Chapter 1 – Pension Plan Basics

1.1 Pension and Pension Plan

Pension is a contract for a fixed sum to be paid regularly to a person over the person’s lifetime, typically
following retirement from employment. In other words, pension is a stream of periodic amounts paid over
the lifetime of a retired person.

A pension plan is a formal arrangement set up by a sponsor in order to provide individuals (such as
residents or employees and their beneficiaries) with a lifetime retirement income. A sponsor can be a
government, a single employer, a group of employers, or a union. Private pension plans existed in the
United States and Canada as early as the late 1800s. The first industrial pension plan in the United States
was established by the American Express Company in 1875. The early pension plans were generally found
in railroad, banking, and public utility fields.

1.2 Economic Problems of Old Age

Longevity is a source of economic insecurity for individuals who may outlive their financial resources to
maintain their living expenses and/or those of their dependents. The extent to which an aged person will
have the financial capacity to meet self-maintenance costs depends on:
• The standard of living desired during retirement years,
• Employment opportunities, and
• Other resources (e.g., personal savings, social insurance, and inherited assets)

Standard of Living after Retirement

It has been generally assumed that the financial needs of an individual would decrease after retirement.
However, this assumption may not necessarily be valid in every retirement situation. Sometimes, personal
expectations and preferences may prevent any drastic change in one’s standard of living upon retirement,
especially for those retired persons who wish to remain fairly active. Another major factor preventing a
decrease in the financial needs of retirees is the likely costs of long-term care during old age.

Today. the trend in social thinking seems to be in the direction of not expecting retired workers to have
much of a reduction in standard of living after retirement. The effect of inflation also has militated against
a decrease in financial needs after retirement.

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Employment Opportunities
In the United States, the proportion of persons age 65 and over with some income from earnings is about
18% at the beginning of the 21st century.1 Many reasons account for the withdrawal of the aged from the
labor force. Voluntary retirement and the physical inability to continue employment might have been the
reasons for the decrease in the percentage of older persons participating in the labor force. However,
these are probably not the most important factors affecting employment opportunities for the aged. The
effects of industrialization, advances in digital technology and automation, and the existence of state
pension programs, private pensions, and other employee benefit programs2 probably have had a more
significant impact.

It is generally agreed that employment opportunities for older workers are more limited than younger
workers. However, this trend could change given the expected impact of population aging and the
potential shortage of certain segment of the workforce projected for the future.

Individual Savings for the Aged

If employment opportunities for the aged are decreasing and financial needs are still substantial at
advanced ages, the need for savings becomes quite apparent. However, studies indicate that a substantial
proportion of the homes owned by the aged are clear of any mortgages. Home ownership reduces the
income needs of the aged insofar as normal maintenance costs and taxes are less than the amounts of
rents required for comparable housing accommodations. Furthermore, there is the possibility that the
home can be used as an income-producing asset or that a reverse annuity3 can be used to provide cash
for living expenses.

In the United States, personal savings rates have been running at historically low levels in recent years.
There have been many forces at work that have restricted the growth of personal savings, e.g., increase
in contributions made to state or employer-sponsored pension plans relative to purely individual forms
of savings, increased expenditure for consumer goods, higher levels of income tax, etc.

Inflation is also a potentially serious threat to the income adequacy of persons who already are retired.
Although the last decade has experienced low levels of inflation, it is important to realize that heightened
inflation would erode the retirees' purchasing power.

1
Anthony J. Gajda and Morris Snow, “Long-Term Care,” The Handbook of Employee Benefits, ed. Jerry S.
Rosenbloom, 5th ed. (New York: McGraw-Hill, 2001), p.310.
2
Employers may be reluctant to hire older workers as they may be of the perception that older workers would
increase their expenditures on pensions and benefits substantially.
3
Under a reverse annuity, the home owner receives a lifetime monthly income in exchange for the title to the
home at the home owner’s death.

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Increasing Longevity
Another dimension to the overall economic problem of old age is the number of aged in the population.
The fact that life expectancy has been increasing is well recognized globally. In the United States, one
effect of the improvements in longevity since the beginning of the twentieth century has been an absolute
and relative increase in the number of persons aged 65 and over. In 1900, there were approximately 3
million persons aged 65 and over, whereas there were about 35 million such persons in 2000. The
proportion of the U.S. population aged 65 and over in 2000 was about 12.7 percent, whereas the
proportion of the population in these age brackets in 1900 was only about 4 percent.

