DC Plans: Fatally Flawed

Policymakers think DC-type plans are a magic bullet. They're not.

February 29, 2012

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bulletsThe shift away from DB to DC plans (Money Purchase Plans-MPPs) is well underway in both the US and Canada. Employers view DC plans as a way of reducing the exposure to DB pension risks as well as benefiting from lower administration costs and contributions. While sponsors, as the plan administrators, retain legal and fiduciary risk, DC plans shift the bulk of legal responsibilities from the sponsor and the pension funding burden from the employer to employees.

The first DC plans were introduced in the US in 1978-1980 but became popular in 1994 when “safe harbor” legislation, ERISA Section 404(c), was introduced. In Canada, the number of DC plans has also increased as awareness of the perceived economic and competitive advantages increased.  In 2008 approximately 23% of pension plans were DC plans. Sponsors are anxious to extricate themselves from DB plans because they are more costly, represent a potential financial risk, are heavily regulated and are expensive to administer.

Each member has an account in a DC plan to fund their  own unique pension liabity i.e. their personal mini-DB plan. Often, this reality is not understood or is conveniently overlooked or ignored by most sponsors and DC service providers.

In almost all cases DC members do not appreciate the subtly or understand the difficult and complex task of managing and funding their pension liability. Retirement planning and education is presented as an exercise in managing (maximizing) returns rather than the difficult task of funding a pension liability. A benchmark indicating the funded status of each member’s account is also often not provided or understood by members.

A 2007 study in the US concluded that DB plans are less likely to generate very low retirement wealth than a DC plan and also noted that the impact of timing and the type investments used in a DC plan were difficult to assess. A study in the US by Friedburg & Owyan (2002) concluded that DC plan member retirement age increased by two years and that elderly DC plan members were likely to outlive their DC pension assets. The documented and well known problems faced by many experienced administrators and investment professionals in managing DB plans point to the challenges faced by the average unsophisticated DC member. It is therefore hard to understand why governments in Canada and the US are encouraging DC plans as the pension program of choice for individuals given these hurdles.

DC plans can also inhibit members from successfully achieving an equivalent level income due to a long list of problems, including:

a) Members do not understand investment risks and the impact of volatility on returns.

b) Members are not aware of the impact of time and the concept of normally distributed returns with respect to funding.

c) Members focus on achieving high returns vs. adequate consistent returns.

d) Members do not take advantage of other tax assisted savings programs e.g. RRSPs, TFSAs which can boost retirement income.

e) Sponsor contributions in most cases do not adequately compensate members for the investment risk.

f) The risk sharing regarding time and investment timing available in a DB plan is not available in a DC plan.

g) Investment losses in a MMP cannot be made up from additional contributions and tax deductions as is the case in a DB plan.

h) DC members pay high fees from their plan assets which significantly reduces investment asset accumulation before and after retirement.

i) It is difficult to make up for investment losses in the draw down stage of a retirement program because of interest and equity premium risk i.e. timing.

j) Longevity risk is borne entirely by the DC member.

k) Having to sell units of fixed income investments to create a monthly income after retirement increases the member’s exposure to interest rate and duration risk.

l) Investments by pooled (mutual) funds are limited (prospectuses) as to the types of investments that can be used. DB funds can invest in higher yielding alternative /diversifying investments.

m) Most DC plans do not include duration matching products e.g. long bond funds to minimize duration risk.

n) Purchasing an annuity to create a retirement income is an option but dependent upon a sufficient amount of savings and a favorable interest rate environment.

To recover investment loses or increase retirement income MMP members, unfortunately, must take on greater investment risk.

DC plans have only been available in the US since 1974: they have not stood the test of time in either the US or Canada. Given the added limitations and investment hurdles presented  to DC plan members why is it assumed an individual will be successful in managing a funding their personal “DB” plan?

The reliance being placed on DC type plans by governments and employers to generate adequate retirement incomes is perplexing. Perhaps this is just another example of grasping for a “silver bullet” solution to a complex problem. The question remains – are DC plans a new evolving frontier or, fatally flawed?

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davidreginald.phipps.1- --great comments - as you indicate sometimes the reality of "what is is right" has to be accpted for better or worse. Since the idea that CAPs are fatally flawed creates angst lets just say we are testing a new frontier? I agree CAPs are a reality -- I think the best approach however is to take a DB approach to managing them which includes includes determining a the assciated pension liability and using a passive approach to investing the assets.


