The grand debate between defined benefit (DB) and defined contribution (DC) models has dominated the pension discourse in labour relations for most of the last two decades.
The main themes in this debate are familiar: employers want to avoid the risk associated with the uncertainty of DB funding requirements, while most workers want to avoid the risk associated with not knowing what they’ll have to retire on. Most employers these days prefer DC systems – that is, when they feel obliged to provide any pension whatsoever. (Keep in mind that almost 80% of private sector workers do not receive any pension benefits from their employer.) Most workers and their unions, conversely, are still fighting to preserve DB principles.
The outcome of this debate, however, is not being settled on grounds of the relative fairness or efficiency of the two approaches. Rather, the continuing trend towards DC plans reflects something more basic and unsavoury. In a labour market marked by chronic unemployment and desperation, combined with unprecedented global mobility and flexibility on the part of large employers, it is clear which side has the power to simply enforce its preferred outcome – whatever its merits.
The clear shift in economic bargaining power toward employers reflects both the state of the macroeconomy and longer-term structural shifts (such as globalization, de-unionization, and deregulation) in the economy and economic policy. In the pension world, the ascendance of employer power means that fewer private-sector workers receive any workplace pension benefits at all. And of those who do, a growing share is consigned to DC plans, with no clarity or security in their future pension benefit levels.
If anything, the wave of employers rushing to convert DB plans to DC (often by closing DB plans to new hires) is gathering momentum. Global firms like Vale and U.S. Steel are able to impose this outcome on unwilling workers, on pain of long work stoppages or disinvestment. Air Canada made it a defining issue in its troubled negotiations with all its bargaining units. Towers Watson reported this year that over half of major DB plan sponsors in Canada have already converted their plans to a DC structure (for current or new hires), and predicted that the DB model was reaching a “tipping point.”
The current deterioration in funded status in most DB plans (resulting from record-low interest and discount rates, lousy investment returns, and continuing actuarial shifts) will certainly further whet the appetite of remaining DB sponsors to reduce or escape the associated costs.
Ironically, however, the accelerating shift to DC plans is occurring just as many pension experts are acknowledging the many failures of individual-savings pension schemes. Honest advisors will recognize that converting to DC hardly solves the “crisis” associated with pension funding in the current challenging environment. It simply breaks that crisis up into many small, individualized packages, and then consigns them to individual retirees (who surely possess less resources and flexibility to address the resulting pressures than their former employers did). And many experts continue to emphasize the benefits of pooling and professional administration that are features of the DB system.
Former Bank of Canada Governor David Dodge, for example, concluded that “appropriately structured defined-benefit plans can do better” at mitigating pension risks than individualized systems.
There is another important economic truth that underpins the value of the DB system: it is more efficient at generating future benefits in the first place, regardless of how the costs and risks associated with those benefits are ultimately shared. Awareness of that underlying advantage has been lost in the current arm-wrestle between workers and management – a debate which has been focused on shifting the risk of pension funding, instead of focusing on how to minimize that risk and fund pensions as efficiently as possible.
A recent report from the National Institute on Retirement Security in the U.S. found that it costs 46% more to provide an equivalent monthly pension benefit funded through a DC model, rather than through a DB plan. There were several reasons for this increased cost, including the greater longevity risk associated with individual plans, inferior investment returns, higher expenses, and poorer portfolio diversification.
In the recent CAW submission to arbitrator Kevin Burkett regarding the outstanding issue of pension benefits for new hires at Air Canada, we performed a similar experiment, with similar results. Our actuarial consultants (Services actuariels Poulin, Inc.) constructed a model in which two alternative approaches were taken to delivering pension benefits, each funded from the same baseline premiums (an escalating premium structure with employees and the employer paying matching premiums that eventually reach 6% of pensionable earnings). Both simulations assumed an equal number of years of service (28 years of service, based on retirement under an “85 factor”), and was based on the current wage schedule for new hires.
Our results were startling. In a DB model, based on current actuarial assumptions, that premium structure delivers a monthly pension after 28 years of service worth $1,888 per month. In a DC system, in contrast, the individual bore higher management expenses, greater costs and risks of annuity purchase, and lower average investment returns (reflecting the documented tendency of individual investors to design sub-optimal portfolios). The monthly pension after the same years of service was only $1,338 – $550 per month less.
The fundamental economic efficiency of a professionally managed DB approach, capturing the benefits of pooling within and across generations, delivers 41% more “bang for the buck” than the individualized DC system. In other words, by maintaining a DB system, the CAW’s submission argued that the same employer premium as was proposed by Air Canada, could deliver a 41% larger pension.
Perhaps this striking evidence played a role in convincing the arbitrator in this case that the DB principle should be kept alive in some form for future hires at Air Canada. He eventually selected the CAW’s final offer in the process (the union proposed a hybrid DB-DC pension plan for new hires, in contrast to Air Canada’s all-DC offer). Based on actuarial assumptions, the new hybrid system will not ultimately cost Air Canada any more than the pure DC plan it was proposing – yet it will deliver a final benefit that is both more generous and more secure than can be counted on through an individualized saving structure. (Of course, in the union’s view a full DB model would be even better, in terms of its ability to deliver a bigger benefit, at the given cost, but that outcome did not seem attainable through the arbitration process at Air Canada, and so the union proposed the hybrid model as a compromise.)
In economic theory, there is a concept called a “Pareto improving” change, in which someone’s welfare is improved, with no loss in well-being for other agents in the economy. The inherent economic efficiencies of the DB model, by making it more affordable to fund pension benefits, clearly create the possibility for Pareto-improving outcomes.
Unfortunately, however, the no-holds-barred fight between labour and management over how to allocate the risk associated with pensions is overwhelming the deeper question of the underlying economic efficiency of pension funding. And because many employers today have the economic power to enforce their preferred outcome, over the objections of their workers, this conflictual process is producing an economically inferior outcome.
A growing share of occupational pension plans is moving to a system that is demonstrably less efficient in hard economic terms: failing to maximize the “output” from a given set of “inputs.” In this regard, fighting over how the pie (and the cost of that pie) is to be shared is producing an outcome characterized by a significantly smaller pie.
Intelligent people should be able to devise some kind of pension arrangement whereby the underlying efficiencies of the DB model can be retained, while the cost and risk associated with that model are managed and assigned in a fair and economically sustainable manner.
Honest analysts will acknowledge that the rush to DC conversion is going to leave many future retirees with an inadequate and unpredictable pension benefit – even as the cost and risk facing employers is reduced. This failure will obviously affect those retirees and their families, but it will also affect our whole society (by increasing the future economic burden on the public pension system, for instance).
Yet as employers happily exert their currently dominant bargaining power to restructure our workplace pension system in their favour, this cost is not being considered. Their drive to reduce their private costs is producing a less efficient system, imposing higher total costs on all of us.
(Jim Stanford is an economist with the Canadian Auto Workers, and a CCPA Research Associate.)