Do DB Plans Reward the Wrong People?

The haves and have-nots in the public pension system.

April 19, 2012

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coin stackThe best way to a secure retirement, one section of the commentariat assures us, is through defined benefit plans that pay out a guaranteed income until death. If you don’t have a workplace plan, then CPP should be doubled to supply an equivalent.

But another part of the commentariat insists that DB plans are unaffordable. And there is admittedly some evidence for that. As Aon Hewitt noted recently: “The median pension solvency funded ratio of a large sample of pension plans has increased from 68% at the end of 2011 to only 69% at the end of March, 2012. About 97% of pension plans in this sample had a solvency deficiency as at that date. The solvency funded ratio measures the financial health of a defined benefit pension plan by comparing the amount of assets to total pension liabilities in the event of a plan termination.”

Now there’s a third perspective, courtesy of the C.D. Howe Institute: who actually reaps the most from defined benefit schemes? Surprisingly, it’s not the lower-wage workers, for whom DB plans, along with CPP, are assumed to be a backstop against poverty in retirement.

In “Winners and Losers: The Inequities within Government-Sector, Defined-Benefit Pension Plans,”  Geoffrey Young writes: “An analysis of representative DB plans shows they systematically transfer income away from groups of employees in occupations with slow wage growth to employees in occupations or careers with higher wage growth rates; this often means from low-income clerks to high-income deputy ministers. The winners are ‘high-flying’ employees who are likely to enjoy pensions that exceed the value of the accumulated employee and employer contributions in their ‘accounts’ at retirement, while the losers are those who would be better off if they simply received the value of their contributions plus interest rather than rely on future payments from a discounted pension.”

To arrive at this, Young proposes that “Although DB plans, unlike RRSPs, do not maintain separate accounts for individual participants, the amount within the plan’s investment fund that is attributable to each employee can easily be calculated, provided the employer contribution is in the form of a percentage of employee earnings and the return on plan investments is known. In this way, one could estimate ‘accounts’ within a DB plan that are the same as the amounts the employees would have in personal RRSPs, had both employee and employer contributions instead been paid into each employee’s RRSP (assuming the RRSP earned the same return as the plan fund, net of administrative costs). “

So theoretically, it’s apples to apples: DC could be converted into DB, and vice versa, with the accumulated value turned into an annuity upon retirement.

Except DB plans don’t quite follow market rules, he suggests. On the contrary, the plan design intervenes, and rewards higher-earners. “In a DB plan, however, the value of an individual employee account is generally not equal to the value of the individual’s pension. DB members, instead, receive a pension based on the plan formula, so that some members will draw pensions that are greater in discounted value than the value of their ‘accounts,’ while others will necessarily draw pensions that fall short of the value of their accounts.”

The way public pension plans are structured, he concludes, is that those who win are those whose income increases the most – and can retire early. A waste of human capital, he calls it. But that’s the incentive built into the system. “[A]n employee who retires between the ages of 53 and 58 is a winner– the value of his future pension payments exceeds the value of his accumulated account. He becomes a loser if he works too long, or quits too soon.”

As for those who remain diligent, long-serving public servants, they don’t really get to reap the benefits they would have had had they had a DC plan, Young suggests, because of final pay schemes. “Given identical lifetime earnings the accumulated value of the contribution accounts for employees with slower wage growth is greater than for those with faster growing earnings, since those with slow-growing earnings make a greater proportion of their contributions in early years and their contribution accounts accumulate more interest before retirement.

“Thus, for given lifetime earnings employees with slow-growing earnings are more likely to be pension losers, both because at retirement their pensions are worth less, and because their contribution accounts are worth more than those of employees with faster growing earnings.”

He gives this example: “[A]career homecare aide (personal support worker) who receives only seniority increases may have lifetime earnings growth of only 0.25 percent annually. In contrast, a person advancing from lowest level of economist to assistant deputy minister might experience earnings growing of 3 percent per year.”

This may all seem hypothetical. Are DB pension payout schemes perverse? Remember the guy who was commissioned to look into Ontario’s public finances and suggested higher contribution rates for public-sector workers? The former bank economist? The former federal finance official? The one who took early retirement at age 56?

Yes,  that was former TD Bank chief economist Don Drummond, who told The Globe and Mail: “It was always my plan [to retire at 56], blame it on the public sector pension plan,” he said. “During my first conversation with Ed [Clark, CEO of of TD Canada Trust], I was 46 at the time, I said ‘ten years will get rid of the actuarial penalty in my federal pension.’ I told Ed a year ago ‘remember that it’s coming up, and it’s still my intent.’”

Drummond is a Canadian treasure and has done exemplary things in retirement and even before, at TD Bank. Ironically, one of them is fostering the DB plan debate, and more broadly, discussion over the pension divide between the haves and have-nots.

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Sure DB plans share many risks and that is what makes them so attractive. Longevity risk, divertissement investment risk, and efficiency of investment risk are three that add up to making DB plans more efficient than DC plans. Studies (eg New York City Comptroller - A Better Bang for New York's Buck) have shown that it would take 30% to 35% more contributions in a DC plan to equal the benefits of a DB plan. How does that make DB bad and DC good?


I am always distressed when reliable magazines such as the Investment Review quote from C.D. Howe. Howe has never waivered in its attempt to undermine public sector pensions. For years, they tried to convince Canadians that evil fat-cat civil servants are biding their time for the day they can collect their fat-cat civil servant pensions. They'd also have everyone believe that it's the ordinary working stiff that has to cover the cost of these pensions. Phase two of their approach seems to be to con those very members of the public sector into thinking that they'd somehow be better off with a refund of their contributions and interest than they would with a lifetime pension. As with many things from this "think" tank, they are just plain wrong. Pension sustainability needs to be addressed, but let's not throw the baby out with the bathwater.


97% of plans with solvency deficiencies? Is there something wrong with the DB model? More surprising is that the CD Howe Institute published their piece about inequities in Government DB plans. That these plans even exist is the inequity that Canadian taxpayers must address soon. Mandatory public service until age 81 is a good start.


    Seriously? 81? Then everyone will complain about how much medical and dental benefits are costing. No matter what public sector workers do, they will always be easy targets. What we really need to do is to stop the endless race to the bottom. If your employer isn't supplying benefits equal to those of a public sector worker, join the public sector. What? Not lucrative, secure or interesting enough? No chances at making a fortune? Does being criticized for all the ills of the people you vote for not appeal? Small wonder.

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