The problem of old-age economic insecurity, therefore, is of concern to an increasing number and
proportion of the U.S. population. And this is also a problem faced by most of other developed countries.
In most countries, the problem of old-age economic insecurity is met through one or more of the following
means: personal savings, private and public pensions, as well as social assistance programs.

1.3 Types of Pensions

Pensions can be classified according to the types of pension providers.

Employment-based pensions (private pensions)

One type of pension is provided by employers for their employees in either the private or public
employment sectors. We call it occupational or employment-based pension. It is an arrangement
established by the employer to provide employees with a lump sum benefit or an income during
retirement upon their termination of employment. Often the plan requires the employer, or both the
employer and employees, to make contributions to a fund while the employees are still actively employed.
The fund is used to provide pension benefits when the employees retire.

In the U.S., the significant growth in private pensions has come around since 1940s. The specific factors
generally considered as having influenced this growth are:

• A systematic method of meeting the problem of superannuated employees can be justified on

sound business and management grounds. Due to advanced age, an employee may reach a point
where he or she experiences a decrease of productivity; that is, at some advanced age, an
employee’s contribution to the productivity of the firm may be worth less than the compensation
he or she is receiving. A formal pension plan permits employers to provide less-productive,
superannuated employees with an acceptable alternative to continued employment in a
nondiscriminatory manner, and the inefficiencies associated with retaining employees beyond
their productive years are reduced.
• Tax considerations provide financial incentives for the provision of tax-qualified pension plans.
• Union involvement has contributed to the growth in private pensions.
• Employers may be motivated to provide pensions in order to compete in recruiting and retaining
workers, or they may provide pensions to reward long service. At times, employers had been

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 encouraged to implement pensions by the marketing efforts of financial institutions (e.g.,
insurance companies, through agents, brokers, and their employee representatives in the
decades of the 20s and 30s; trust departments of banks, corporate trustees and asset managers
since early 1950s).

Social and state pensions

Another type of pension is directly provided by governments. Many countries have created retirement
plans to provide their citizens and residents with income when they retire (or in some cases when they
become disabled). This may require contributions to be made by citizens throughout their working years
in order to qualify for benefits later on. A basic type of state pension is a "contribution-based" benefit
which is determined based on an individual's contribution history. Examples are the Canada Pension Plan
in Canada, National Insurance in the UK, or the Social Security in the United States.

Many countries have also put in place a “social pension”, known as a non-contributory pension. These are
regular, tax-funded cash transfers paid to older people. Eligibility is based on age and citizenship/residency,
and sometimes subject to a means test based on income, assets or other resources. Over 80 countries
provide some forms of social pensions. Examples are the Old Age Security in Canada and the Universal
Superannuation scheme in New Zealand.

1.4 World Bank Conceptual Pension Framework

In 2005, the Word Bank published a report titled "Old Age Income Support in the 21st Century: An
International Perspective on Pension Systems and Reform", addressing the needs of diverse populations
to better protect the financial security for the elderly. Build on the three-pillar model presented in its 1994
report "Averting the Old-Age Crisis: Policies to Protect the Old and Promote Growth", the 2005 report
adds two more pillars: a universal or means-tested basic government pension not tied to contributions
and other sources of informal support. As such, the World Bank conceptual pension framework currently
comprises the following five pillars:

• Zero pillar - non-contributory basic pension plan financed by the state with the objective of
providing elderly people with a minimum level of income protection;
• First pillar - mandatory earnings-related public pension plans;
• Second pillar - mandatory earnings-related occupational or private pension plans;
• Third pillar - voluntary occupational and/or personal savings plans; and
• Fourth pillar - non-financial support including access to informal support (e.g., family support),
other formal social security programs (e.g., health care and/or housing), and other individual
financial and non-financial assets (e.g., homeownership, reverse mortgages where available)

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1.5 Arguments For and Against Pension Plans

Unlike the Hong Kong MPF system, in the United States or Canada, it is not compulsory for employers to
set up a pension plan for their employees. If it is not compulsory, why should an employer set up a plan?
Are there any incentives to establish and maintain such a plan?

Arguments for Pension Plans

Recruitment and retention of employees - Most employers recognize that they must establish and
maintain some form of employee benefit program in order to attract and retain desirable employees. The
existence of a good quality pension plan has proved valuable in giving employers a competitive edge in
recruiting and retaining employees when facing a tightening labor market.

Meeting competitive standards – Employee benefit programs are an important part of an employee’s total
compensation. They are highly visible and are readily subject to comparison with other companies in
similar industry in terms of benefit level and costs.

