Defined Contribution Savings Plans

Even with incentives, some Canadians don’t fully participate in these savings plans. Whose fault is that?

Recently we were asked to comment in a CTV interview on a report from a major seller of financial services, Sun Life Financial Inc., on defined contribution (DC) plans. A National Post article commenting on the report ran with the headline “Canadians losing out on as much as $3 billion in ‘free money’ defined contribution pensions.”

The ‘free money” arises from the offer of employers to match their employees’ contributions, often up to 3-6% of employee earnings. According to the report, over half of the employer contributions go unused because either employees do not contribute at all or because their contribution is less than the maximum. The article suggested Canadians were suffering from “inertia” and maybe they needed a “nudge”.

It is always pause for thought when the financial industry accuses Canadians of behaving badly. DC plan providers are in business to earn fees from the assets invested in these plans. Generally in most areas of commerce such as auto sales, for example, if a vehicle is not selling well, despite some discounts, then it is unusual for the auto dealer to blame their customers. Even odder would be for the auto dealer to suggest that new rules should be put in place to “nudge” prospective customers to step up and buy their product.

Here are some suggestions as to why some Canadians may not choose to make DC plan contributions even when incentivised by matching employer contributions.

They don’t have the money. Participation rates are lowest amongst the young and lower paid workers. If the choice is paying off debt or meeting car payments so they can get to work, then deferring participation may be unfortunate but necessary. It is worth remembering poverty rates are twice as high in the general Canadian population as amongst retirees. In fact, poverty rates amongst Canadian retirees are less than a third of poverty rates of the USA, Japan and Switzerland¹.
They don’t understand the product. We often advise clients who have workplace pensions and they are confused by the language and the choices they are asked to make. In a 2012 pension survey, 76% of DC (and similar) plan providers cited lack of member financial knowledge and understanding of the plan as a key concern².

The first challenge is that DC plans are not pension plans, but savings plans, a misconception repeated in the National Post headline. To call them pension plans invites confusion with defined benefit plans that provide a guaranteed income. There is no such guarantee with a DC plan, which should be grouped together with other savings plans such as RRSPs and TFSAs. Both defined benefit and DC plans set the amount contributed by the employee and contributions (with some limited exceptions) are locked in until retirement.

DC plans are not pension plans because there is no clear link between inputs: buying assets (usually mutual funds) and outputs: generating a pension income for life. This is explored in more detail here. How much an investor needs to save depends on how much income they want in retirement, when they retire and how long they are going to live. Of course, no-one knows how long they are going to live. Defined benefit pensions have an advantage over DC savings plans when dealing with this longevity uncertainty because they pool the risk amongst plan participants. Thus defined benefit plan participants who die early subsidize those who live a long time. DC plan contributors have to shoulder the risk of outliving their money.

Even if a DC plan participant is clear about their objectives, implementation can be a challenge. The DC plan participant is usually required to make perplexing choices, in some cases from over 100 fund options.

Typically there will be several pages of funds with cryptic names, for example:

LM Batterymarch NA Equity
JF International Fund C
CI Port Series Max Growth

Which funds or combination of funds is most appropriate is a complicated investment management question. Aside from figuring out the fees, performance, and what these funds actually hold, addressing the issue of building a sensible portfolio requires some understanding of the plan participant’s assets and liabilities, savings rates, volatility of their employment income and an understanding of their target retirement consumption, to name a few. DC plan providers typically provide information about individual funds, but the task of assembling all these raw ingredients into an appealing retirement meal is left for the plan participants to figure out.

It is as if you go to buy a car and have a set of requirements in mind (E.g. the ability to take 4 adults, plus a dog, to Windsor and back on one tank of gas) and the salesman only talks in compression ratios, brake horse power and the risk of the car being stolen in Toronto.

DC plans can be a useful part of a retirement strategy for many, and responsible employers will encourage participation. However, in their current form, there remains a significant gap between what they provide and what Canadians need to build a secure retirement. Don’t blame Canadians for that.

¹ See for example, “The Real Retirement” by Fred Vettese & Bill Morneau.
²2012 Canada’s Pension Landscape Report, Canadian Institutional Investment Network