Pensions 

Historical Background and Trends

Up to 1980’s the majority of pension plans offered by corporations, Provincial Governments, Federal Government and their crown corporations to their employees where defined benefit registered pension plans. Employees remained with the employer for many years usually until retirement. The majority of these plans where set up in the 1950’s, 60’s and 70’s. When these plans where set up actuarial work was done to determine the life expectancy of the employees and their spouses. Actuaries determined the number of years benefits would have to be paid out for during retirement. The plan sponsor had all the risk, to fund the plan, invest the money, and generate returns on investment for the plan to be fully funded.

There are a number of different types of pension plans and hybrid solutions for a company to choose from. They can include: Group RRSPs, deferred profit sharing plans (DPSP), individual pension plans, defined contribution pension plans, defined benefit pension plans or a combination of different plan types. 

In company pension plans the employer is referred to as the plan sponsor and the employee is referred to as the plan member.

There two types of company pension plans in Canada they are:

1. defined contribution pension plans

2. defined benefit pension plans.

The funding formula for defined benefit pension plans is complex, it is a combination of different variables some of which are unique to the company's pension plan which includes:

1. 1. average age of employee,

   2. years of service with the employer,

   3. returns on investment of the plan assets,

   4. average annual earning over the last five years of employment prior to retirement, 

   5. actuarial assumptions (life expectancy).

With defined benefit pension plans the benefits are based on the years of service with the employer and their average income over five years prior to retirement. Defined benefit pension plans provide generous benefits to employees that remain with the employer for many years.

Defined benefit pension plans are far less attractive to employees that frequently change employers due to their funding formula that is based on years of service with the employer and five year average income prior to retirement. Defined benefit pension plans are also more restrictive in their plan design. If the employee has no spouse and dies prematurely all the pension assets of the employee belong to the pension plan. The only beneficiary option in the plan is the employee's spouse. There are some plans that do not provide spousal benefits to the employee.

The employee has the option to transfer their pension to their own individual plan, the amount they are able to transfer is known as their commuted value. Each plan has its own rules and conditions set out by the employer (the plan sponsor) as to when the commuted value can be transferred and the formula used to determine the amount of the commuted value of the employee (plan member).

Starting in 1980’s companies started to move to defined contribution pension plans. This was due to the changing marketplace of employees changing employers more frequently and the employers not wanting to take on long term liabilities to fund their employees' retirement. There are not many defined benefit plans left in Canada. Defined Benefit Pension Plans are offered by the federal government, provincial governments, crown corporations, unions, and some large corporations to their employees.

Defined contribution pension plans offer more flexibility to the employee when they change employment. Defined contribution pension plans allowed companies not to take on long term liabilities to fund their employee's retirement. The employee also benefited by having more flexible investment options to invest their pension plan contributions. The main reason why companies moved away from defined benefit pension plans to defined contribution pension plans is defined benefit pension plans where becoming underfunded forcing companies to make addition contributions to fund the shortfalls. In a denied contribution pension plan the company has no liability to fund the employee's pension benefits at retirement.

Problems in defined benefit pension plans started to occur and according to some studies 80% are still underfunded. There are two main reasons why they became underfunded. The first reason is when they were initially set up and the actuarial work was done actuaries did not anticipate that life expectancy would increase so dramatically forcing pension benefits to be paid out for longer periods of time during the employee's retirement. The second reason is investment returns and low interest rates. The decades of 1980’s and the 90’s where exceptional for the stock markets returns, the decade of 2000 was negative. In a low interest rate environment made it difficult if not impossible to generate returns on low risk investments like government bonds to fund pension liabilities. Pension plans were forced to take additional risk with investments in order to generate higher returns to fund their pension liabilities. As with all investments the higher the risk the higher potential returns or losses.

There are also horror stories like CanWest Global, Nortel and many others that became insolvent resulting in a reduction of pension benefits to their employees. The moral is there is no such thing as a pension plan without risk.

When planning ones retirement employees never anticipate that their defined benefit pension plan benefits will be cut or run out of money. Employees should not solely rely on their pension plan benefits for their retirement. A more responsible way to approach retirement is to start saving through other investment vehicles like RRSP’s, life insurance policies, non-registered investment accounts and tax free savings accounts. It is impossible to predict what a company will look like in 20 or 30 years there is always an element of risk.

Each situation is different and should be analyzed on a case by case basis. When a company goes bankrupt in Ontario the Pension Benefits Guarantee Fund insures their pension benefits up to a certain limit. As of the last report the Pension Benefits Guarantee Fund is facing solvency issues due to the number of claims. Looking forward we predict we are only at the tip of the iceberg of this problem. Employees need to take more responsibility to look after their retirement and become more pro-active in managing their affairs. 

At Stone-Hedge Financial we take the approach "plan for the worst case scenario and hope for the best case scenario".

Contact Us to Review Your Pension Plan Options

The information provided on this web site is intended for general information only. It should not be construed as legal, accounting, tax or specific insurance and investment advice. Clients should consult a professional advisor concerning their situations and any specific insurance and investment matters. While reasonable steps have been taken to ensure that this information was accurate as of the date hereof, Stone-Hedge Financial Group Inc. and its affiliates make no representation or warranty as to the accuracy of this information and assume no responsibility for reliance upon it.