Optimizing tax benefits – Because of the high-income tax rates in Canada, tax is an important
consideration by employers when designing an employee benefit plan. Employer and employee
contributions to registered pension plans are tax deductible. Consider a simple example where
investments earn a before-tax return of 5% per year and the applicable tax rate is 50%. If the company
were to place $1,000 into a tax-qualified fund, after one year the fund would accumulate to $1,050 as
interest is non-taxable. If the fund is then paid as a retirement benefit, the after-tax proceeds would be
$525. If instead of contributing to a tax-qualified plan, the company pays $1,000 to the employee who will
only get $500 after tax. If this is then placed in a non-tax-qualified fund, the fund would earn $25 of
investment income, on which $12.5 would be owed as tax. The after-tax proceeds would therefore be
$512.50. By setting up a formal pension plan, there would be additional interest earned on company’s
contributions (difference between $525 and $512.50 in the above example) thereby resulting in a higher
retirement benefit. The additional interest would compound if the fund accumulation were extended over
many years.

Useful human resource tool - Certain types of pension plans (e.g., defined benefit pension plan discussed
later) would enable a company to retire older employees in an orderly fashion or to dismiss redundant
employees as a part of business structuring.

Alignment with company’s interests – Some types of retirement savings plans such as the deferred profit
sharing plan can be designed to improve the employee’s interest in the business objectives of the
company and, as a result, improve labor productivity. Most employers believe a benefit program, along
with other positive compensation and personnel practices, is an important factor in maintaining employee
morale at a proper level.

Social responsibility – When long-life careers in one company were still common, the employer felt that
it had a social responsibility to provide an adequate income to employees after they retire. This in turns
would lessen the financial burden on the society in general.

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Arguments against Pension Plans
Not all employers would want to set up a formal pension plan for employees. For instances,

• Some employers may prefer to use their available cash to reinvest in their own business, where the
potential return could be higher than invested in a pension fund.

• Some employers are discouraged by the high administrative costs and efforts required to comply with
complex pension legislation.

• There are societal developments toward a greater emphasis on the individuals as being responsible
for their retirement provision. By providing employees with sufficiently high cash compensation and
with various tax incentives available to savors, employees should be able to accumulate adequate
retirement income through savings of their own.

In Canada and the United States, there has been a trend of placing increasing responsibility on individuals
to save for their own retirement. The risks associated with retirement provision are progressively shifted
away from the employer toward the employees.

1.6 Defined Contribution versus Defined Benefit Plans

Traditionally, an employer has two broad choices in selecting a plan to provide pension benefits. One of
these is the defined benefit (DB) plan, which promises employees with a pension at retirement,
determined according to a fixed formula (which usually depends on the employee’s service and/or pay.)
The second choice is the defined contribution (DC) plan, which provides a pension benefit at retirement
that is dependent upon the amount of contributions made to an individual account set up for each
employee and the investment returns earned in that account. A defined contribution plan can require a
specific contribution rate be made on a periodic basis (as in a money purchase pension plan), or it can
take the form of a profit sharing, thrift or voluntary savings.

In recent years, some employers have adopted plans that combine certain features from DB and DC plans.
They are referred to as hybrid or combination plans, which may include target benefit, defined ambition,
cash balance, and other hybrid arrangements.

Defined Benefit Plan

The pension benefit provided by a defined benefit pension plan is determined by a fixed formula that can
incorporate the employee's pay, years of employment, and other factors. A simple example is a "Dollar
Times Service" plan design that provides a certain pension amount per month for each year of the
employee’s service. For example, a plan offering $100 a month per year of service would provide a pension
of $3,000 per month to a retiring employee with 30 years of service. This type of plan is popular for
industries that employ trades-people (e.g., electricians, carpenters, etc.). However, Final Average Earnings
(FAE) formula remains the most common type of defined benefits that are offered in the public sectors of
Canada and the United States. In FAE plans, the pension benefit is determined based on the average salary

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over the last few years of an employee's career. Another type of defined benefit is the career average pay
(CAE) formula where the benefit is based on the employee's pay over the entire period of employment,
e.g., 1.5% of total career pay.

In the United Kingdom, pension benefits provided under defined benefit pension plans are typically
adjusted for inflation after retirement. In Canada and the United States, only public sector pension plans
and few larger corporate pension plans provide inflation-adjusted benefits. Inflation during an employee’s
retirement erodes the purchasing power of a fixed dollar pension; the higher the inflation rate, the lower
the purchasing power of a fixed pension amount as time lapses. Indexing is advantageous for the
employees since it protects the purchasing power of pensions to some extent.

