Target Benefit Plans. The Future of Sustainable Retirement Programs. June Aon Hewitt Consulting 2012 Aon Hewitt Inc. All Rights Reserved.

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1 Target Benefit Plans The Future of Sustainable Retirement Programs June 2012

2 2 Target Benefit Plans The Future of Sustainable Retirement Programs Table of Contents Executive Summary 3 I. Introduction 4 II. Sustainable Pensions 6 III. Business case for TB 10 IV. Defining TB 12 V. Implementing TB 16 VI. Standards review 19 VII. Conclusion 22 References 22 Contributors 23 Acknowledgements 24

3 3 Executive Summary As Canadians, we have reached a critical point in planning retirement schemes. Not only can individuals ultimately receive a pension for significantly longer than they contributed towards it, but overall, sustainable pension funding is increasingly becoming a challenge with which we must grapple. We define a sustainable pension plan as one that can consistently deliver, through both favourable and adverse circumstances, an appropriate range of benefits within an acceptable range of costs over the long-term. A sustainable approach to providing pensions is based on a solid understanding by all stakeholders of the risk factors involved. This, in turn, would work toward the key objective to avoid severe corrections to both contributions and benefits. The Target Benefit (TB) pension plan is definitely an idea that holds substantial promise for achieving sustainable retirement income for Canadians. TB is not a simple point on the design spectrum between DB and DC. This Guide demonstrates this by providing a detailed look at TB pension plans. A TB pension plan has fixed contributions, a target defined benefit formula and a benefits/funding policy that prescribes the methods for varying benefits based on affordability, with pre-set reserve levels and a pre-determined order of benefit adjustments. We distinguish TB from other sustainable approaches, the key difference being that TB pension plan contributions are set first, at a fixed level, and benefits are derived from what can be afforded by that contribution level, with the ability to adjust benefits as experience develops. A couple of real life examples provide color to the definition of TB by highlighting the operational and design considerations for designing and maintaining a sustainable TB plan, which are found throughout this Guide. The challenges of transitioning to a TB plan are typically more political or employee relations related in nature. The standards (pension, taxation, actuarial practice and accounting) applicable to pension plans are reviewed to examine their ability to accommodate TB plans. As TB is a plan feature or concept, not a new type of pension plan, most standards will primarily require clarification and attention to a few details rather than major modification.

4 4 Target Benefit Plans The Future of Sustainable Retirement Programs I. Introduction It s clear that operating inflexible programs within volatile dynamic systems inevitably leads to breakdowns and failure. This is what we have experienced in trying to deliver sustainable retirement programs using DB and DC tools in the dynamic and often chaotic economic environment of the past decade. A new economy calls for new tools and an adaptable approach. With the aging of the baby boomers, retirement and retirement savings plans are ever-present on both the minds of Canadians and the 6 o clock news, and have increasingly found their way onto the political agenda - no mean feat for any topic. This was evident with the Drummond Report in Ontario including pension plans in its analysis on ways to increase efficiencies in Ontario. Countless hours have been spent commenting on and analyzing what needs to be done going forward. This is clear from the pension review commissions in various provinces and the many papers commissioned by various experts. There seems to be unanimous agreement on the need for change, both changes to our public programs (i.e., C/QPP, OAS, GIS, etc.) and employment-related programs. However, there still remains a range of proposed solutions with a lack of consensus or preferred direction. Many employers, especially larger employers, both in the private and public sectors, still believe retirement savings plans to be an important part of their total rewards offering to their employees and are willing to actively participate in helping their employees towards a financially secure retirement. Because of the limitations of traditional DB and DC programs (discussed later in the paper), there has been a call for a new approach from many parties of a target benefit nature. The purpose of this paper is to bring a real and practical focus to this critical discussion on sustainable pensions, specifically the target benefit (TB) concept, drawing on the insights we have gained from in-depth analysis of the past 60 years of operating employer-sponsored pension arrangements as well as personal experience in working with TB solutions. We do not see TB as just another way of designing a pension plan a simple point on the design spectrum between DB and DC.

5 5 To be successful, a TB plan must encompass a holistic approach to sustainable pension management, using all three key levers: benefits policy, funding policy and investment policy. The following is an outline of how this paper develops the topic: Definition of sustainable pensions, with examples of what they can look like. The business case for the target benefit plan concept as a good model for sustainable pensions. What it takes to design a sustainable TB plan. Practical considerations for implementing TB. What do we hope to achieve in writing a paper such as this? Fundamentally, we believe that sustainable pensions are essential for the prosperity of our country especially in light of the general aging of the population. Those committed to Canada s future must push for structures and legislation that support affordable lifetime pensions that will endure in other words, sustainable pensions. We have the tools and market insights to find solutions and achieve sustainable pensions, where government, individuals, employers and society all can win. With tangible solutions within our reach, our goal is to educate ourselves on all the available options, and work together to help Canadians feel secure about their retirement years.

