DB vs. DC Pensions

72881 Views 183 Replies 37 Participants Last post by Eclectic12, Nov 30, 2011

Sampson

Discussion Starter · Oct 23, 2009 (Edited)

The series of articles in the Globe and Mail about the growing problem of underfunded public and private pensions has got me thinking.

Are DB really that good? I know from some of MDJ's posts that Federal Government Employees can get 70% of their average salary from their last few years of service, but I think that's rare. In my public pension plan, it appears that % of salary paid out are about 55%, 47%, 39% for 35yrs, 30yrs, and 25yrs of service respectively.

Given that my contribution rates keep going up (20% next year - half from employer), I was wondering whether I'd be better off with my employer simply giving me that money.

I made some preliminary models, and I'm actually finding it difficult to see an obvious benefit to the DB model. My rates of returns over the years of service were very modest (4-5%) - and considering many DB pension plans have severe penalties for early retirement, I'm starting to think I wish I had a DC plan (with similar rates of employer matching funds).

Taxes obviously play a major role, but lets assume all the money goes into an RRSP so is not taxed in either the pension, or in my own hands.

I'm I way off base here? Thoughts?

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MoneyGal

· #2 · Oct 23, 2009

You are focussing on one aspect of retirement income streams -- expected return.

In my view, this is not the appropriate way to evaluate whether you'd be "better off" with a DB or DC pension.

DB pensions protect against two three major risks to the sustainability of income in retirement -- longevity and Sequence of Returns. If they are inflation-adjusted, they protect against inflation risk as well.

MoneyGal

· #8 · May 26, 2010

AndrewF: yes. It is more expensive to purchase annuities privately than to get the same kind of longevity insurance through a DB pension plan, though.

MoneyGal

· #12 · May 26, 2010

The magical thing about DB pensions is that they are cheaper for employees to participate in and employers to buy.

Why? Forced participation.

People who buy annuities privately tend to be healthier than the population as a whole, which drives the price of annuities up relative to the longevity insurance provided by DB pension plans.

In a DB pension plan, *everyone* participates, whether they are long-lived or not, and whether they personally have no longevity risk aversion (and thus would opt out of the company pension plan if they could). And then those who die earlier (and stop receiving pensions) subsidize those who live longer than average.

No privately-purchased personal pension can ever match that. This is the same reason why CPP is a "good deal" for recipients, and pays more than a similar lump sum (the discounted value of CPP entitlements at retirement) would buy in the open market.

I think the "grass is greener" arguments arise because people compare two different things. If you look at longevity risk, DB pensions are a no-brainer winner. But if you are looking at retirement savings through an investing lens (not a longevity risk lens), all of a sudden DB pensions look "riskier" because the payout depends on an uncertain and random date of death (plus loss of liquidity, credit risk of the issuer, etc).

In addition, I think a couple of issues are being collapsed in this discussion: one is - which is the best way to save for retirement? And the other is, which is the best way to provide for a guaranteed lifetime stream of income once you are IN retirement?

I think these two questions need to be considered separately, and suggesting that somehow DB and DC pensions are "the same" or "there's no winner" is evidence of these two aspects being collapsed.

JMO.

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MoneyGal

· #13 · May 26, 2010

X-post with HC, who makes excellent points. An inflation-indexed annuity purchased at age 55 (especially for a woman) is staggeringly expensive and the true value of public sector pension plans is enormous.

MoneyGal

· #14 · May 26, 2010

An indexed pension of $50,000 for a 55-year-old woman costs about $1M today.

MoneyGal

· #17 · May 26, 2010

Sampson: the forced participation is a benefit to *everybody* in a DB plan during the accumulation stage. You only lose out if you die before 50% of your cohort.

And I don't know why you'd say "I don't know how these public pensions will fare" - they are backed by the strongest counterparty going, the one that can actually print money to back up the promise.

But yes, public sector pensions are not linear. They are among the only pensions that pay based on best five (or whatever) years of salary. So what that means is a clerk (for example) who started with a salary of $32,000 but finishes with a salary of (for example) $62,000 will receive a pension as if she had made contributions on a $62,000 salary for her entire career.

It's really a staggering benefit. The last actuarial valuation of the federal public service plan showed that at the then-current yield of 1.73% (on a RRB), the plan was worth more than 33% of pay. Discounting at today's rates (I usually use 2% to estimate a long-term inflation-adjusted rate) would produce a contribution rate of exactly 30%. That's the cost of the public sector guarantee.

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MoneyGal

· #19 · May 27, 2010

Yes, but:

1. public sector workers do not contribute 15% of the totals required to fund their pensions (because of the last-best earnings issue I described earlier) and

2. what 55-year-old female private sector worker earning $60-$65K do you know who has been able to build up a lump sum of $1M by making maximum RRSP and TFSA contributions?