Many defined benefit plans include early retirement incentives to encourage employees to retire early,
before the attainment of normal retirement age (typically age 65). Some of those incentives come in the
form of additional temporary or supplemental benefits, which are usually payable from the early
retirement age to the normal retirement age.

The "cost" of a defined benefit plan cannot be precisely calculated. It can only be estimated using actuarial
assumptions. These assumptions include the retirement age chosen by employees, the expected lifespan
of pensioners, and the interest rate or investment return expected to be earned by the pension fund.

Illustration: Determining the Value of a Pension

If you are entitled to a pension and you want to exchange the pension for a lump sum amount, what
should that amount be? There is no unique way to determine the value of a pension as it varies
depending on the purpose of the valuation. Unlike tradable assets such as stocks or bonds, there is no
public market for trading pensions and so there is no readily available market value information.

One approach of determining the value of a pension is to calculate the present value of the future
payment stream, but what interest rate should be used for discounting. In a way, pension is similar to
a bond in that both pay a periodic fixed amount to its holder. On the other hand, pension is different
from bond in that the period for payment is uncertain. The payment period under a pension is
contingent upon the survivorship of the pension holder (and if applicable, the holder's beneficiaries),
which is not known in advance. Typically, actuaries calculate the present value of an immediate pension
using two assumptions:
• A discount rate that varies depending on the purpose of measurement4; and
• A mortality assumption that reflects the life expectancy of the pension holder.

In the context of an employment-based pension plan, plan members earn a pension benefit as they
render their service to their employer. The accrued pension benefit (i.e., earned pension) is not payable
until the member terminates employment and the actual amount payable is dependent on the terms

4
Some examples of measurement purposes are: contribution budgeting, defeasance or settlement, market-
consistent measurements, etc.

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and conditions of the pension plan. Consider a simple pension plan that provides a fixed dollar pension
of HK$400 per month per year of service.
Simple example
Pension formula HK$400 per month per year of service
Form of pension Single life annuity payable from age 65

Member data at date of valuation:

Sex Male
Attained age 40
Years of service 10

Actuarial assumptions:
Interest rate 6%
Pre-retirement death or termination None
(12)
Life annuity at age 65- 𝑎̈ 65 10, based on 6% interest and some mortality table

Calculation of actuarial present value of accrued pension

Accrued pension at date of valuation = $400 x 10 = $4,000 per month
Actuarial present value (PV) of accrued pension =
(12) 1
𝑣 65−40 × 25𝑝40 × [$4,000 × (12 × 𝑎̈ 65 )] = 1.0625 × [4000 × 12 × 10] = 111,839,

where 25𝑝40 = 1.
Notes:
• Actuarial present value is dependent on the interest and mortality assumptions used:
o Lower interest rate gives rise to a higher value
o Lower mortality (i.e., longer life expectancy) gives rise to a higher value
• The value of benefit accrual exhibits a J-shaped pattern: The value of accrued pension grows
slowly early in an employee’s career but accelerates rapidly starting in mid-career due to:
o The shortening period for interest discounting as the employee is close to retirement,
o The decreasing likelihood of leaving the pension plan as the employee is close to
retirement, i.e., less discount for pre-retirement decrements if such an assumption is
used
Implication: This means that it would cost more to provide the same amount of pension to older
employees than to younger ones.

Take home exercise:

Using the above assumptions, compute the actuarial present values of the pension benefit earned by
an employee from working an additional year at ages 30, 35, 40, 45, 50, 55, 60 and 64 under the
particular plan. Graph the change in the actuarial present value of accrued benefits from an additional
year of service against the employee’s age. What conclusions can you draw about the pattern of benefit
accruals under a defined benefit plan?

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Contributions from the employer, and sometimes also from plan members, are invested in an asset pool
(i.e., a pension fund) toward meeting the payment of benefits. The future returns on the investments, and
the future benefits to be paid, are not known in advance, so there is no guarantee that a given level of
contributions will be enough to meet the benefits. Typically, the funded status of a plan is regularly
reviewed in an actuarial valuation by comparing the plan's assets and liabilities, carried out by an actuary.

In a defined benefit pension plan, investment risks and rewards are typically assumed by the
sponsor/employer and not by the individual plan participants. If a plan is underfunded as a result of
unfavorable experience relative to the assumptions made in the valuation, the required contributions will
increase. In some cases, the employer may not have the financial resources to meet the increased funding
requirements of the plan. For the DB type arrangement, the benefit is relatively certain but the level of
employer contributions is relatively uncertain even if it is estimated by a professional actuary. This has
serious cost and risk implications for the employer offering a DB pension plan.