6 6 Target Benefit Plans The Future of Sustainable Retirement Programs II. Sustainable Pensions Retirement is still a novel concept for humankind and it continues to evolve. We have reached a critical point in planning retirement schemes where, in much of the world, individuals can end up receiving a pension for significantly longer than they contributed towards it. This was not the case when existing DB pension plans were originally designed and adopted. One of the most unfortunate problems with providing retirement pensions is that it is impossible to accurately assess the cost of that pension until it has been fully paid. The only thing we can be certain of is that all cost estimates done in advance are just that - estimates. Depending on the mode of pension delivery, it is highly likely that either: (i) in the case of DB, the actual costs will be different than expected, in or (ii) in the case of DC, the actual benefits will be different than expected. In any event, the effective securing of an expected pension involves an ongoing iterative process. In a DB plan, providing a high degree of benefit certainty for members can come at a high cost and with significant contribution uncertainty for those funding the benefits. Furthermore, there can be significant intergenerational inequalities as retired members continue to receive benefits whether or not the cost was adequately valued. The reverse holds true for DC plans where contribution certainty comes at the cost of complete benefit uncertainty. Interestingly, the uncertainties in these two situations arise from the same factors, including: a reliance on investment returns and interest rates, which are by nature volatile and which can turn out to be lower than anticipated, and an exposure to longevity risk. Defining Sustainability A sustainable pension plan, we submit, is one that can consistently deliver, through both favourable and adverse circumstances, an appropriate range of benefits within an acceptable range of costs over the long-term. To accomplish this, a sustainable approach to pensions will allow a pension plan to adjust both costs and benefits in response to actual experience, with the key objective that adjustments be infrequent and low in magnitude. The whole point of sustainability is to avoid severe corrections to both contributions and benefits. A sustainable approach to providing pensions would necessarily be based on the sharing by all stakeholders of the key risks involved. Furthermore, the governance structure of such a pension arrangement should consider the nature of that risk sharing arrangement.

7 7 Examples of Sustainable Pension Programs An excellent Canadian example of sustainability is the Canada Pension Plan. Over time, adjustments have been made to the funding, benefit and investment policies, based on regular long term projections of the plan s financial position. Changes have been made far enough in advance of adverse circumstances to materially influence the expected results. Another trend towards sustainable solutions we ve seen is with large jointly sponsored public sector plans in Ontario (commonly known as JSPPs) in their move away from automatic full CPI post-retirement indexation to a combination of some automatic indexation and some indexation contingent upon the funded status of the plan. Three plans that have gone in this direction are the Ontario Teachers Pension Plan, the Healthcare of Ontario Pension Plan and the Colleges of Applied Arts and Technology Pension Plan. In BC also, the large jointly sponsored public sector plans have moved to a more sustainable basis by rebalancing inflation-protection provisions to improve generational equity, removing/reducing post-retirement non-pension benefits, requiring higher employee and employer contribution rates, maximizing return on contribution dollars (through scale and minimization of dollars lost to profit taking entities such as fund managers and insurers), and adopting responsible investment management and risk management policies. Most recently, the Province of New Brunswick went through an extensive review of its pension plan system via its Task Force on Protecting Pensions, in collaboration with a number of union leaders. The result is a new pension model based on a well established Dutch Model (see below) that incorporates a number of measures such as increased retirement age, conditional indexing, a shift to enhanced career-average earnings, and higher contributions. Some of the measures will be incorporated over a 40-year period. The new model is initially applicable to four public sector plans and one private sector plan. A good example of how to define sustainable pensions can be seen in the recommendations found in what is commonly referred to as the Hutton Report from the UK. Lord Hutton of Furness was tasked

