Hybrid Pension Plans Not the Best Answer

One of the key elements of the new collective agreements recently reached by the Canadian Auto Workers with Ford, GM and Chrysler is a “hybrid” pension plan for new employees. It has both “defined benefit” (DB) and “defined contribution” (DC) components. This hybrid solution follows a similar arrangement between Air Canada and the CAW reached in September 2011.

Hybrid pension plans appear to meet both employer needs for predictable funding and employee wishes for predictable benefits. But employers should look at a better choice: “target benefit” plans.

A few basics:

DB pension plans guarantee pensioners a specific benefit calculated by formula, usually based on past earnings and years of service. The employee knows what will be paid in retirement, but employer funding obligations are uncertain. Today’s low interest rates and volatile markets have exacerbated the uncertainty.

DC pension plans do not provide guaranteed benefits. Instead, contributions are made in predictable amounts. The pension that is paid is based on the accumulated contributions plus net investment returns. The employer has cost certainty, but the employee bears the investment risk.

Hybrid plans usually provide a guaranteed minimum benefit, or “floor” (the DB component) with a top up tied to a DC account.

Hybrid plans avoid the choice between the stark alternatives of DB and DC plans, but they may simply include the worst of both: the funding obligation for the DB component and the benefit to be received from the DC component are both uncertain.

In contrast, target benefit plans can combine the best of both DB and DC plans.

Under a target benefit plan, contributions are made at a fixed rate, the best feature of a DC plan. The plan also sets a “target” DB calculated with reference to a formula that the fixed contributions are intended to fund in full. That helps to provide the certainty in benefits enjoyed by employees in a DB plan.

As for the certainty in cost that employers want, the target benefit plan has built-in flexibility to deal with the vagaries of the market. If a surplus arises, contribution levels may be reduced and/or the target DB may be increased. If a deficit develops, contribution levels may be increased and/or a lower target may be established.

To make this work, target benefit plans are often jointly administered by equal numbers of employer and employee representatives, and sometimes also retirees. Joint administration ensures that members have a say in crucial decisions affecting their pensions.

Some Canadian jurisdictions allow single-employer target benefit plans, but further advantages can be gained with multiple employer arrangements: A larger asset base means that investment management and other services can be obtained at preferential rates, and members employed by a number of different employers can pool longevity risk to deal with the problem under DC plans of retirees outliving their savings.

Not every Canadian jurisdiction allows target benefit plans, and some of those that do impose additional requirements. Federally-regulated target benefit plans are subject to the regulator’s veto over decisions made by the plan’s administrators to deal with funding shortfalls. In Ontario, target benefits plans are not available to the vast majority of employees who are not covered by a collective agreement.

The good news for employers in BC is that the new Pension Benefits Standards Act (Bill 38), will allow single-employer and multiple employer target benefit plans. Bill 38 will also empower the administrator to reduce accrued benefits if the plan’s funding level requires it - without the need for prior regulatory approval.

Bill 38 is not yet in force but it should provide BC employers with a new option to bridge the DB and DC solitudes without the inherent limitations of a hybrid plan.

We will keep you posted as new regulations are passed and Bill 38 comes into force.