Does the employer have a fiduciary duty to provide a lifetime income, or a fiduciary duty to provide a reasonably well run MPP. Employers have made the decision that they are no longer even trying to promise an adequate pensions. That is fair. Can I as a small employer promise my employees life-long incomes - no. Can your local dentist promise his hygenist that - no. Employers and policy makers are rightly focusing simply on trying to create DC plans that are equal to or superior to the plans available to the self-employed. The only real problem is that the policy makers themselves still have DB plans. Only when the policy makers themselves no longer have DB plans will we see them implement legislation that allows the vast majority of Canadian to save the required amount to get near their DB plans - take away the policy makers DB plans and watch how quickly new and actually effective legislation appears.


    Neither the employer nor administrator have a fiduciary responsibility in a DB or DC plan to guarantee a pension. DB retirement income is dependent upon the financial health of the plan and the sponsor e.g. if a sponsor is bankrupt and the plan is under funded pensions may be reduced or curtained. The plan also has to only be funded in accordance with actuarial funding estimates. A DB or DC administrator has a fiduciary responsbility to act in the best interests of members hence monitors the DB funded position. Problems would be brought to the DB Pension Committtee (and sponsor). A DB pension is not guaranteed.Governments have taxing power and resources to fund public sector pensions which are considered less at risk. A DC administrator has similar fiduciary responsibilities. A DC pension comes entirely from the members succss in investing contributions: no guaranteed pension. The administrator nmust provide diversified investment otions however and certain information and "tools".


CJ -indeed admittedly there are drawbacks to DB plans from both a sponsor and member perspective. In your case if you left and got back your DB contributions you conceivably you could be better off too - depends on the investments and timing. DB and DC plans are portable in the sense they can be transferred to a locked in RRSP - but that opens a new set of "MMP" issues. Government employees - the idea of converting these types of plans to MMPs would involve a major labour confrontation on a couple of fronts. I'm sure their unions would reject DC plans being an answer. However, ... IF ..... DC plan members were properly compensated for the investment, longevity, duration risks etc via higher sponsor contributions (some say this needs to be in the 18-20% range) it would be a leveler playing field but, very costly and the shortfalls and risks for DC members would remain. Maybe some type of a hybrid DB plan is the better option? Thanks for the comment G


David - not fatally flawed? perhaps a brave new frontier then?? - you have a choice in this case?? LOL Your comment raises a very interesting but unresolved legal point: employers usually serve in the dual role of sponsor and administrator and have a fiduciary duty to act in the best interests of plan members. Being "well aware of the risk and problems they are creating for their..." members - as you point out creates an interesting dilemma from a fiduciary perspective ---- do you think this could be a future problem? My view is that sponsors who convert their DB plan members to DC plans without clearly explaining the "risk(s) " (good luck) and the potential problems are going to be at risk. The underlying question that tends to get ignored is "what is the objective of a pension program?"... IF... the objective is to create an "adequate" pension for the employees then I think MPPs in general are seriously flawed? Thanks for the comment G


There are huge drawbacks to Defined Benefits (DB) plans that shouldn't be overlooked. One that I find most irritating: they lock an employee in to a particular employer. The DB plan I'm part of reduces my RRSP contribution room. Yet, if I were to leave my employer today, all I would get back would be my contributions, with no growth, no inflation adjustment, and no employer matching. After a few years of contributing to a DB plan (I've heard "seven" by some investment advisors) leaving that employer could incur a massive, unrecoverable financial hit. Long gone are the days of working for the same employer one's entire adult life. I would prefer a Defined Contributions (DC) plan that was portable. Further, DB plans in the hands of government are "golden handcuffs" for the reasons listed above. Do we really want dead weight clinging to public service jobs because, for financial reasons, they "can't leave?" This places an massive, incalculable drag on the public sector.


Excellent article. Policy makers and employers are not under any false impressions regarding how DC plans work - they know the problems, and are well aware of the risk they are creating for their constituents. That being said, I can't agree that DC plans are fatally flawed. They can't be, becuase they are the new reality and to believe that they are fatally flawed would be to give up hope. To this end, the list of problems forms a good checklist of issues to struggle with.

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