8 8 Target Benefit Plans The Future of Sustainable Retirement Programs with recommending the reforms needed in the UK to ensure the sustainability of their public sector DB pension plans. The deal on which he based his recommendations is summarized in the following table (see his report for further details) and provides a good glimpse into the characteristics needed for sustainable pensions: The Deal For Public service workers A good pension in retirement A defined benefit plan Accrued rights protected Fair process of change Better management of schemes For Taxpayers Fairer sharing of benefits of living longer Align pensionable age with longevity Fixed cost Greater transparency of cost Single legal framework Interestingly, the recommendations did not contain a shift from DB to DC. The focus of the recommendations consisted of de-risking the DB plan provisions by, for example: Shifting from a best average earnings approach to a career average approach Removing/modifying early retirement subsidies Increasing the pensionable age in line with changes to the state pension age Establishing a fixed cost ceiling Extending these conditions to regional government plans The Hutton Report contains several examples of innovative sustainable pension programs both within the UK and abroad, such as: John Lewis In 2008 the company made changes to its non-contributory final salary plan. A Life Expectancy Adjustment Factor (LEAF) was introduced as a means of sharing longevity risk with members prior to retirement. The LEAF adjustments are calculated annually in advance, with earned pensions adjusted accordingly. This change, along with several others, was agreed to by employees and their representatives before being implemented. Sweden In 2003, Sweden replaced its defined benefit career average system with a Notional Defined Contribution (NDC) system. Total contributions of 16% of pay (7.5% from employees) are credited to a notional account, which is then adjusted annually to reflect per capita wage growth and changes to specific economic factors. Upon retirement, the plan pays annuities calculated based on life expectancy at retirement.

9 9 The Netherlands The Dutch Collective Defined Benefit Contribution (CDC) model runs like a career average defined benefit program, but with the benefit risk being managed through: (i) the explicit funding of a 130% solvency target, and (ii) conditional indexing (i.e., indexing of earned benefits is suspended when the plan funded ratio falls below specified thresholds). Through the good times of the 1980 s and 1990 s, DB pension plans in Canada were transformed, with the unintended result of making them much riskier than expected. During those years, we saw a shift from career pay to final pay, enhancements to early retirement features and a movement from ad hoc to automatic indexing. Much of what is needed today to make Canadian plans more sustainable is to carve back the certainty of some of these past improvements that have turned out to be much more expensive than we ever could have imagined at the time they were implemented.

10 10 Target Benefit Plans The Future of Sustainable Retirement Programs III. Business case for TB While a TB plan is clearly not the only means of achieving the sustainability principles outlined above, it is definitely an idea that holds substantial promise in the Canadian context. In many respects, the traditional DB plan has been a 50-year experiment that we have finally begun to understand, while the traditional DC plan is a 30-year experiment that has yet to fully mature and from which we continue to learn. The need going forward is not necessarily to focus on DB versus DC, but, as we ve stated earlier, to focus on sustainability and the means to achieve it. TB is far from a new concept in Canada. Many of the principles on which TB plans are based have existed for years in the traditional multi-employer pension plan (MEPP). In the typical MEPP, the plan is provided to individuals who work in a specific industry and who can easily work for several of the employers engaged in that industry, even several in any given year. Contributions going in are fixed through collective bargaining (often stated in terms of cents per hour), with a targeted DB benefit in mind (often based on a flat rate per years contributed). However, MEPP legislation varies across the country regarding whether accrued benefits can in fact be reduced. In any event, a key feature of MEPPs is that they aren t DC plans; they provide a pooling of investment and longevity risk, which doesn t exist in DC plans. What the TB plan provides is the opportunity for a significantly better balanced risk management model than either traditional DB or DC plans can provide, and on a neutral basis concerning funding, accounting and tax standards. From a funding perspective, both DB and DC plans are heavily dependent on investment returns for their success. In recent years, however, we have seen weak equity markets combined with continually declining interest rates. DB plan sponsors have been unable to invest their way out of their DB pension problems, and DC plan members have been personally exposed to the same issues. Further, tax and accounting standards can end up favouring either DB or DC, to the detriment to the other design. This is less true with TB. While TB offers substantial opportunities for employers and plan members in many situations, there are situations that seem ripe for TB. In many cases, the ideal private sector situation is one where the employer: is suffering with poorly funded plan(s) and is contemplating getting out of DB;

11 11 isn t satisfied they can manage their pension risk primarily through their funding and investment policies and wants to make better use of benefit levers that could become available; has strong unions and/or a culture that limits the viability of a move to DC; is in an industry that has good prospects going forward. TB also has great potential for public sector situations where: the cost of the existing plan is becoming unsustainable for members and/or employers and intolerable for taxpayers; existing benefits have no levers for adjustment in adverse times; the scale permits effective risk pooling and cost efficiency; human resources requirements, and the nature of the career path, means there is a need for a compromise solution that involves something other than traditional DC. TB has its applications whether dealing with a single employer pension plan, a large jointly sponsored pension plan, or a broader more universal retirement system. Regarding the latter, proposals by both Brown & Meredith and Ambachtsheer regarding new broader retirement systems have contained a TB element as key to their proposals. TB should not be seen as the flavour of the day. Rather, it is one viable alternative for mitigating pension plan risk, and mitigating risk is crucial to providing sustainable retirement income. We can learn much from a close examination of the TB plan concept, as the principles required to effectively manage a TB plan are the same principles that are required for managing any pension arrangement on a sustainable basis. This section dealt with TB in general. The next two sections drill down into TB plan design, implementation and management.

