DB or DC? There is no risk-free choice.

May 4, 2016 Steven Laird

Many defined benefit (DB) pension plan sponsors in Canada have either closed their DB plans to new entrants or frozen their DB plans to existing plan members and opened up defined contribution plans (DC) to their existing plan members and new entrants. In doing so, they feel they will get out from under the traditional DB plan risks. Instead, they’re trading one set of risks for another.  So let’s look at those trade-offs.

Defined benefit risks

In closing or freezing their DB plans, many plan sponsors cite reasons such as DB plans are too expensive, DB costs are volatile in that they increase and decrease abruptly from year to year, and in order to be competitive in their industry plan sponsors feel compelled to change because their competitors have already changed to DC.

"Both DB and DC plans have risks in their operations. Some are the same and some are different but neither plan is risk-free."
“Both DB and DC plans have risks in their operations but neither plan is risk-free.” Faisal Siddiqi, Principal and Consulting Actuary, Wealth Practice Leader – Canada

The underlying reasons for high and often volatile DB costs stem from interest rate risks (bond rates increasing/decreasing each year, creating a fluctuating liability target), investment risks (stock market and bond market over/under performance relative to expected returns), and mortality risks (generally from plan members continuing to have longer life spans than current mortality tables measure). There are other risks in the DB world but the three mentioned are the ones causing financial headaches to plan sponsors.  In moving into a DC world, many plan sponsors expect to feel relieved of these uncontrollable and expensive DB risks.

Defined contribution risks

However, the DC world has other risks which are not faced in a DB environment. In a DC world, plan sponsors also face three main risks. These risks are administration risks, communication risks, and governance risks.

The administration risks come from the daily, weekly, or monthly task of collecting employer and employee contributions, remitting them to the record-keeper, keeping a record of individual and total remittances, checking they were invested by the record-keeper in the right funds and in the right amounts, checking that members are enrolled properly, the paperwork is correct, beneficiaries are selected, and when members leave that they receive the right options and funds are transferred out promptly and properly. Inevitably, plan sponsors begin to feel the pressure of the constant administration risk in DC plans.

Then, they become faced with the communication challenge to plan members. Did their plan members understand how to invest their employer and employee contributions, do they know the risks they are assuming, do they understand the difference between bonds and stocks or what a target-date fund is and how it works?  Plan sponsors begin to see that communicating to plan members may require a multi-pronged media approach: pamphlets, websites, YouTube videos, one-on-one presentations, etc.  It has to be done otherwise plan members can always say, “I never really understood what I was getting”.

Third, the governance risk becomes more acute in a DC plan as sponsors establish pension committees and determine which funds to offer, the risks of each fund, meeting with investment managers, monitoring performance, and establishing lines of authority on which changes can and can not be made.

No risk-free choice

Both DB and DC plans have risks in their operations. Some are the same and some are different but neither plan is risk-free. Understanding the trade-off becomes an important part of the analysis in changing from one type of plan to another.

Your turn: What’s the biggest risk you face in sponsoring your retirement plan? Use the comment box below to tell us your story.

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