Financial fairness and risk sharing central to making target benefit pension plans work

The Canadian Institute of Actuaries (CIA) has published a new report on target benefits plans (TBPs), which combine the features of defined benefit (DB) and defined contribution (DC) plans to create relatively unique financial arrangements that are gaining traction in Canada.

Entitled Balancing Act: Exploring Intergenerational Risk in Target Benefit Plans, the report looks at financial fairness in the plans, cost transfer, benefit accruals within a single generation, cost transfers across generations and addressing benefit payout disparities. It also discusses benefit smoothing and the ramifications of incorrect assumptions in valuation.

“Central to TBPs is the concept of intergenerational risk-sharing,” they write, adding that contributions and investments are pooled to create stable retirement incomes. “However, this approach raises concerns about fairness, equity and cross-subsidies between generations,” they add.

Intergenerational cross-subsidies 

“This paper delves into three types of intergenerational cross-subsidies within TBPs: implicit cost transfers, shifts in investment risk and temporal cross-subsidies. Our objective is to deepen the understanding of intergenerational risk within these plans, informing legislative policy development and facilitating transparent, equitable plan designs,” they write. “TBPs present a promising solution in retirement planning.” 

Within a TBP framework, they add, employer contributions and liabilities are limited to predetermined levels. Shortfalls are addressed collectively by retirees and employees through increased contributions or reduced benefits. “Notably under a TPB, investment and longevity risks are collectively shared among all members, distinguishing it from DC plans where individual members assume their own risks,” they state. “In cases of underfunding, the plan’s governing body may choose to reduce indexation, lower future benefit accrual rates or decrease accrued pension benefits.” 

Shared-risk pension plan model 

They note that New Brunswick was the first province to introduce a shared-risk pension plan model in 2012. “Several Canadian provinces, including Quebec, Alberta and British Columbia, followed suit by enacting TBP legislation and regulations between 2012 and 2015. However, the two largest pension jurisdictions, Ontario and the federal government, have not fully implemented these measures,” they add. 

The paper concludes, warning that TBPs require careful management of intergenerational risk.

“The design and operation of TBPs are crucial to their effectiveness. The determination of contribution rates, benefit adjustment mechanisms and flexibility in design play pivotal roles in shaping the outcomes of these plans. Legislative policies must provide a supportive framework that allows plan administrators and trustees the flexibility to tailor TBPs to their specific objectives while safeguarding against undue risk,” they state. 

“The declining phase of TBPs (also) calls for particular attention. As the plan matures and the number of active members dwindles, the focus must shift towards safeguarding accrued benefits for all members. Policymakers should explore risk transfer mechanisms to ensure the fulfilment of benefits accrued by members, even in challenging economic conditions.”