12 12 Target Benefit Plans The Future of Sustainable Retirement Programs IV. Defining TB The TB approach involves fixed contributions, or a fixed range of contributions, similar to a DC plan, which are not expected to vary over time. Benefits are then based on what the plan is projected to be able to afford. In this way, contributions and benefits are directly linked in a way that doesn t currently exist in traditional DB and DC plans. Furthermore, the TB plan never has a deficit per se as the plan liabilities can never exceed the plan assets. Any identifiable surpluses not used to improve benefits are treated as reserves, providing a buffer against future adverse experience. No excess assets would ever revert back to the plan sponsors as their commitment to the plan is their fixed funding rate, and once made, the sponsors no longer have any direct interest in the plan fund. More specifically, key elements of a target benefit plan include: Fixed employer and/or member contributions. These fixed contributions can also exist within an acceptable narrow pre-defined range. Target DB plan formula, but without the same degree of risk as a traditional DB. This means less emphasis on (i) options where members can select against the plan, as with traditional subsidized early retirement or spousal benefits, and (ii) benefits that are both hard to cost and have greater volatility, such as indexing. The promise can also be constructed as a minimum guaranteed benefit and a target benefit that will be delivered if the plan can afford it. Margins built into the costing of the benefit options used in setting and testing the sustainability of the benefit levels; Benefit variability based on affordability with pre-set reserve levels and a pre determined order of benefit adjustments (both improvements and cutbacks); and Full integration of benefit, funding and investment policies. A TB plan has sometimes been referred to as a pooled DC plan, where members share the plan risks through adjustments to their benefits. Taking this view, member equity is of critical concern. Benefits design must take a hard look at member equity relative to the risks borne by the members. Embedded options where members can make choices that increase their benefits relative to other members need to be identified and considered carefully. For TB, the funding policy is a critical part of the overall plan design. The basic principle for the funding policy is that the benefit adjustments are to be minimal in terms of both frequency and magnitude. This means that there

13 13 is a deliberate and quantified margin in the contribution that is projected over a long period of time to be sufficient to maintain benefits at the current level and is projected using a range of sensitivity tests to be sufficient to maintain targeted benefits in a broad enough range of potential future scenarios. Should the TB plan experience an extended period of turbulent times, the TB approach gives the plan sponsor/plan trustees/pension committee a full dashboard of options to adjust benefit, funding and investment policies to maintain the plan in a sustainable balance. Before moving on to some Canadian TB examples we would like to distinguish what we mean by TB from another sustainable approach that can look and feel like TB but should really be treated as a separate category. In Section II we referred to some Ontario and BC JSPPs that had started to modify benefits going forward in order to improve the sustainability of their programs. We prefer to think of these as either managed DB or shared-cost DB as the contribution levels are a function of the benefits being delivered and if the cost of the benefits gets beyond certain threshold levels, that often are not defined in advance, then future benefits are scaled back. The key differences between this approach to sustainability and true TB is that under TB the contributions are set first at a fixed level, benefits are derived from what can be afforded by that contribution level, and there is an ability to adjust accrued benefits if necessary while the plan is ongoing. Maintaining a clear definition of TB will likely continue to be a challenge due to the lack of uniformity in pension legislation across the country. In Ontario s Report of the Expert Commission on Pensions a Target Benefit Pension Plan is defined as follows: Target benefit pension plans aim to provide a defined benefit but are funded through fixed contributions. If the fixed contributions are insufficient to provide the target benefits, the benefits may be reduced. MEPPs are typical target benefit plans. While this definition appears pretty clear, recent TB legislation doesn t present the same clarity. BC s recently revised Pension Benefits Standards Act defines a number of types of pension plans but considers a target benefit provision to simply be one where there is a formula by which the amount of the pension that is intended to be payable to a member and provides that the actual benefit under the plan may be reduced. There appears to be no mention of fixed contributions. Interestingly, the new Act contemplates conversions to target benefit provisions, with the details for such conversions set in the Regulations that have yet to be released.