Criticisms
As mentioned earlier, the defined benefit plan design (because of their typically uniform benefit accrual
rate and the decreasing time for interest discounting as people get closer to retirement age) tends to
exhibit a J-shaped cost pattern of benefit accruals. The present value of accrued benefits grows quite
slowly early in an employee's career and increases significantly from mid-career onward. This means that
it would cost more to fund the same amount of pension for older employees than for younger ones (this
is known as an "age bias" phenomenon). In addition, defined benefit pensions tend to be less portable5
than defined contribution plans, even if the plan provides a lump sum cash payment at termination. Last
but not least, DB plans pay the retirement benefits as a life annuity, so the risk of low investment returns
or the risk of retirees living longer than expected is borne entirely by the employer. The open-ended
nature of these risks to the employer is the main reason why many employers have chosen to discontinue
their defined benefit plans and switch to a defined contribution plan in recent years.

The age bias, reduced portability and open-ended risk make defined benefit plans only suited to employers
with large and stable workforces, such as the public sector (which also has the support from taxpayers).
Defined benefit plans are sometimes criticized as being paternalistic as they are designed on the
assumption that employees would remain in employment with the same employer until retirement. They
are not considered to be suitable for today’s highly mobile workforce.

Defined Contribution Plan

In a defined contribution pension plan, contributions determined according to a fixed formula (usually a
predefined percentage of a member’s pay) are paid into an individual account for each member. The
contributions are invested, for example, in a combination of stocks and bonds, and the returns on the
investment (which may be positive or negative) are credited to the individual’s account. Expenses
associated with plan administration are also allocated to and deducted from individual member accounts,

5
Portability means the member’s ability to transfer his or her benefits and rights from one private occupational
pension plan, or public social security program to another.

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unless they are directly paid by the employer. On retirement, the member’s account is used to provide
retirement benefits, either in a lump sum or through the purchase of a life annuity.

In the past, it was thought that defined contribution plans were administratively costly because of the
individual account record keeping required and because many transactions (e.g., withdrawals, changes of
investment choices) that could take place. However, changes in pension legislation, particularly the
imposition of actuarial filing requirements and comprehensive member communications as well as the
plan termination insurance provisions of the law, have caused the administrative costs of defined benefit
plans to increase to the point where they may, indeed, be more expensive to administer than typical
defined contribution plans. Because of the lower cost of administration and the ease of determining the
employer's funding requirement (which is predefined by formula and can be determined without the
assistance of an actuary), defined contribution plans have become increasingly more favored by
employers, especially those in the private sector. In fact, defined contribution plans have become
widespread all over the world in recent years, and are now the dominant form of new pension plans
established in many countries. For instance, the number of defined benefit plans in the US and the UK has
been declining very significantly over the last decade. More and more employers have disbanded and
replaced their long-standing defined benefit plan with a defined contribution plan.

In a defined contribution plan, investment risks and rewards are assumed by each employee
participant/retiree and not by the sponsor/employer. In addition, participants do not necessarily purchase
annuities with their savings upon retirement, and are thus exposed to the risk of outliving their retirement
assets.

The "cost" of a defined contribution plan is readily calculable, but the benefit for an employee depends
upon the account balance at the time the employee is looking to convert the accumulated assets to a
lifetime income. So, for this type of arrangement, the contribution is known but the benefit is unknown
(until it is converted into a life annuity).

Despite the fact that the participant in a defined contribution plan typically has control over investment
decisions, the plan sponsor still retains a significant degree of fiduciary responsibility over investment of
plan assets, including the offer of investment options and the selection of fund trustees and administrative
providers.

Advocates of defined contribution plans point out that each employee can tailor the investment portfolio
to his or her individual needs and financial situation, and make the choice of when and how much to
contribute, if anything at all. However, others indicate that most employees might not possess the
financial literacy to make the correct investment choices or have the discipline to regularly save for
retirement. In recent years, many employers have sponsored programs in an attempt to educate their
employees about basic investment principles, with the hope that this will make their employees better
investors of their retirement assets.

The following table provides a summary comparison of defined benefit plan and defined contribution plan.

