Defined-benefit (db) pension plans, with their guaranteed benefits and cost-of-living protection, have long been viewed as the gold standard when it comes to workplace pension plans. But not anymore.
With investment returns under siege, as well as mounting corporate and government concern about the long-term funding and solvency of DB pensions, these plans are becoming both less common and of less value. Increasingly, private-sector DB plans are being replaced by defined-contribution (DC) plans, in which only the contributions are fixed.
In addition, more and more governments are looking for ways to scale back on who is eligible for a public-sector DB pension and are tinkering with attractive but very expensive features, such as annual indexing for inflation.
As a result, financial advisors are likely to see more and more clients with urgent questions about the future of their DB plans and what they should do if their company is switching to a DC plan. To make matters worse, the majority of clients don’t address the question of pension shortfalls until there is little time left to mitigate the problem.
“It’s been our experience that most people don’t worry about their pensions until they are getting ready for retirement,” says Ian Burns, a managing partner of The Pension Specialists in Whitby, Ont. “Then, all of a sudden, they run into issues because their DB plan may be running a huge deficit and liability. They suddenly realize that this pension plan that they thought would be there forever will not be there.”
In any case, failing to have the answers — on any type of pension question — can mean trouble for you as an advisor. Notes Monique Madan, an independent financial planner in Toronto: “Technically speaking, if you are not getting the right advice from an advisor, this could really mean a big error [in the pensioner’s financial future]. Even DB and DC pensioners need a relationship with someone who is a planner or an advisor.”
Although there are some well-known examples of employees losing most of their benefits under DB plans due to their former employer’s insolvency — Nortel Networks Corp. is still the Canadian poster child for catastrophes of this kind — many companies with DB plans are heading off the issue of underfunding in the future by switching to DC plans (which transfer the risks of managing the investments to the employee).
Some firms that offer DB plans are also encouraging employees who leave their companies before retirement age to commute the value of their pensions to a lump sum, which avoids the extended (and uncertain) liability of a DB plan. The commuted pension’s value thus is transferred to another tax-free registered vehicle and, generally, remains locked in until the (former) employee turns 65 years old.
The pension money then becomes more like a DC plan, in that the client must make the decisions about where the money should be invested.
As a result, many clients leaving a company with a DB plan may be looking for advice about whether to stick with their plan or undertake investing the proceeds on their own.
But pension details are nothing if not complex, and even the basics of a DB plan can be a challenge. Burns notes that many clients nearing retirement now are showing up in their advisor’s office with documents from their employer and asking complex technical questions about their plans, such as how the indexing formula works (if there is one) or whether or not they can use their pension to provide a legacy.
Burns says that it is key for you to obtain a copy of your client’s actual pension plan (not a summary), examine it and analyze the actual options available to your client: “Our experience has been that we have actually worked with companies and even actuarial firms where we have pointed out different pension options that the client has that the company didn’t know about.”
For instance, says Madan, DB plan members who are single and retired are at somewhat of a disadvantage if they want to leave a legacy because their pensions generally pay out only while they are alive. However, these clients can choose, at their own cost, to take a form of pension that provides a guarantee for five, 10 or 15 years, then select anyone they want as the beneficiary, including a charity or a friend.
Often, says Madan, the easier alternative is to advise these clients to take out a life insurance policy. “They don’t need to take the commuted value in order to have post-mortem control and leave a legacy to the next generation,” says Madan. “They can still get that reliable indexed pension payment and leave an estate by using a portion of their pension income to buy a life insurance policy.”
For clients with public-sector DB plans, the picture is more positive, as these plans are backed by taxpayers and are very unlikely to become insolvent. However, these plans are also undergoing change. Virtually every province has begun the process of making incremental changes to their public-sector pension plans that will result in lower benefits for the planholders.
So far, most of these changes relate to the “indexing to inflation” feature. Alberta, for instance, has made changes that will permit cost-of-living increases on pension benefits only when the funding of the plans permits.
And in both Ontario and British Columbia, some public-sector pension plans have been revised so that cost-of-living increases are not automatic but are based on the financial health of the pension plan — that is, whether or not it is fully funded from one year to another. As a result, billions of dollars in public funds have been saved. IE