14 14 Target Benefit Plans The Future of Sustainable Retirement Programs Ontario and Nova Scotia have taken a slightly different approach whereby a target benefit provision must conform to listed criteria to be considered such, including: The pension benefit must not be DC; The employer contributions are limited to a set amount outlined in one or more collective bargaining agreements; The administrator is authorized in the plan documentation to reduce accrued benefits without restriction, both while the plan is ongoing and upon wind-up; and Reductions of accrued benefits are not prohibited under the terms of any applicable collective agreement or pension legislation. Canadian TB Examples In looking at real life Canadian examples of TB plans, we see they have embraced many of the elements listed above. The University of British Columbia Staff Pension Plan has operated successfully as a target benefit plan for decades within the BC pension regulatory system. Resolute Forest Products (former Abitibi Bowater) concluded negotiations in 2010 concerning some employee groups resulting in the agreement to set up two new TB plans that will operate within Quebec s pension regulatory system, where the regulations for TB plans in that province are currently being finalized. The following table shows how key elements of these real life plans conform to the TB model: Design Element UBC Staff Pension Plan Resolute Negotiated TB Plans Member contributions Fixed percentage of pay Fixed percentage of pay Employer contributions Fixed formula based on pay Fixed percentage of pay Lifetime retirement benefits Based on final average earnings Based on final average earnings in one case and indexed career earnings in the other Unreduced early retirement Post retirement indexing Benefit variability Age 65, with actuarial reductions for earlier retirement Percentage of inflation based on plan's benefits/funding test (includes pre-retirement indexing) The plan margins have been sufficient that no benefit adjustments have been necessary, for almost 40 years, until January 1, 2012, when future indexing was reduced from 100% to 50% of inflation Age 60, with near-actuarial reductions for earlier retirement In one case, conditional based on solvency ratio and granted for only a single year; in the other case, none Benefit reductions will be made such that the plan would be expected to attain 100% solvency within 5 years after the adjustment. Benefit reductions can be reinstated once the plan attains a 100% solvency ratio plus the target reserve.

15 15 Running a TB plan is more complex than running a traditional DB plan. In our experience, the following criteria are recommended to maintain a sustainable TB Plan: From an operational and design perspective: Joint governance There are additional fiduciary risks associated with a TB plan if the employer manages it independently of members. Sharing of all plan risks between employers and members can be achieved only if all parties actively participate in the management of the plan in a meaningful way. Scale These plans need to be large enough to have meaningful pooling of plan risks as well as have the resources to handle the additional management costs. Regular ongoing monitoring The use of stochastic projection tools rather than typical deterministic actuarial valuation are critical to understanding how to test the pricing of the plan benefits and to determine reasonable margins and reserves. Distinct benefits/funding policy With fixed contribution rates, the funding policy should provide clear direction on margins to establish in the pricing of plan benefits and target reserve levels and should also specify trigger points for benefit adjustments. Equity-driven designs Intergenerational equity can be managed through a focus on career pay (vs final average), minimizing early retirement subsidies and having no subsidized spousal benefits. Cost-sensitive designs It is important that the TB design be based on conscious identification and decisions regarding allocation of plan costs. This might involve providing benefit indexing only nominally or on a conditional basis, or defining normal retirement age in terms that adjust with mortality improvements. Expanded member communication The nature of the deal warrants clear and ongoing communication, with the potential upside of much greater member engagement than in traditional DB and DC plans. From a regulatory perspective (see Section VI for more detail): Exemption from regular funding rules for traditional DB plans. Acceptance as a DC plan for pension accounting purposes Acceptance as a DC benefit for tax reporting purposes (i.e., pension adjustment) Be available outside of collectively bargained situations, provided certain governance-related criteria are met

16 16 Target Benefit Plans The Future of Sustainable Retirement Programs V. Implementing TB Talking and writing about TB is easy. Making it happen is another matter. Not to mention that innovation is seldom for the faint of heart. In this section we will expand on the two examples we highlighted earlier, the UBC Staff Pension Plan and Resolute, by illustrating how they ve succeeded and then provide general commentary on transitioning to TB from both DB and DC programs. UBC Staff Pension Plan The UBC Staff Pension Plan has a long history going back to Prior to that, staff were members of an industry DC plan. When UBC was forced to exit the industry plan, the fixed contribution nature of the arrangement was maintained, and the University opted for a traditional DB benefit. During the 1990 s the plan s administrators and advisors increased the focus on the sustainability of the plan by initiating affordability testing to avoid premature use of the surplus that had developed. The plan has evolved over time and key to the ongoing operation of the plan have been: Ongoing affordability testing, ensuring that projections show the fixed contribution level can be expected to sustain the target DB benefit in the vast majority of projection scenarios without benefit adjustments being required; Establishing a target reserve level, that would need to be reached before any benefit improvements could be contemplated. The purpose of the target reserve was to minimize the probability of a benefit improvement followed by a benefit reduction; Establishing a separate minimum reserve level, which, if not maintained, would trigger a modest benefit reduction. The purpose of the minimum reserve was to signal a small reduction on a timely basis, rather than be forced to make a larger reduction with a lower expectation of recovery. The vision and determination of the plan s administrative board and advisors, who in the late 1990 s pushed the envelope and were able to obtain special dispensation from the Canada Revenue Agency regarding the treatment of the target reserve in determining maximum surplus under the Income Tax Act ( ITA ). (Note that this is less of an issue now, given the recent ITA change to permit up to 25% of the liabilities as surplus.); Careful analysis of every benefit provision, to understand how plan costs were truly being allocated and make informed decisions on this allocation. As a result of this analysis, the plan was redesigned on a cost neutral basis in 2009 to improve lifetime retirement benefits for the majority of members while, at the same time, removing ancillary benefits that favored some members over others.