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 Attributes Defined Benefit Plan Defined Contribution Plan
Who assume investment Sponsor/employer Plan participants/ Employees
risks/rewards?
Cost to fund pension Cost not known in advance – Cost readily calculated based on
estimated using actuarial predefined formula, no age bias
assumptions. Cost more for
older employees than for
younger ones (“age bias”)
Benefit certainty Benefit is known and relatively Benefit is unknown and depends
secure (back-stopped to a upon account balance at the
certain extent by government in time an employee is looking to
the US and the UK) use; risk of outliving
accumulated assets
Investment decisions Controlled by Participants typically have
sponsor/employer; participants control over choice of
are not involved in making investments for their accounts
decisions on investment of plan
assets
Portability Some plans allow participants to Individual accounts are easily
transfer the present value of portable
accrued pension out of the plan
upon termination before
retirement; pensions in pay are
not portable

Discussion question: Assume that you are an employee aged 25, and you are given a choice of
participating in either a defined benefit plan or a defined contribution plan. The most recent actuarial
valuation on the defined benefit plan determines the employer’s annual cost for current service to be 6%
of each participant’s pay, the same as the rate of contribution paid to the defined contribution plan by
the employer. Which plan would you prefer to join? Describe how you made the evaluation and any
assumptions required.

1.6 Retirement Income Adequacy

Replacement ratio is a measure of retirement income adequacy. It is defined as a person's gross income
after retirement, divided by his or her gross income before retirement. Assume someone earns $60,000
per year before retirement and he or she retires and receives an old age pension of $45,000 from the
government and other sources. The person's replacement ratio is 75 percent ($45,000/$60,000).

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Generally, a person needs less gross income after retirement as saving for retirement and work-related
expenses are no longer needed. For countries with a social security system (for example, the United
States), social security taxes would end at retirement and social security benefits may be partially or
fully tax free. This reduces taxable income and, therefore, the amount of income needed to pay taxes.

A replacement ratio formula may take into account changes in age- and work-related expenditures after
retirement, in addition to taking into account savings patterns and changes in taxes after retirement, as
the following example6 shows:

Gross pre-retirement income $60,000

Pre-retirement taxes - 10,967
Pre-retirement savings - 2,225
Changes in expenditures at retirement +/- 115
Post-retirement taxes + 49
Retirement income needed = 46,972

Replacement ratio (46,972÷60,000) 78%

Another formula is a "tax and savings" model which disregards age- and work-related expenditures. A
third formula is a "tax only" model which disregards both savings and changes in age- and work-related
expenditures.

1.7 Plans with Defined Benefit and Defined Contribution Features

Traditional defined benefit and defined contribution plans have their respective advantages and
disadvantages that may or may not meet the needs of the employers and employees. Some employers,
finding it difficult to tweak the design of traditional defined benefit and defined contribution plans to
meet the unique needs of their employees, have responded by offering their employees a choice between
a defined benefit plan and a defined contribution plan. Others have begun turning to a hybrid plan design.

Hybrid plan design blends the attributes of traditional defined benefit plans and defined contribution
plans in an effort to meet the sponsor’s risk-sharing objectives that may be difficult to achieve with a
traditional defined benefit or defined contribution design. A hybrid plan may provide a pension of one
type subject to the minimum of the other type. For example, a hybrid plan may provide a pension benefit
derived from the member’s defined contribution account, subject to a minimum benefit of, say, 1% of
final average 3-year earnings for each year of service. Other hybrid plans include:

Cash balance plan defines the basic benefit in terms of the contributions accumulated in a
notional account credited with a specified rate of interest. The balance may be paid as a lump
sum at retirement or converted to a life annuity at specific rates. As with defined benefit plans,
investment risk during the accumulation phase is largely borne by the plan sponsor. As with

6
Source: Replacement Ratio Study - A Measurement Tool for Retirement Planning, by AON Consulting Inc., 2008

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 defined contribution plans, benefits are expressed in the form of notional account balance, and
are usually paid as a lump sum upon termination of employment. The portable lump sums and
relatively early accrual of benefits under the cash balance plans are attractive to employees who
terminate at younger ages and with fewer years of service, while employees with long service are
likely to receive less benefits than a defined benefit plan with comparable cost. Some employers
in the U.S. offered this type of plans in the 1990s but they are not common in Canada.

Target benefit plan is a defined contribution plan designed to resemble a defined benefit plan.
The fixed rate of employer contributions is determined to achieve a target retirement income
based on reasonable actuarial assumptions. However, the target benefit may be reduced if the
accumulated fund assets and expected future contributions are determined to be insufficient to
provide the target level of benefits. Therefore, unlike defined benefit plans for which the
employers bear the entire risk of pension provision, members of a target benefit plan would
assume the risk of investment and demographic losses. As a consequence of global financial crises
and the dramatic decline in long-term interest rates, many defined benefit plans in Canada and
the United States have become significantly underfunded and are considered to be increasingly
unaffordable by their sponsors. Target benefit plan is seen as a promising alternative to defined
benefit plan for achieving sustainable retirement incomes.

