Gordon Pape: It’s time to get smarter about your pension options

Defined-benefit (DB) pension plans are gradually going the way of the dodo, unless you are fortunate enough to work for a government. Companies in the private sector are opting out of these expensive programs, replacing them with less costly defined-contribution (DC) plans.

According to the most recent numbers from Statistics Canada, there were 4.2 million DB plans in Canada at the end of 2015, a drop of 4 per cent from the year before. That was a continuation of the downward trend we have seen for some time. Significantly, almost 70 per cent of those plans were in the public sector.

DC plans are still in a minority, with about 1.1 million operating. But that was up 2.8 per cent from the previous year, again a continuation of past patterns. About 87 per cent of those plans are in the private sector.

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Why is this important? Because a growing number of Canadians are being asked to take charge of managing their retirement savings, although most of them do not have a clue how to go about it. The odds are that a lot of them are going to end up in serious financial trouble when the time comes to stop work.

To understand why, let’s look at the difference between the two types of plans. DB plans guarantee a certain level of income at retirement, usually based on a combination of years of service and income. Financial professionals look after the money, making all the buy/sell decisions and adjusting the asset mix as market conditions dictate.

DC plans offer no guarantees. The assets you accumulate in the plan over the years will determine the post-retirement income you receive. If you have managed the money well, you should be able to live comfortably in your old age. If you have not, you have a problem.

In short, members of DC plans are expected to be their own money managers. They are required to choose from a wide range of investment options offered by the plan sponsor, often with very little assistance.

I have given seminars for members of DC plans, so I am aware of how little most of them know about investing. At one recent session, I asked how many knew what a mutual fund is. Not a single hand went up. Yet that particular plan asks them to choose from 27 mutual-fund options.

In an effort to make things easier for members, pension plan administrators are offering a range of target-date funds. These are balanced funds that mature at a date close to when the plan member intends to stop work. The manager adjusts the asset mix to reduce the risk level as the maturity date nears.

Many members of DC plans opt for the target-date approach because it is easy to understand and offers one-stop shopping. You don’t have to build your own portfolio of funds; just put it all in a target-date fund and forget it.

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The problem is that you may be taking on more risk than you are comfortable with and not even realize it.

For example, let’s look at a few 2020 target date funds. They would be the choice of anyone who is due to retire within the next three years. At this point, I would advise being very conservative with any accumulated assets. Stock market valuations are high and the last thing anyone wants is to be hit by a major market correction just a couple of years before stopping work. Remember, the financial meltdown of 2008 knocked down stock prices by about 50 per cent.

The most conservative entry in this group is the BMO LifeStage Plus 2020 Fund. It was 100-per-cent invested in fixed-income securities as of the end of August, which means zero exposure to the stock market. With interest rates on the rise, it’s not surprising to find that performance has not been great – a loss of 1.3 per cent in the past year. But investors don’t have to lose any sleep at night over fears of a market crash.

The Vanguard Target Retirement 2020 Fund, which is available to institutional investors only, takes a more aggressive approach. It had 54.5 per cent of its assets in the stock market as of the end of June, with 44.8 per cent in bonds and the rest categorized as “other.” It showed a 5.4 per cent gain over the year to Aug. 31, thanks to the continued strength in equities.

The Phillips, Hager & North LifeTime 2020 Fund takes a middle-of-the-road approach. It has 43 per cent of its assets exposed to the stock market with the rest in bonds and cash. It is marginally down over the past year, with a loss of 0.8 per cent.

Note the very different asset mix approach of these three funds. All have the same maturity year, but the degree of stock market risk varies significantly.

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Anyone who chooses a target-date portfolio needs to be aware of the manager’s asset allocation policy. The closer you are to retirement, the more important this is. A target-date fund may seem like a simple choice. But you need to look behind the curtain to see what is really going on.

One last thought: Even if you are a member of a private-sector DB plan, don’t get too complacent. If the plan is not fully funded, there could be payment problems if the company runs into financial trouble. Just ask the folks who were members of the Nortel Networks Corp. pension plan or those who worked for Sears Canada.

Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to buildingwealth.ca.

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