17 17 Resolute Forest Products The Resolute interest in TB arose out of a company restructuring situation where the new company going forward needed a more stable pension cost than that provided by its existing DB pension plans. But given the significant union presence, traditional DC wasn t a viable option. The DB benefits in effect prior to the adoption of a TB approach were kept in place and not converted to TB. Aspects of the TB design that were important to ongoing success included: A fixed contribution going into the plan; For the employees: maintenance of an adequate benefit level for current and new members; The creation of a safety margin in the pricing of the target benefit to increase the likelihood of being able to sustain the target benefits without reductions; There would be a natural increase in the margin inherent in the contribution rate based on the expectation that the workforce would get younger over time, resulting in a reduction in the underlying current service cost component of the contribution rate; A specific reserve for post-retirement indexing with clear rules on when and how indexing is granted; Joint governance with half of the Board of Trustees comprised of plan member representatives; Complete review of the investment policy to take into account the change in the nature of plan risks in moving from traditional DB to TB Transitioning from DB to TB There are several plan sponsors who have already started moving their traditional DB plan in the direction of TB. The most difficult challenges have typically been more of a political or employee relations nature, as opposed to plan design or funding. Thus far, in the absence of legislation that could potentially permit otherwise, the approach has been to start fresh with the TB plan going forward while accepting the fact that the plan sponsor has an existing responsibility for funding the traditional DB plan. An alternative is to consider wrapping a TB provision around traditional DB benefits accrued prior to the date of conversion. Sponsors seeking to limit their exposure to DB risk on a go-forward basis have the following options open to them: Close the plan to new members, while allowing existing DB members to continue earning DB pension benefits;

18 18 Target Benefit Plans The Future of Sustainable Retirement Programs Freeze the plan, with no further service accruals and perhaps no recognition of future earnings (where permitted by pension legislation); or Wind up the plan (although this option is not likely to be attractive as it would mean the TB plan is starting from scratch with zero assets and an insufficient base for plan expenses). Transitioning from DC to TB While conversions from DC to TB may appear more straightforward in terms of funding, the most difficult challenges again are based on politics and employee relations. A key issue concerns whether DC members would be willing to pool their assets in a TB plan, as, under DC, they have clear ownership of their personal portion of the fund. Without the transfer of a substantial portion of the plan s existing assets, the plan is unlikely to have the critical mass required to absorb expenses. The following is the approach we have taken with a DC to TB conversion that is currently under examination: Plan members automatically have their full DC account value transferred into the TB Plan. The DC account value is associated with a target pension through a table of factors that reflect margins comparable to the margins applied to funding of future service benefits. The table is subject to change on a basis identical to the treatment of future service benefits. There is no option to withdraw funds from the plan on conversion. However, it is proposed that members be offered a one-time choice to keep a percentage of their account value on a DC basis. When the member comes to retire, he can either use his DC account to buy additional pension, or transfer the balance out of the plan in a lump sum (subject to conditions under applicable pension standards). The member s benefit on termination will be no less than a refund of the initial account value transfer with interest. If an adjustment to target benefits is required, it is made consistently and equitably across all members and all plan benefits, for both future service and past service. However, no such adjustment, either up or down, is made to the portion of the past service benefit maintained as DC. Transitions to TB from existing programs will be highly dependent on TB pension standards regulations and the ITA. The challenges will expand considerably for multi-jurisdictional plans until there is consistency among TB standards across the country.