Recent developments
In 2021, the UK Government introduced a new Pension Schemes Bill to create a legislative framework for
a new bleed of pension plans, known as Collective Defined Contribution (CDC) plans. CDC is a form of
target benefit plans that merge some elements of defined benefit plans with the basic principle of defined
contribution plans.

In CDC, investment and longevity risks are placed with the members but unlike in DC they are pooled and
shared among the members. Also, CDC differs from the traditional DC plans in that it does not produce
an individual member account but pays out a regular but variable retirement income to retired members
from the collective fund. A high-level comparison of CDC against the existing forms of occupational
pensions DB and DC is presented in the table below.

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 DB DC CDC
Longevity risk With the employer With the members, With the members,
individually shared collectively
Investment risk With the employer With the members, With the members,
individually shared collectively
Pension level Promised (may be A function of individual Target level
guaranteed by account balance and
government up to a spending strategy Not a promise. Actual
certain extent) pensions can be higher
or lower depending on
Does not depend on investment returns and
longevity outcomes and longevity outcomes
investment returns

1.8 Terms and Conditions of Pension Plans

A formal pension plan has two main features:

1. The plan contains provisions stating how the pension and other benefits are determined, together
with the terms and conditions under which the benefits will be payable; and
2. Financial arrangements are made to provide the funds needed when benefits fall due, usually by
building up assets in a trust fund or an insurance contract.

This section outlines the principal terms and conditions that must be included in a plan text document,
together with the choices and considerations involved in designing the plan. The considerations will vary,
depending on whether the pension plan is a defined benefit, a defined contribution or a hybrid plan,
whether the plan is single employer or multi-employer, and whether the employer is in the private- or
public-sector.

The principal provisions for pension plans include the following:

• Eligibility;
• Pension formula;
• Pensionable or credited service;
• Employee contributions (for "contributory" plans);
• Retirement age;
• Normal and optional forms of pension;
• Death benefits before retirement;
• Termination benefit;
• Disability benefits; and
• Inflation protection.

Each of these provisions is briefly described below.

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Eligibility – determines what class of employees and the date on which an employee may or must become
a member of a pension plan. Most pension standards legislation in Canada requires that employees be
eligible for plan membership after two years of employment.

Pension formula – defines how pension benefits will accumulate during employment. Employer will
determine the pension formula based on an acceptable level of income replacement for its employees. In
designing the pension benefits, considerations will be given to cost, benefit adequacy and
competitiveness.

Pensionable or credited service – period of service for which the employee will earn pension benefits.

Employee contributions
• Employees are required to contribute under a contributory plan. Contributory plans are common
in Canada mainly because employee contributions are tax deductible; in the private sector,
employee contributions tend to be in the range of 3% to 5% of earnings.
• In the case of a non-contributory plan, employer pays the full cost of benefits.

Retirement age
• Normal retirement age is the age specified in the pension plan at which the employee has the
right to retire on a full pension. In Canada, the typical normal retirement age is 65, for both men
and women.
• Early retirement age – a member may retire at an age earlier than the normal retirement age. In
Canada, an employee has a right to retire at any time within 10 years of the normal retirement
age. The early retirement pension may be of equal value, determined on an actuarial basis, to the
normal retirement age pension. A plan may otherwise provide an unreduced pension on early
retirement or an early retirement pension subject to less reduction. A plan may also provide a
bridge benefit on early retirement. A bridge benefit is a temporary life annuity payable from the
early retirement age to the normal retirement age at which the social security benefits commence.

Normal and optional forms - A pension plan must specify the normal form of pension that will determine
what benefits, if any, an employee’s spouse or beneficiary will receive when the employee dies after
retirement. A plan may provide a pension payable for the lifetime of the retired employee, with a
minimum guarantee that if death occurs within a certain number of years after retirement, the pension
will continue for the balance of the period, e.g., life annuity with a 10-year term certain. In Canada, a
registered pension plan must provide a joint and survivor annuity that pays upon the death of a retired
member a pension to the surviving spouse not less than 60% of the pension payable to the retired member.

Death benefits before retirement – A pension plan must define what benefits, if any, an employee’s
spouse, beneficiary or estate will receive if the employee dies before retirement. In Canada, the typical
pre-retirement death benefit is the present value of the pension benefit that would have been payable to
the plan member if he or she had terminated employment at the date of death.