MoneyGal

· #22 · May 27, 2010

CC: I have access to tools through work. I'm not aware of any free tools for these calculations.

MoneyGal

· #23 · May 27, 2010

Also: someone retiring at 55 cannot collect full CPP, because they will have too many "drop-out" years before the normal retirement age of 65. But yes, the comparison should be of total pension entitlements, not just public service pension. I was just throwing up one quick example though.

However, if you want to make an apples to apples comparison, you should only allow the private sector worker to invest in GICs or RRBs - something with no market risk.

MoneyGal

· #25 · May 27, 2010

Sampson said:
I'm not so worried that they will fail, I'm just more concerned that if the pension pool of money performs poorly, then to receive the same benefit, my personal contribution will continue to rise to fund those already retired.

Indeed; a concern you share with every taxpayer out there (civil servants included).

MoneyGal

· #27 · May 27, 2010

Andrew: you have no disagreement from me. But I am speaking (writing) in relative terms, not absolutes. All other factors held constant, I'd choose a public sector DB pension. (It's a moot point anyways; I have no pension plan.)

MoneyGal

· #32 · May 28, 2010

Both DB and DC pensions have market risk. The question is who bears the risk. In DB plans, the employer bears the risk - the employee does not.

MoneyGal

· #36 · May 29, 2010

bean438 said:
Kinda chips away at some of the gold plating of the DB.

No, the actuarial calculations take integration of the federal pension plan with the CPP into account. The gold-plating is still pretty solid.

MoneyGal

· #41 · Jun 1, 2010

What points of comparison do you want? Yours sounds like a very standard, non-public sector DB pension plan.

If you want to read more about other plans, you could take a look at this report from Mercer Canada - "How Does Your Retirement Plan Stack Up?"

MoneyGal

· #54 · Apr 15, 2011

Rob79 said:
I am on a DC plan at work and...the one nice thing about the DC plan...at least they can not threaten to change my payout half way through

They can't threaten to change your payout because they make no promise of any kind about the payout.

MoneyGal

· #60 · Apr 16, 2011

Pretty much only banks and railways have retained DB plans in the private sector. Everyone else is DC, if they offer any pension plan at all. I've never worked for a private sector employer who does.

MoneyGal

· #63 · Jun 15, 2011

Here's a recent, decent article from Malcolm Hamilton on DB pensions:

http://www.benefitscanada.com/news/db-not-affordable-anymore-hamilton-16463

Excerpt:

Between 1960 and 1979, the median Canadian pension fund earned a 1.5% real rate of return, and between 1980 and 1999, the median fund earned an 8% real rate of return. “These are profound changes.”

In the last decade (2000 to 2009), the median pension fund earned a 3% real rate of return. But while it’s not the 1.5% return of the ’60s and ’70s, Hamilton said that there’s a sense that things are still bad now. “We’re looking at 50-year low interest rates,” he said. “The DB plan is no longer affordable and never again will be.”

MoneyGal

· #67 · Jun 21, 2011

olivaw said:
Perhaps Malcolm Hamilton doesn't know that you should never say never. He's an actuary. Most actuaries are too smart to say "never again will be".

Hamilton is not the only person using "never" in this context. My own takeaway from this is that if a conservative (I don't mean politically), high-profile consulting actuary is using absolutes, I better sit up and pay attention.

I only quoted the interest rate part of that argument. The other part is life expectancy. Depending on who you read, you will see the arguments that DB pensions were never really sustainable from the get-go, and now a "perfect storm" of increased life expectancy and historic low interest rates mean the optical illusion of DB pension sustainability has been exposed for what it is.

MoneyGal

· #71 · Jun 28, 2011

HaroldCrump said:
So what makes the public sector DBPs (in Canada) more sustainable?
Or are they not?
It must be the same set of factors and parameters that they are up against.
What makes them different?

Because there is virtually no counterparty risk. The Government of Canada isn't going to declare bankruptcy (and if they do, you will have much bigger problems than a default on your government pension plan).

MoneyGal

· #89 · Jun 29, 2011 (Edited)

Well, for what it's worth, I have also written that the pension tango takes two - and there's no real guarantee if one of the partners can waltz off the dance floor. In fact, we even discuss Nortel by name.

http://www.irpp.org/po/archive/mar10/milevsky.pdf

Arguably Nortel's demise was severely hastened by their looming pension obligations. That is, had they remained solvent, they would have (continued to) bear the longevity risk for retired employees. We did get e-mail after writing that article that we were "too harsh" in our characterization of companies that "waltz off the dance floor."

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