19 19 VI. Standards review While TB has garnered much appeal and interest, work still needs to be done to clarify all of the rules that would apply to it. In the balance of this section we look at TB from the perspective of various standards it would need to work within. Pension Standards Legislation TB is being promoted as a plan feature or concept, not as a specific and new type of pension plan. This means that the TB approach can be adopted for qualifying single employer pension plans, multi-employer pension plans and jointly sponsored pension plans, based on the regulations of the applicable pension jurisdiction. So far a number of pension jurisdictions have made commitments to introducing TB: Ontario enabled TB in Bill 120, which received Royal Assent in December Regulations defining how TB will operate are still to come; Quebec, we understand, is actively working on TB regulations to be released in 2012; Nova Scotia has incorporated the concept of TB in its new Pension Benefits Act, which received Royal Assent in December 2011, with final regulations still to follow; Federally, the regulator seems to be satisfied that the rules for negotiated contribution plans will be sufficient for TB; British Columbia released a restated Pension Benefits Standards Act in April 2012 with regulations to follow; and New Brunswick is amending its pension standards to introduce a form of target benefit plan it is calling shared risk pension plans. The revised standards create the opportunity to convert existing defined benefit plans and even change vested rights to escalating adjustments to a form of contingent indexing

20 20 Target Benefit Plans The Future of Sustainable Retirement Programs With the devil being in the details, the regulatory environment will have to cover a significant number of aspects of pensions, including: Definition of acceptable plan administrator Acceptable plan governance structures Whether allowed for a single employer Whether allowed outside of the collective bargaining environment Approach to actuarial valuations and reporting standards, especially for testing the sustainability of targeted benefit levels Application of the uniform benefit accrual rule Application of the 50% employer cost rule Methodology for determining termination transfer values Conditions under which accrued benefits can be reduced Variable normal retirement date based on changes to expected longevity Member communication standards Income Tax Act (ITA) The ITA currently only recognizes DB, DC and SMEPPs. Given that provincial legislation is not, thus far, treating TB as a completely new type of plan, it remains to be seen whether TB will need to have its own ITA regulations, or whether it could fit within the DB or DC rules depending on the nature of the TB feature. Specific issues needing attention and clarification include: Contribution limits It seems natural for TB to follow the DC rules as the concept of special payments that exists for DB doesn t exist for TB; Pension adjustment (PA) It also seems natural for the PA to be determined using the DC rules, provided that the plan operates under the TB principles as we ve laid them out in Section IV. If TB is allowed to operate under the DC rules then a number of other potential issues then would be automatically resolved, such as pension adjustment reversals (PARs), maximum DB benefit limits, and maximum tax-free DB transfer limits.

21 21 Canadian Institute of Actuaries (CIA) Standards of Practice (SOP) The CIA will need to promulgate standards on some of the regulatory matters where there is specific reliance on CIA SOP, the primary area being standards for commuted values. It is our understanding that the CIA s Actuarial Standards Board is looking at this issue and may provide commentary soon. It s worth noting that the CIA published an educational note on the financial risks inherent in MEPPs and TBs in May 2011 to support practitioners working with MEPPs and in recognition of the increased interest in TB. Accounting Standards Although there is a general movement towards IFRS accounting standards for private sector companies, there will always be situations that rely on other accounting standards, whether they be FASB or CICA, especially CICA standards for private enterprises, non-profit entities and public entities. While the general gist of pension accounting has always been fairly common among all of the accounting standards, there have been numerous differences. Accounting standards tend to be clear with respect to MEPPs and multiple employer pension plans as to whether they should follow DC or DB accounting standards. Without a doubt, employers undertaking a TB approach would want to be able to treat their participation in that plan under the accounting rules applicable to DC pension plans. While it remains to be seen as to what position the various accounting standards boards will take, our analysis of IAS, CICA and FAS indicates that TB would fit naturally in the DC definition for IAS and CICA accounting. The situation isn t as clear under FAS where it looks like TB could be treated as either DC or DB depending on the interpretation of different sections of the FAS standards.

22 22 Target Benefit Plans The Future of Sustainable Retirement Programs VII. Conclusion Simple solutions are seldom effective when dealing with complex problems, and few problems are more complex and have greater uncertainty than providing for sustainable retirement on a cost effective basis. In Canada, we have taken two relatively simple tools, DB and DC design, and regulated them to death but with little positive impact on actually delivering sustainable retirement systems. While it is time for change, we don t necessarily need radical change. We actually have the tools in place we just need to use them more effectively and permit more flexibility in their application. TB has great potential to achieve what we are all looking for: sustainable retirement income. References Addendum, Arbitration between Air Canada and National Automotive, Aerospace, Transportation and General Workers Union of Canada (CAW-Canada), Local 2002, in the matter of: Final Offer Selection Pension Arrangements for New Hires Ambachtsheer, Keith, C.D. Howe Institute Commentary, The Canada Supplementary Pension Plan (CSSP), May 2008 Aon, Restoring Retirement Security: Recommendations for Updating Canada s Pension System, 2008 Aon, FORUM July 10, 2008 Brown, Robert and Meredith, Tyler, IRPP Study, Pooled Target-benefit Pension Plans, Building on PRPPs, March 2012 Canadian Institute of Actuaries, Educational Note, Financial Risks Inherent in Multi Employer Pension Plans and Target Benefit Pension Plans, May 2011 Commission on the Reform of Ontario s Public Services, Public Services for Ontarians: A Path to Sustainability and Excellence, 2012 (the Drummond Report) Hall, Karen; Choquet, André; Milnthorp, Troy, The Long Run, Sustainable DB plans can provide a solution for Canada s pension woes, Benefits Canada, October 2011 Lord Hutton of Furness, Independent Public Service Pension Commission: Final Report 10 March 2011 (the Hutton Report) Report of the Expert Commission on Pensions (Ontario), A Fine Balance Safe Pensions, Affordable Plans, Fair Rules, October 31, 2008 The Association of Canadian Pension Management, ACPM Target Benefit Paper, March 30, 2012

