Evaluating your pension plan

Evaluating your pension plan
Plans are healthier overall and the popularity of defined contribution plans continues, but government plans are still important to retirement income.
By Ross Archibald and Rick Robertson
 

How financially strong are the country's pension plans? How well governed are they? These are just two of the questions addressed in the Richard Ivey School of Business / Financial Executive Institute Canada (FEIC) biannual Survey of Pension Plans in Canada. The survey has been developed to provide timely, periodic insights into the state of large Canadian company pension plans so that managers can compare their performance and have data available to assess the conditions that may be changing. The twelfth survey has just been completed and it identifies a few key areas that require careful monitoring, if not concerted action.

In general, a number of trends identified in previous surveys, such as the strengthening of fund health, the vital role of the Canada/Quebec Pension Plan (CCP/QPP) and Old Age Security (OAS) and the shift to defined contribution plans are continuing. However, a number of issues that require remedial action have also become more apparent. Two of these issues are the product of lagging tax legislation and one results from the continuing adaptation of defined contribution pension plans.

The survey questionnaire was distributed to FEIC members and a group of similar organizations with net worth in excess of $5 million, capital greater than $15 million or more than $20 million in operating expenses. The results are based on year-ends between July 1, 1997, and June 30, 1998.

 
PENSION PLAN HEALTH

The trend of improving health for defined benefit plans observed in the three prior surveys appears to have continued. Based on 106 responding pension plans, 82% reported surpluses that totaled $11.13 billion, while 17% reported deficits (unfunded liabilities) totaling $0.45 billion. One plan reported pension assets equal to actuarial liabilities. The financial health of the private pension system is better assessed by considering the relative size of the surpluses and deficits. A standardized ratio measure may be generated by dividing the surplus or deficit by the respective plan's actuarial liability (Table 1). For plans with surpluses, more than two-thirds report a surplus in excess of 10% of the actuarial liability, and 31% have surpluses greater than 20% of the plan's actuarial liability. For deficit plans, only 27.8% have a deficit greater than 10% of their actuarial liability and, in six of the 18 deficit plans, the deficit is less than 5% of the actuarial liability.

When compared to prior surveys, the results indicate that there has been a progressive improvement in the strength of corporate-sponsored pension plans. The median size of pension surpluses has increased somewhat to 14.5% in 1998 from 10.9% in 1996; both are better than the 1992 survey result of 9.7%. On the deficit side, the 1998 survey continues the trend to lower proportional deficits from 10.4% in 1992 to 6.3% in 1998. It would appear that plans with deficits have been strengthened by positive equity markets and declines in interest rates. For surplus plans, the performance of plan assets may have been offset by some pension funding holidays.

Plans Are Getting Healthier
More than two-thirds have a surplus in excess of 10% of the actuarial liability.
Relative Size of Pension Surpluses and Deficits*
Relative to Actuarial Liabilities
Surplus Responses
Unfunded Liabilities
 
Number of Plans
Per cent of Plans
Number of Plans
Per cent of Plans
Less than 5%
12
13.8
6
33.3
5% - 10%
15
17.3
7
38.9
10% - 20%
33
37.9
5
27.8
Greater than 20%
27
31.0
0
00.0
Median ratios
This survey
14.5%
6.3%
Eleventh survey
10.9%
7.0%
Tenth survey
11.0%
8.1%
Ninth survey
9.7%
10.4%
*Surplus or Unfunded Liability / Actuarial Liability
 
THE IMPORTANCE OF GOVERNMENT PLANS

For employees, the primary purpose of a pension plan is the replacement of a significant portion of their pre-retirement income. Table 2 reflects the income replacement percentages for a retiring employee who is a member of a defined benefit pension plan, is 65 years old and has 35 years of service. The replacement percentages are provided both with and without the inclusion of full CPP and OAS. To permit understanding of the longitudinal trend of income replacement, all percentages are based on the years maximum pensionable earnings (YMPE) for the CPP for the year in question. It is important to recognize that these calculations pertain to a long-service employee who would have full pension entitlements. In today's labour market, few reach these service levels and so would likely be entitled to a lower level of income replacement.

Several key observations stand out. First, when CPP and OAS are included, the income replacement for all but the highest paid employees meet or exceed the 70% rule of thumb often suggested as a target replacement ratio to ensure that lifestyle can be maintained. For those Canadians with earnings equal to the YMPE ($35,400), payments under the CPP and OAS programs are a critical component of retirement income, providing approximately 40% of the income replacement. The income replacement ratios excluding CPP and OAS are quite low when pre-retirement income is equal to the YMPE. This reflects the common practice of integrating corporate pension plans with the CPP.

The income percentages have remained quite stable over time except for a decline for individuals with pre-retirement income equal to four times the YMPE ($141,600). The pension of an individual with this level of income is restricted by long-standing government legislation that limits the maximum pension entitlement to just over $1,722 for each year of service. For an individual with 35 years of service, their pension is limited to approximately $60,000 or 42% of pre-retirement income. Seventy per cent of the survey companies indicated that they were making promises to provide retirement income in excess of these limits. On average, these companies indicated that five per cent of their employees would become entitled to an excess amount. The survey provides support for our belief that this limit will gradually impact a greater number of employees until the government increases it.

