Editor’s note: This is the first article in a three-part series on what’s new in pensions.
The devil is in the details when a client’s employer decides to make a shift from a traditional, defined-benefit (DB) pension plan to a defined-contribution (DC) plan.
As a result of the most fundamental shift that such a change entails – the transfer of investing risk to the employee from the employer – clients and their financial advisors must ensure they are fully informed about the new plan and how it is administered. Otherwise, funding of your clients’ retirement may be inadequate.
“[With a DB plan], the investment risk used to … lie squarely upon the shoulders of the employer,” says Matthew Ardrey, consultant and manager, financial planning, with T.E. Wealth, a subsidiary of Industrial Alliance Insurance and Financial Services Inc., in Toronto. “Now, [the risk] lies upon the shoulders of the employee.”
Clients in this position inevitably will face greater uncertainty about their pensions than clients who continue to enjoy the guaranteed payout rates of DB plans. But clients with DC plans have lots of company. Between 1991 and 2006, the number of employees with DC plans in Canada’s private sector almost doubled, according to a 2009 Statistics Canada report. And that’s a trend that is likely to continue as more companies decide that they cannot afford the costs of funding DB plans. “That is a trend that we absolutely expect to continue,” says Alasdair Rew, national director, DB strategic solutions, Manulife Financial Corp. in Toronto.
The key challenges your clients face when they are moving to a DC plan arise on two fronts: ensuring that your clients appreciate that their pension income from employment now will be uncertain; and that the shift will require a full reassessment of how clients’ other savings and retirement income will fit together with their revised pension – and whether other adjustments should be made, such as altering asset allocations. You can help with both of these challenges.
As a starting point, your clients need to be aware that returns from DC plans depend upon several factors: the size of the contributions to the plan; the period over which the contributions are made; client decisions about investing risk and asset allocation; and the timing of the client’s retirement.
Although there are substantially more risks with a DC plan, clients faced with the shift from a DB plan don’t necessarily have to change their retirement plans radically, says Douglas Lamb, financial advisor with HollisWealth Advisory Services Inc. in Toronto: “A well-managed DC plan can support [an individual] as well as a DB plan.”
To make sure that’s the case, however, careful planning is required. The first step is to ensure that your clients pay attention to notices from their employer about the upcoming changes. These notices inform employees of key dates to be aware of during the switch and the actions that need to be taken, such as attending information sessions and monitoring of how the plan is performing.
“Announcements, employee session presentations and the employee enrolment packages,” says Rew, “are all really good documents for the advisor to get his or her hands on.”
The first priority is to understand the basic structure of your clients’ plans, as DC plans vary widely. “That’s the fundamental question,” says Jana Steele, partner, pensions and benefits group, with Osler, Hoskin & Harcourt LLP in Toronto. For example, a previous DB plan could be wound up completely or be closed to new members. Some employees may be given an option to continue accruing benefits in a DB plan while other employees may not.
You also will want to make sure your clients have a complete picture of the investments available under the plan. “[The more] information you can glean or get when you’re setting up these [DC plans], the better,” says Ardrey.
For example, you should ask about accessing the performance history of investment funds offered under the DC plan and their management expense ratios (MERs). These MERs often are significantly lower than what is available to most retail investors.
One of the most important decisions relates to funding. Most employers offer a range of employee contribution levels, which typically are 2%-6% of gross income and in addition to the employer’s contributions.
You and your clients should decide how much to contribute to their plan, generally through payroll deductions. You can fulfil an important function here by emphasizing the benefits of higher contributions, which usually are matched to some extent by funds from clients’ employers. Sometimes, it can be too tempting for clients to spend rather than save, Lamb notes: “They may decide they need a new car or a trip a little more than making those contributions.”
Taking full advantage of an employer’s matching rate can make a big difference in a plan’s overall growth. Says Ardrey: “[Clients] should take advantage of as much of this free money as [they] can.”
For example, a client making $50,000 a year who starts contributing to a DC plan at the age of 40 – with an employer’s basic contribution rate of 4%, an employee contribution of 5% and an additional employer match of 5% – will have a balance of $375,684 by the age of 65 (assuming a 5% rate of return and a 30% marginal tax rate). In comparison, the same client who makes no contribution and uses only the employer contribution of 4% will have a balance of $107,338 by the age of 65.
Referring to the difference in the two scenarios, Ardrey notes: “If you had someone who was even making $50,000, do you want $4,500 toward your retirement for free? Or should I just throw this [extra money] in the garbage? It’s very much a no-brainer.”
At the same time, you play a key role in helping your clients structure their new pension plan in combination with their other savings and investments. For example, Lamb says, the guarantees associated with DB plans give clients the comfort of knowing which basic living expenses will be covered in retirement, allowing clients to take a more discretionary approach – including higher risk – when it comes to their other investments.
However, DC plans may require a shift in your clients’ mindset: depending upon how a DC pension is converted at retirement, a client’s age at retirement and your clients’ other sources of income, your clients may need to take the opposite approach: more conservative choices for some investments outside the plan.
In addition, placing another portion of non-pension investments in a more growth-oriented strategy to mitigate longevity and inflation risks, with the level matched to each client’s individual risk levels, may be advisable.
Every client’s situation is different and his or her final decisions on asset allocation and risk levels in both the DC pension plan and other investments will depend upon the details of each client’s situation, says Ardrey.
For example, if a client is two years away from retirement, he or she probably doesn’t want to have 80% of his or her portfolio in equities. To help to gauge a client’s risk tolerance, Ardrey asks his clients how well they can sleep at night with a particular asset allocation.
At the same time, ultra-low risk is unlikely to achieve practical results. Says Ardrey: “[Clients] can’t just shove their money in a money market fund and expect that they’re going to retire [with the same income] at the same age as they would have under a DB plan.”
Showing your clients how their pension investments fit into their overall retirement plan can help to offset worries about inadequate income in retirement. For example, if a client already has a portfolio mostly concentrated in equities in a non-registered account, says Ardrey, then a good strategy might be to focus on fixed-income in that client’s DC pension plan.
Another consideration when selecting the investments for the pension plan is cost. DC plans generally allow members to take advantage of group purchasing power, which often means much lower MERs than otherwise would be available. As a result, Ardrey suggests, you may wish to consider selecting investment funds for the pension plan that might be more expensive if held in a private account.
Once a DC pension account is set up, a client can expect to be kept informed by the DC carrier via letters, as well as through pension account statements and a secured website regarding any changes in funds held in the plan.
In the March issue, we will examine recent court decisions affecting the laws pertaining to pensions.
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