The Pension Deficit Problem?
David Christianson, CFP, R.F.P., TEP
Here I am in Toronto, of all places, instead of enjoying another perfect weekend in my Manitoba paradise, just to learn the latest about estates and trusts!
Drawing me here is the annual conference of the Society of Trust and Estate Practitioners (STEP), where I am chairing a panel on the latest tax rules regarding charitable donations. (The nice thing about being chair is that I can ask the experts on the panel to answer any question I want to duck.)
Look for a future update in this space, but in the meantime, I want to talk about whether or not members of Canada’s defined benefit pension plans have reason to be concerned about their plans and future benefit levels.
How Pension Plans Work
A “defined benefit” (DB) pension plan promises a certain benefit to retirees, based on a factor of years of service and final average salary. For example, if the pension promises 2% of final salary for every year of service, then a retiree with 20 years of service at normal retirement age will get 40% of final average salary as a lifetime pension.
This is in contrast to a “defined contribution” (DC) plan, which is now more common. A DC plan makes no promises about the value of the future pension. Instead, it is the contributions which are defined, according to a formula such as “3% of salary, contributed equally by each of the employer and employee.”
The money that goes in is invested and grows over the long run, just like a group RRSP. At retirement, whatever has accumulated in each member’s account is available to buy a pension for that member.
The amount of the pension, therefore, is based on the investment returns, the length of time and the amounts contributed. There is no guarantee of what the future pension will be.
Now, back to the DB plan. This plan has defined the future benefit that is owing to the plan member, so the plan itself must produce enough investment return to fund the future benefits for its particular member demographic, or it must adjust contributions or benefits. In years past, when plans showed large surpluses, benefits like early retirement and inflation protection were sometimes added.
In a deficit situation, it is usually the plan sponsor (the employer) who is responsible for any extra funding needed. An actuarial report produced every one to three years tells the health of the plan, and whether there is a surplus or deficit.
The factors going into that valuation include the age and life expectancy of the plan members, the career expectancy of current workers, expected rates of return on the fund and inflation, where that is a factor in the benefits.
The Demographic Issue
So here’s the problem, using the Ontario Teachers’ Pension Plan as an example. (It reported a $12 billion deficit after its 2007 results.)
On average, teachers now work about 25 years and collect pension benefits for 36. In the 1980’s, there were four teachers for every retiree and now there are fewer than two. To make it all worse, those ornery retirees are living a lot longer than originally expected.
Low interest rate assumptions have not been helping. Just as an illustration, it might cost the pension plan $900,000 to provide a $41,000 per-year pension if rates are 2%. If rates were 5%, then the same pension might only cost the plan $600,000.
What does it mean? Either contribution rates have to rise, or benefits - like inflation protection, early retirement flexibility or even amounts of pension per year of service - must decline.
What You Can Do
If you are a member of a defined benefit pension plan, read your mailings. Find out how your plan is doing.
Continue to expand your additional sources of retirement funding, like personal RRSPs, personal savings, other investments like rental properties, and eliminating debt as you head toward retirement.
In other words, become fully informed about your plan and your future, and prepare appropriately. (That sounds like good advice to all people, especially those who do NOT belong to a plan. If you do not, then you have a lot more personal responsibility for your retirement funding than someone who has a pension. To provide that same $41, 000 of retirement income starting at 60, you will need some $600,000 of capital. Start saving.)
Being realistic may mean spending less now than you had planned; to squirrel away more for retirement. Better to find out now, than later.
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This article originally appeared in the Winnipeg Free Press on Friday, June 6, 2008.
David Christianson is a fee-only financial planner and investment counsel with Wellington West Total Wealth Management Inc. His column, ‘Dollars & Sense’ appears Fridays in the Winnipeg Free Press.