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Defined contribution plans see gains in popularity

Risks include inaction by members, possible litigation

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CHARLOTTETOWN, Prince Edward Island--Defined contribution pension plans are gaining popularity among Canadian plan sponsors, but they have their own inherent risks that employers must address, plan sponsors say.

Among the risks associated with defined contribution plans are inaction by plan members that could result in an inadequate retirement income and possible litigation related to low investment returns, plan sponsors said during the Assn. of Canadian Pension Management's annual conference Sept. 10-13 in Charlottetown, Prince Edward Island.

Financial market volatility and the impact that has on the ability of defined benefit plan sponsors to fix their pension contributions is the impetus for the movement toward defined contribution plans, observers say.

Canadian National Railway Co., for example, contributes about $100 million per year to its defined benefit plans, which are about 100% funded, said Jay Mann, senior adviser, pensions and benefits for the Montreal-based company. Projections have shown, though, that its defined benefit plans' funding levels could easily fall to 90%, which could force the company to contribute four times that amount to keep the plans fully funded, he said.

While the vast majority of CN employees remain in defined benefit plans, the company last year switched to a defined contribution plan for management and new hires, Mr. Mann said. "It's not just a passing trend," he said of companies switching to the defined contribution plans.

Defined contribution plans, though, have significant regulatory and legal risks, said Robert Landry, chief counsel, labor relations and human resources governance for Aurora, Ontario-based Magna International Inc., which has most of its employees in defined contribution plans.

Guidelines for capital accumulation plans--the majority of which are defined contribution plans--that govern the rights and responsibilities of plan sponsors became effective on Dec. 31, 2005 (BI, Dec. 19, 2005).

Although the CAP guidelines provided some clarity for managing defined contribution plans, they still carry substantial risks--namely the potential for an inadequate return on plan assets and the level of advice given to employees responsible for directing their pension investments, he said.

"There is a significant risk in DC that cannot be underestimated," Mr. Landry said.

Defined benefit plans, though, also have litigation risks that include potential shareholder lawsuits challenging the management of company pension plans and the costs involved with providing the benefit, Mr. Mann said.

"I believe the risks under a DB plan would most likely end up costing a company more than a DC plan," Mr. Mann said.

Plan sponsors can take steps to mitigate the risks in defined contribution plans, including providing employees with retirement planning information, Mr. Mann said. "If you want to mitigate your legal risk down the road, (educating employees) is something you should do," he said.

While CAP guidelines do not require member education, plan sponsors should educate their employees, said Shirley McIntyre, director of pensions for Calgary, Alberta-based TransAlta Corp., which introduced a DC plan in 1997. "I don't know if we should be responsible for it," she said. "I think we should do it."

Even when employers try to educate their employees on properly planning for retirement, they often find that employees do not attend information seminars, do not read the investment materials they are sent and do not take action to manage their pension funds, Ms. McIntyre said.

"We know what we should do and we're doing it, but it isn't working," Ms McIntyre said.

In response, plan sponsors can mandate attendance at information sessions, invite spouses to attend, test their employees' knowledge of retirement issues and reward attendance, she said.

Employers can also introduce better default options to counter the inaction of their employees, plan sponsors say.

Life cycle or target-date funds--mutual funds that automatically shift to a more conservative mix of investments as they approach a particular date--are the most appropriate default fund because "plan members are prone to keep doing whatever they're doing today unless some external force is presented to them," Mr. Landry said.

Pension plans have often utilized money market funds--mutual funds that are required by law to invest in low-risk securities--as their default options, but these funds will not meet the objective of providing adequate retirement income, he said. Magna's default option is now a life cycle fund because of its employees' tendency to remain in the default option, Mr. Landry said.

CN's benefits staff is attempting to change the default option from a money market to a lifestyle fund because of data that showed that 40% of its employees remain in the default option.

"That's just not acceptable," Mr. Mann said. "The downside to doing this is that employees become even more passive."

Plan sponsors also should limit investment choices in their defined contribution plans because if employees have too many options, they will default to what they consider to be the safest choice such as a money market fund, Mr. Landry said. But there is "no magical number" on how many options to offer to employees, he said.

Limiting investment choices, though, is not always in the best interest of plan members, particularly in the current workplace in which people frequently change jobs, Ms. McIntyre said.

If employees are only given one or two choices, they may be unable to manage the funds on their own if they leave the company, she said. "At some point, we have to stop looking after people," Ms. McIntyre said.