Beyond the limit on tax assistance, a high income individual would receive little, if any, OAS due to the clawback. As a result, the income replace ratio when government plans are considered is actually just below 50%.

Retirement Income Predicated On CPP/QPP and OAS
For those with earnings at the YMPE ($35,400), payments from government programs are critical.
Pre-Retirement Income
Pension Replacement Percentages
 
1998
1996
1994
1992
Including CPP and OAS
YMPE
84.5%
83.2%
83.2%
82.3%
2 x YMPE
75.5%
71.5%
72.3%
70.0%
3 x YMPE
69.8%
69.0%
67.7%
67.0%
4 x YMPE
52.3%
52.1%
53.2%
58.9%
Private Pension Only
YMPE
45.5%
45.5%
45.1%
44.1%
2 x YMPE
56.0%
52.3%
53.5%
50.9%
3 x YMPE
56.8%
56.2%
55.4%
54.3%
4 x YMPE
42.6%
42.6%
43.8%
49.4%
 
INVESTING WITHOUT ADEQUATE KNOWLEDGE

Defined contribution pension plans continue to grow in popularity. The survey found that 21 of 67 (31.3%) of responding defined contribution plans replaced another form of pension plan within the past five years. This survey's findings are again consistent with the previous conclusion that it is the employees who are largely driving this trend, although management clearly perceives distinct advantages because 40 of 41 respondents indicated they had realized the anticipated benefits of their change to defined contribution plans. It will be interesting to see whether the popularity of these plans continues now that the markets have become much more volatile and less robust. Recent legislative changes, such as the pension adjustment reversal that provides extra RRSP room for individuals changing jobs, may also lessen employees' demand for defined contribution plans.

Respondents were asked to specify 1) investment categories available to them (money markets, bonds, equity, or other); 2) if available, the number of options within that category; and 3) percentage of assets in these areas. The results are shown in Table 3 where it can be seen that at least 53 of 73 plan respondents (72.6%) offer one or more of the following investment options: money market funds, fixed income, equity funds or balanced funds. On average, each plan offers 3.4 investment categories. Within these categories, multiple options are available to employees, at most 3.1 average options for equity investments. With respect to asset allocation, balanced funds attract the largest average allocation at 44.3%, followed by equity funds at 29.7%.

Where Does the DC Money Go?
Balanced funds attracted the largest allocation, followed by equity funds.
Investment categories available:
If yes, number of options:
If yes, what per cent of asset allocation:
 
Yes
No
Mean
Median
Mean
Median
Money markets
53
12
1.5
1.0
13.0
8.0
Fixed income
53
12
2.0
1.0
13.8
8.0
Equity
55
9
3.1
2.0
29.7
30.0
Balanced
57
9
1.7
1.0
44.3
42.0
Other*
33
26
2.0
1.0
20.9
8.7
* Of the respondents indicating "Other" investment categories, 12 reported GIC and eight reported foreign content funds.

These data suggest that employees are faced with a growing array of choices and are diversifying their portfolios into longer terms and balanced investments. If one assumes that one-half of the balanced funds are in equities, then it would suggest that defined contribution plans have approximately 50% of their assets invested in equities. This is likely an adequate level of exposure to growth assets to provide plan participants with a reasonable pension adjusted for inflation but these data do not give us insight into the relative level of investment performance of individual pension plan members.

The findings of the study in this area give rise to serious concern about the future outcomes of this expanding situation. First, a key characteristic of defined contribution plans is that the employees bear the risk and rewards associated with the investment performance of the plan's assets. Though employees should ensure that they obtain the education necessary to take on this onerous responsibility, many, if not most, may not fully understand this reality. Certainly, very few have the training necessary to manage even modest portfolios. Furthermore, employers may not be entirely free from liability if employees make bad investment decisions that result in little or no retirement income. This is potentially a highly volatile situation.

The survey findings support the belief that employees may be assuming risks without the necessary knowledge to make sound investment decisions. Just 40% (27 of 69) of those sponsoring a defined contribution plan offer introductory investment management seminars, and fewer than 20% offer intermediate level seminars. As for retirement counseling, more than half (35 of 68) respondents do not make this vital service available to employees. Yet, two-thirds (48 of 70) of defined contribution plans require employees to make their own investment choices, and a further 20% have a shared responsibility for those choices.

Clearly, there is a need for better investment training, particularly now that the markets are more volatile and slower growing, because inappropriate types of investments or allocations of funds will adversely affect an individual's retirement income. n

Ross Archibald is a professor, and Darroch (Rick) Robertson is an associate professor at the Richard Ivey School of Business at the University of Western Ontario in London
Transcontinental Media G.P.