Insights: Defined Benefit Pension Plans

In a galaxy far, far away, where economic forces clash and uncertainties loom, could defined benefit pension plans potentially emerge as Jedi Knights?

From a retirement planning perspective in Canada, the last few years have brought their share of uncertainty. This has created distinct circumstances and opportunities within the retirement benefits landscape:

• Defined benefit pension plans are back on the map. In my opinion, the current economic conditions and labor market make these times uniquely positioned to bring back lifetime pensions to Canadian employees and employers.
• The desire for defined benefit pension plans never left. Canadians consistently report a desire for predictable, lifetime retirement income.¹
• Financial security in retirement will stimulate the economy. Providing employees with employer-sponsored defined benefit pensions through efficient structures will allow Canadians to spend more today.

Recent years also have been characterized by economic trends, including the following:

• Volatility in the financial markets
• Increasing inflation that has resulted from supply chain disruptions, labor shortages and higher consumer demand
• Rising interest rates, reflecting the monetary policy responses of central banks to stimulate economic recovery and curb inflation
• Labor market shortages, creating challenges for employers to attract and retain skilled workers in a competitive environment

These trends affect plan sponsors as they have an impact on the funding status and risk exposure of pension plans and the retirement income adequacy of plan members. Current economic trends have resulted in certain challenges and opportunities within the retirement landscape in Canada that we will explore in this article.

Defined Benefit Pension Plans—In With the Old

Defined benefit pension plans were the traditional form of pension in the private sector for decades. However, over the last 20-plus years, private sector plan sponsors have closed their defined benefit plans and begun offering defined contribution plans to their employees.² Moreover, risk management frameworks were implemented to manage the existing defined benefit liabilities. These frameworks include:

1. Asset allocation strategies that aim to have assets and liabilities move in tandem.
2. Risk transfers through the purchase of annuities, thereby transferring a portion of a plan’s liabilities and assets to an insurance company.
3. Demographic and funded status metrics that trigger a plan wind-up, which involves terminating the plan and settling all the benefits with either lump-sum payments or annuities.

Over the last few years, rising interest rates have translated into plans having surpluses and implementing some of these risk management strategies. Since 2021, liabilities totaling almost $8 billion annually have been settled through the purchase of annuities of either ongoing or wound-up pension plans.³ As of Dec. 31, 2023, defined benefit plans registered in Ontario are estimated to be in surplus with a funded status of 119%.⁴

Jonathan Barry, a managing director and head of client solutions in the Investment Solutions Group at MFS Investment Management, described, in a conversation, these surpluses as an unexpected windfall, noting that such funded status positions enable plan sponsors to wind up plans with no additional cash contributions. “But plan sponsors should ask themselves, is that really the best thing to do with that windfall?” Barry said. “For many, the answer to that [question] is yes, but other plan sponsors may want to take a step back and look at another option. They may find a lot of value in the [defined benefit] plan they have in place.”

IBM’s Defined Benefit Pension Plan

In November 2023, IBM surprised many by announcing that effective Jan. 1, 2024, it would reopen its frozen defined benefit plan. IBM closed its defined benefit plan to new entrants in 1984 and froze benefit accruals in 2008. In fact, IBM is credited with being one of the catalysts of the mass exodus of defined benefit plans to defined contribution plans in the 1990s. IBM has since been providing defined contribution benefits—consisting of both employee contributions and matching IBM contributions—to its employees.

With this 2024 change, all IBM contributions will be remitted to the defined benefit plan to provide a cash balance benefit, while employee contributions (no longer required to trigger IBM contributions) can continue to be remitted to the defined contribution plan. At the end of the day, plan members will have access to lifetime income and an account balance.⁵

An IBM spokesperson noted, “By introducing this retirement benefit within IBM’s personal pension plan, which is stable and well-funded, IBM is able to provide a benefit to employees that also helps diversify their retirement portfolios.”⁶ Of note, in doing this, IBM also will be able to access the surplus within its defined benefit plan and use it in lieu of cash contributions.

IBM’s defined benefit plan is one of the largest defined benefit plans among U.S. publicly traded companies. Will IBM again be credited with being a first-mover within the retirement benefits space? A leading consulting firm has noted that they have been answering more calls about unfreezing or starting a new pension plan in the past year than in the past decade.⁷

Why Are Some Pension Industry Experts and Organizations Looking to Defined Benefit Plans?

Studies have shown that defined benefit pension plans increase employee tenure. In a tight job market, defined benefit plans can help retain experienced employees, reduce turnover and hiring costs, and maintain an organization’s culture and enterprise excellence.

Defined benefit pension plans provide lifetime income by pooling investment and longevity risks. Modern-day investment and plan design strategies could help manage much of the risk and related contribution volatility that employers were looking to do away with when moving to defined contribution plans. Barry says, “[Defined benefit] plans could be a key component in helping solve … retirement challenges.”⁸

How Have Current Economic Trends Affected Canadians and Views on Retirement in Canada?

Economic uncertainty, market volatility and the rising cost of living have greatly increased Canadians’ financial stress.⁹ Almost three out of four Canadians spend time each day thinking about their finances at work. The average Canadian worker who is financially stressed spends about 30 minutes each workday thinking about their finances. That sort of distraction impacts employers as well. The National Payroll Institute estimates that “workers worrying about their finances on the job … cost employers more than $40 billion in 2022.”

Moreover, only 29% of Canadians are confident in maintaining their standard of living in retirement, notwithstanding that maintaining a standard of living is the top priority at retirement.¹⁰ Therefore, it is no surprise that Canadians want a predictable monthly pension that will last a lifetime and keep pace with inflation.¹¹

Could Defined Benefit Pension Plans Be Impactful for Canadians and Canada?

Former Bank of Canada Governor Stephen Poloz says yes.¹² In one of his reports, Poloz states pensions will become more essential in an increasingly uncertain world. Poloz highlights Canadians’ lack of preparedness for retirement due to uncertainties surrounding life expectancy, income and investment returns. Growing volatility in the global economy further exacerbates these uncertainties and fosters a sense of insecurity. With governments facing fiscal constraints and political challenges, the responsibility for managing these risks will likely fall on companies and households. Poloz asserts that a resurgence of defined benefit pension plans could be a solution, as they provide a stable and secure retirement income, which mitigates various risks and uncertainties.

In lieu of shifting the risk from employees back to employers, one suggestion Poloz articulates is that large, professionally managed pension plans should oversee the pension assets and liabilities, as these plans leverage significant economies of scale, pool longevity risk and maximize investment diversification through access to a broad range of asset classes.

I believe offering lifetime income to employees will provide employers with a leg up in the marathon for talent. On their end, employees could potentially experience greater financial security at retirement, which, in turn, could enable more immediate spending and stimulate economic growth in Canada today.

Conclusion

Current economic conditions have opened a world of opportunities for pension plans. One viable option is a second look at defined benefit plans. The labor market crunch means employers will want to ensure distinctive advantages and tools for maximizing attraction and retention.

It seems to me that employees also could be looking at competitive differentiators, and lifetime income can provide not only that but also certainty that is comforting in uncertain times. This additional financial security at retirement could reduce financial stress, improve productivity and foster economic growth.

In the vast expanse of financial uncertainty, the “force” of defined benefit plans could bring retirement stability and security, and economic growth, to a galaxy far, far away—and to Canada!

Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.

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