Termination benefits – A pension plan must define the benefits and rights of the employee upon
termination of employment other than by death or retirement.

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 • In a contributory plan, a terminated member is always entitled to a benefit that has a value
at least equal to his or her own contributions with interest.
• Vesting – refers to the right of a terminated member to the portion of the pension benefit
provided by employer contributions. In Canada, the typical vesting requirement is 2 years of
plan membership.
• Locking-in – means that the member cannot withdraw any employee or employer
contributions or any portion of the pension benefit in cash after a certain retirement age.
• Portability – means the transfer of the pension benefits and rights to another pension plan or
retirement vehicle. In Canada, a member who terminates employment prior to eligibility for
early retirement has a right to portability.

Disability benefits – A pension plan may specify what benefit provisions to apply to an employee who
becomes disabled. If such benefit is provided, the plan should contain a clear definition of “disability”. If
employees are not covered by some form of group disability insurance plan, the pension plan can be
designed to provide an immediate disability pension.

Inflation protection
• Before retirement – Final average earnings plans provide an implicit inflation protection up to
the date of retirement. Career average earnings and flat benefit plans do not compensate for
inflation prior to employee’s retirement unless the benefits are updated from time to time.
• After retirement – Post retirement inflation adjustments are designed to compensate, in full
or in part, for the loss of purchasing power associated with the pension in pay. A plan may
provide increases to pensions according to a wage or price index – e.g., 1% increase in pension
for every 1% increase in the consumer price index (CPI). Some pension plans provide ad-hoc
cost-of-living adjustments (COLA), instead of automatic indexation, with no promise of further
future increases. This is popular among employers since the related costs are within the
employer’s control.

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1.9 Trends in Employment-based Pensions
Private sector employers are exiting the traditional defined benefit pension plan domain en masse. The
number of single employer DB plans and the number of active participants in the United States began to
fall in 1984 and continues to fall steadily thereafter.7 It is projected that there will be no active participants
left by 2036. The total of DB plan assets has reached a plateau (as of 2020) and will soon begin to decline.
The situation in the U.K. and Canada is similar.

An aging workforce, declining interest rates8 and poor investment returns of the early 21st century have
convinced many employers to terminate or freeze their DB plans. Small employers, in particular, see no
advantage to maintaining a DB plan. Such plans are much more complex, both to administer and to
communicate to employees. The administrative cost, on a per capita basis, can be much higher for a small
DB pension plan than for a small DC pension plan. In addition, it is difficult for small employers to bear
the longevity and investment risks in a DB plan. The swings in required annual employer contributions can
be overwhelming for a small company with limited cash resources.

For private sector employers, DC-type arrangement has become the dominated form of retirement
provision. Employees are required to bear the burden of risks that are difficult for them to manage. Both
the longevity and investment risks are borne by the employer in a DB plan and both are shifted to the
employee in a DC plan. In particular, longevity risk is a difficult concept for most workers to grasp. It
probably won’t be appreciated fully until retirees with primarily DC plan benefits begin outliving their
retirement savings and are forced to rely almost entirely on governmental benefits like Social Security.

Likely, different employers will find different solutions, depending on their mix of occupations, turnover,
human resource goal and corporate culture. In the public sector and multiemployer space, some solutions
may involve target benefits, longevity pooling and intergenerational sharing of investment risks. Others
may adopt retirement plan designs in which investment and longevity risks are shared between the
employer and employees. DC plans may involve personalization of retirement income planning advice,
using big data techniques and employee records.

7
https://www.dol.gov/sites/default/files/ebsa/researchers/statistics/retirement-bulletins/private-pension-plan-
bulletin-historical-tables-and-graphs.pdf
8
The 30-year Treasury bond rate fell from well over 10 percent in the early 1980s to under 3 percent in the last
few years. As a result, the cost of a pension guaranteed to be paid over 30 years rose dramatically, from under 6
cents on the dollar to over 40 cents on the dollar.

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Supplemental Readings

AON Consulting. "Replacement Ratio Study", 2008

Defined Contribution Institutional Investment Association. "Defined Contribution Plan Success Factors",
2015

HK MPF Fact Sheet: http://www.gov.hk/en/about/abouthk/factsheets/docs/mpf.pdf

Society of Actuaries. "Managing Post-Retirement Risks: A Guide to Retirement Planning", 2011

Society of Actuaries. "Managing Post-Retirement Risks: Strategies for a Secure Retirement", 2020

Vernon, S. "The Next Evolution in Defined Contribution Retirement Plan Design", Society of Actuaries,
2013

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