23 23 Contributors Barry Gros Barry Gros is an associate partner in the Retirement practice of Aon Hewitt s Toronto office. His primary responsibilities cover the servicing of clients in all aspects of retirement plan issues as an account manager and lead actuarial consultant. Barry also provides Aon Hewitt s Retirement practice with significant thought leadership as a member of its Practice Development Council. He is responsible for identifying the immediate and future implications of trends and changes in legislation for Aon Hewitt s clients and is a key contributor to Aon Hewitt s external publications and seminars. Barry has over 30 years consulting experience. Barry graduated from the University of Winnipeg with a Bsc degree majoring in mathematics and minoring in sports coaching. After three years with a major life insurance company Barry completed two years of graduate studies in actuarial mathematics at the University of Manitoba. Barry is a Fellow of the Society of Actuaries, a Fellow of the Canadian Institute of Actuaries and a Certified Compensation Professional with WorldatWork. Karen Hall Karen Hall is an associate partner in the retirement practice of Aon Hewitt s Vancouver office. She has extensive experience consulting to clients in the design, implementation and administration of retirement arrangements. She provides pension and actuarial consulting services to Aon Hewitt clients in British Columbia and across the country. Karen has particular experience in the design of benefits and funding policies for Target Benefit pension plans and is also the chair of Aon Hewitt s national task force focused on supporting and bringing innovation to public sector pension plans. Karen has a BSc in Applied Mathematics and an MA in Leadership. She is a Fellow of the Canadian Institute of Actuaries (FCIA) and a Fellow of the Society of Actuaries (FSA). Karen has over thirty years of professional experience in the areas of pension actuarial consulting, flexible benefits consulting, senior management and HR leadership. Claude Lockhead Based in Aon Hewitt s Montreal office, Claude Lockhead is a Partner who plays a key role in Aon Hewitt s Investment Consulting and Retirement teams. He oversees the Eastern Retirement Team. Claude has extensive experience as a consulting actuary, primarily in the area of investment management and pension plan funding. He is also an authority in the negotiation of pension plans with joint trustee committees. He has been chosen by the Government of Québec to serve as a specialized arbitrator in disputes involving pension plan surpluses. Claude holds a Bachelor s degree in Actuarial Sciences from the University of Laval. He is a Fellow of the Canadian Institute of Actuaries (FCIA) and a Fellow of the Society of Actuaries (FSA). Troy Milnthorp Troy Milnthorp is an Associate Partner in Aon Hewitt s Saskatoon office. As a member of our retirement strategies team, Troy provides pension and actuarial consulting services to our clients locally and across the country. He is also a member of the national Public Sector Team and the Target Benefit Task Force. Troy specializes in the design and implementation of retirement arrangements for organizations and executives. He has a broad knowledge of accounting principles and methods for pension and other benefit plan costs under Canadian and International accounting standards. Troy has extensive experience working with the public sector in Saskatchewan in all different aspects of retirement. Troy graduated from the University of Saskatchewan with a Bachelor of Science degree (Honours) majoring in Statistics. He is a Fellow of the Canadian Institute of Actuaries (FCIA), a Fellow of the Society of Actuaries (FSA) and a former Council Member of the Canadian Pension and Benefits Institute, Saskatchewan Region.

24 24 Target Benefit Plans The Future of Sustainable Retirement Programs Acknowledgements We greatly appreciate the cooperation of the University of British Columbia Staff Pension Plan and Resolute Forest Products for allowing us to share some elements of their pension plans. About Aon Aon plc (NYSE: AON) is the leading global provider of risk management, insurance and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 61,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative and effective risk and people solutions and through industry-leading global resources and technical expertise. Aon has been named repeatedly as the world s best broker, best insurance intermediary, reinsurance intermediary, captives manager and best employee benefits consulting firm by multiple industry sources. Visit for more information on Aon and to learn about Aon s global partnership and shirt sponsorship with Manchester United.