Defined-benefit (DB) pension plans often are viewed as the gold standard for pension plans. DB plans, when properly funded, promise a guaranteed level of pension income for the life of plan members, often with indexing for inflation. The need for individuals to save may be reduced.
However, the stability of the plan sponsor – generally, the employer – often is an overlooked feature. Public-sector DB plans are virtually incapable of failing because they are supported by taxpayers, but private-sector plans depend on the solvency of the plan’s sponsor.
And the ability of the plan’s sponsor to ensure that the plan is, and remains, adequately funded can be challenging, says Terry Kirby, senior vice president, institutional sales, with Franklin Templeton Investments Corp. in Toronto.
Commercial conditions may change, undermining a business. The actuarial assumptions that forecast the performance of the investments that fund the DB plan may be altered by a range of unpredictable factors, notes Heather Holjevac, certified financial planner and senior wealth advisor with TriDelta Financial Planners Inc. in Oakville, Ont.
These factors can include market conditions, credit and liquidity risks, and demographics. But, if the anticipated rate of return is not achieved, the plan can end up having an unfunded liability or a solvency deficiency, Holjevac adds, unless the plan’s sponsor funds the deficiency.
The current low interest rate environment also makes achieving DB plans’ portfolio return targets difficult, says Kirby. According to the Financial Services Commission of Ontario‘s 2015 Report on the Funding of DB Plans: “The solvency position of pension plans continues to pose significant challenges.”
A more recent pension plan solvency survey conducted by human resources consulting firm Aon Hewitt Canada found that the health of 438 Canadian DB plans declined slightly in the third quarter of 2016, with the median solvency ratio falling to 84.6% as of Sept. 29 from 85.4% as of June 30, in spite of relatively robust equities markets.
With so many unknowables, these plans are becoming less and less popular with employers. And that is creating uncertainty for clients who are enrolled in these plans.
In order to deal with the uncertainty, Holjevac typically forecasts her clients’ retirement readiness by simulating three scenarios: one with the full DB benefits, one without the benefits and one with reduced benefits.
David Ablett, director, tax and estate planning, with Investors Group Inc. in Winnipeg, suggests that the stability of DB plans can be assessed by reviewing the valuation of the plan as a going concern: these types of valuations periodically assess the solvency of a DB plan and their scope and processes are mandated by pension plan regulators.
In the event that a DB plan with a solvency deficiency is terminated or, in the worst-case scenario, the plan sponsor goes bankrupt, plan members still will receive a portion of their benefits. This is because the assets of a DB plan are segregated from the assets of the plan’s sponsor and cannot be accessed by creditors, says Ablett.
For example, Ablett explains, if the solvency ratio of the plan of a bankrupt plan sponsor is 85%, then “the benefits of plan members will be permanently reduced by 15%.”
Kirby, in referring to the bankruptcy of Nortel Networks Inc., a large, once prosperous firm, says members of Nortel’s DB plan still received a portion of their benefits, which ranged between 57% and 75% of their benefits based on whether or not they were members of a union and on their province of residence.
Whether or not plan members are concerned about the vulnerability of their DB plan, they can take the commuted value of their pension benefits. The commuted value of a plan typically can be taken when the plan member terminates active membership of the plan, retires, or leaves or loses his or her job.
But whether or not to withdraw the funds and embark on a different plan path with the commuted proceeds is not always a simple decision.
For example, says Ablett, plan members may choose to take the commuted value for the following reasons: they have concerns about the health of the plan sponsor; they have unique cash-flow needs; there is a need to leave money for dependents or survivors; they have serious health issues; or they leave the employment of the plan sponsor.
In cases in which spouses both have DB plans, one spouse may choose to take the pension and the other to take the commuted value.
However, the rules on taking the commuted value vary with different plans and legislation in provincial jurisdictions. For example, in certain cases, if a plan member is over age 55, or if he or she is within 10 years of retirement, the plan member may not be able to take the commuted value.
“Depending on where plan members work, they might not be able to get the entire commuted value of their pensions,” says Kirby. Generally, a portion must be transferred to a life income retirement account using an age-based factor and the annual payout, he says. Any excess amount can be taken in cash and is taxable.
“Taking the commuted value can seem attractive, but also can be potentially short-sighted,” cautions Kirby, given that returns then may be very difficult to predict.
Whether the money in a DB plan is withdrawn depends on how comfortable your client is with taking the risk to invest the funds on his or her own vs getting a defined benefit by leaving the money in the pension plan.
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