Why Defined Contribution Pension Plans are a Pain: Fixed Income Choices or Lack Thereof

Like many Canadians, part of our retirement income will come, we hope!, from a defined contribution pension plan. This is the type of plan where you choose what to invest in, hope it earns profits, and hope that by the time you retire there’s enough money in the plan to pay you something monthly. It is not the kind most people want, which is a defined benefit plan, which is (almost) guaranteed to pay you something monthly. It’s up to us (and you if you have one) to make sure our defined contribution pension is invested the best way possible and that’s what makes the plan a pain.


Lack of Fixed Income Choices in DC Plan Frustrates

While some plans swamp employees with too many choices to invest in, others, like ours, offer too few.

For example, here’s what we can invest in for the fixed income category:

  • a mid-to-long term bond fund managed by a major financial firm
  • a money market fund managed rather poorly by another major financial firm

Yep. That’s it.

Short Term to Maturity Bond Funds are Better Right Now

If you’ve read anything about the future of the bond market, you’ll know it’s at risk of a major drop. As interest rates climb, the rates offered on new bond issues will also climb. That will make existing bonds with lower rates undesirable. To bolster demand, the owners will have to cut the price they are trying to sell them for to offset the lower interest paid.

Say I have a $10,000 originally-20-year bond paying 1.5% a year that has 5 years left on it before it matures. New 20-year-bonds appear on the market offering 2.5% a year. That new bond pays about $100 a year more interest than the old bond. To find a buyer for the old bond, I would likely have to reduce my price from $10,000 to $9500 or less (5 years remaining x $100 per year) to find an interested buyer.

The interest paid on bonds has not increased by much yet. But it still may be necessary to offer a reduced price when selling old bonds just because the buyer thinks the interest rates will be rising. Unfair but true.

That’s why many people suggest going with short term-to-maturity bonds right now. Buyers are less likely to be worried that interest rates will climb high quickly in a short time. Therefore you might be able to persuade them to buy your bonds without offering much of a discount. and you could always just hold the bonds to maturity and re-invest at a higher rate when they mature.

So why does our DC pension plan not offer us a bond fund with a short average term to maturity?!

Even our bond fund manager is painfully aware of the risk right now. I’ve noticed if you look in the details about what the fund holds that they are playing some interesting paper games to try to reduce risk. They will do things like buy some 40-year term-to-maturity bonds at a ridiculously low interest rate to counterbalance buying a lot of very short term bonds. The result is that they can stay within their fund’s defined required range of age to maturity with less risk than if they invested solely in mid- to long-term range bonds.

Money Market Funds are Risky

Some people mistakenly assume a money market fund is like a bank account. You put your money in, earn some interest, and it’s all waiting for you when you want it out.

Wrong.

Money market funds invest in things like commercial paper. In theory, this is fairly safe and the funds are fairly low risk. They are not NO risk though.

In fact in the 2008-2009 financial fiasco huge amounts of commercial paper went bad. You can read up on it online in articles like When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007–2009.

Money Market Funds Preparing for “Negative Earnings”

“Negative earnings” is what you and I call losing money!

In a January 2013 article by Bloomberg, for example, it explains how some big investment houses are resetting the rules for their money market funds to allow them to drop in value below their nominal (usually $10) value per unit. The article RBS Changing Money-Market Funds to Accommodate Negative Yields.

Firms that are doing this include

  • JPMorgan Chase & Co. (JPM)
  • Morgan Stanley
  • RBS Asset Management Ltd.
  • and various European fund providers

The move is driven by the fact that funds have been experiencing losses and ***are expected to have further losses.*** They want to be able to give you back less money than you paid when you bought the fund. That doesn’t sound much like a bank account to me. (Unless you had one in Cyprus.)

By the way, do you think the average pension plan member knows about all of this? This is why I think DC Pension Plans are a real danger.

Why Our Defined Contribution Plan Doesn’t Offer Truly Safe Fixed Income Choices

Some DC Plans allow members to invest in GICs. These guaranteed investment certificates ensure your principal is safe and offer a very low, but safe, payment of interest.

Our plan does not offer GICs. If I understand correctly it’s because people would put too much money into low interest GICs. Then, by the time they want to retire, there would not be enough money in their DC plan to buy an annuity to get a reasonable monthly cheque.

That tells me two things:

  • people are scared of losing what little money they have in their pension plan
  • the company hasn’t considered ways to offer GICs while managing risk

I think they should offer some truly safe investment like GICs but limit the total amount of the pension plan that can be invested in that category. The limit should change depending on how close a person is to retirement.

Pension Planning is Easier if You Have a RRSP and a DC Pension Plan

Things are a bit easier for us than for some members of our DC Pension plan. We have RRSPs in addition to our work savings. So we balance across the two plans. We can, for example, buy GICs or deposit cash in a CDIC-insured daily interest savings account within our RRSP. Then we can keep our DC pension plan earnings in the stock market, if we wish.

Many people are not that fortunate, however. Lots of employees do not have a RRSP or a TFSA for a variety of financial reasons, some good, most sad. What are they supposed to do?

Keeping Aware of How a DC Pension is Invested Is Work

To keep up to date on the types of fixed income investments offered in our DC pension plan is work.

In the olden days this work was done for employees by a financial specialist who would make investment choices for the entire company within the defined benefit pension plan. Now, each employee must do this work himself or herself. It’s a waste of time and energy. And frankly many of the employees lack the skills to do the research and make good choices. It’s worrying and it’s a pain.


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