The Jack Mintz Report

On Friday, December 18, 2009 our federal-provincial-territorial Finance ministers and treasurers met in Whitehorse, Yukon to assess retirement income adequacy in Canada. On the agenda was a report prepared by Dr. Jack Mintz, Research Director. The purpose of the report is to expand Canadians’ knowledge of retirement income adequacy and explore related issues. The report concludes that “overall, the Canadian retirement income system is performing well, providing Canadians with an adequate standard of living upon retirement.” The conclusion is something of a puzzle, as it doesn’t reflect how Canadians feel about the situation. The gap between Dr. Mintz’s and the publics’ perceptions is very wide. The question then is; why does the gap exist?

Dr. Mintz uses a very broad definition of the retirement system. He includes pensions, both private and public (C/QPP), transfer payments (OAS, GIS and provincial supplements), RRSPs, Tax-Free Savings Accounts, any other savings that can provide support in retirement, home ownership and all financial assets. Based on this he concludes that the disposable income of those aged 65 or older is about 90% of the average disposable income of all Canadians. On this basis, on average, we do very well indeed.

After that introduction, the report starts with an assessment as to whether Canadian saving has declined. Sufficient saving is important so that enough accumulated wealth will provide a reasonable income on retirement. Saving is typically thought of as the difference between annual income and the consumption of goods and services. On this basis Canadians have been saving between about 3% and 5% of personal disposable income over the last decade. Saving rates were much higher in the early-1980s and we are now back to what they were in 1961, i.e. 5%. This would seem to indicate that saving has declined, but Dr. Mintz suggests that a correction should be made and that purchases of consumer durables should be added into the savings rate. Consumer durables are mass-market heavy goods that are expected to last for some time. These include washing machines, refrigerators, furniture, cars, TVs, etc. When this is done the savings rate jumps up to about 15% and has been reasonably stable over the last 40 years – except in the early-1980s, when people decided to save real money instead of consumer durables. A saving rate of 15% would certainly be enough to fund an adequate retirement income, although I think I would rather have the saving in something other than consumer durables that wear out over time.

The report leaves savings behind and turns to retirement income adequacy. Dr. Mintz discards income replacement rates as a measure of adequacy as needs vary considerably depending on individual circumstances. He expects that people will consume less than available income during the years they work in order to fund consumption after retirement. He then recommends a measure called “consumption smoothing” whereby a person maintains a similar standard of living when they retire. The smoothing takes into account such things as retirees no longer needing to support their children or parents (?), having more time to do household duties (?, if able), having bought a home, car and other consumer durables prior to retirement (?, nothing wears out), and being able to take out a reverse mortgage. He then returns to income replacement ratios and says that 60% of pre-tax income should be adequate to maintain expenditures. This is reduced to 50% for those earning double the average. The reference to “pre-tax” may be a typo since he refers to 60% “after-tax” in his next paragraph.

He refers to a longitudinal study – looking at individuals over a period of time – that indicates that few have inadequate resources at the lowest income levels, 20 to 25% have inadequate resources at the median income level and 35% have inadequate resources at the top quintile level. The study concludes, “a significant minority of Canadians may not have sufficient replacement income.” The key is to have a high income replacement ratio at least until people enter their 70s. Dr. Mintz acknowledges that it would be important to understand what factors play a role in explaining the income replacement ratios, but seems to discard the conclusions since the study did not take into account the role of consumer durables and owner-occupied housing.

Dr. Mintz presents several tables that he feels demonstrates that once the value of owner-occupied housing is taken into account, people achieve retirement income adequacy. The tables are based on either snapshots or hypothetical models, not longitudinal studies. For example, for one table the assumption is that each household buys a home with a value of 3 times earnings while working. Clearly something is missing in this description as no one is going to spend 3 times their total earning over their career. My best guess is that he means 3 times the highest annual earning, which in the model would be earned in the year prior to retirement. This value is then amortized back into income over the 20-year period that the retiree is expected to live. A test is then made as to where the household experienced either a 100% or 90% consumption replacement. There are several problems with this approach:

· The 20-year amortization period is roughly the period from age 65 to life expectancy for an individual. But, 50% of individuals live longer than the life expectancy and that percentage is much higher for a couple. Given that people cannot predict their own life expectancy and would surely not want to run out of resources before they die, a much longer period should have been used.

· Home ownership involves many more costs than the purchase price of the home – maintenance, repair, heat, light, replacement consumer durables, etc. For many, these costs today exceed the yearly costs of purchasing the home and with inflation they will continue to rise in the future. The costs will also rise as the ability to self-maintain diminishes with age and more reliance is placed on repair and maintenance people.

· A home cannot be sold in bits and pieces to match the expenses of the retiree. The retiree needs real income in order to have some sort of standard of living and to be able to purchase the consumer durables – frig, stove, car, TV, etc. - that will wear out over the period of retirement.

· Many people have paid for their house well before they retire. This changes the results of any comparison that is made to pre-retirement income.

· The approach bears no relationship to reality. It’s interesting that in one of the tables a two parent family has a higher consumption replacement after retirement than a couple with no children. Presumably having children gets you used to spending less and saving more.

The effect of adding a home ownership component to assess retirement adequacy is very significant. In 2005 retired Canadians were found to have an average net worth of $485,000. Of this $174,000 per household is pension and tax sheltered savings and $152,000 is principal residence. However, when one adjusts for taxes on the pension and savings – not on the residence – the residence is actually the most important category of worth. These numbers are averages and are therefore influenced by the wealthy. If a median number is used, net worth drops to $300,000. It’s hard to say what this change does to the pension and residence categories. The biggest impact may be on the pension category as later in the report Dr. Mintz indicates that for those without RPPs (pensions) there is some reliance on the GIS even in the third and fourth quintiles.

The balance of the report deals with issues related to retirement income adequacy such as investment performance and risk, the costs of various funds, why passive management is better than active management and overall efficiencies. There seems to be little correlation between costs and size of funds – contrary to the super fund concept that is being promoted by many. This part of the paper is quite good and well worth the read. It clearly points out how the public is likely paying for services it doesn’t need and that these costs affect retirement income adequacy.

Dr. Mintz raises the question as to whether a new savings program would encourage more savings. An example might be expanding the mandatory savings programs. His feeling is that the introduction of a government public pension fund could result in public pension funds being substituted for current private pension plans. Based on his comments earlier about costs, both investment and administrative, and how low they are in the government plans, substitution would clearly be attractive. But, given the paltry amounts that those in the lower to middle income brackets are saving today, I’m not sure substitution would be much of a problem.

So, the conclusion is that “overall, the Canadian retirement income system is performing well, providing Canadians with an adequate standard of living upon retirement.” This is only true if the value of the owner-occupied home is included as an asset. This explains most of the gap in understanding between Dr. Mintz’s report and the views of Canadians. As a policy paper, this one is not of much help. There are too many guesses and assumptions. What is needed is a comprehensive longitudinal study, one that traces what actually happens to retirees’ incomes.

Reforming pension regulation

A recent Globe and Mail article describes how Can West retirees and active workers are waiting for news on the amount of their benefits once their pension plan is liquidated. The latest financial results indicate a 22% reduction in benefits. The article includes comments from a 72 year old retiree who may have to sell his house.

The Can West story is not unique - the same thing is happening to retirees and active members across the country. People thought they had a safe and secure pension and have planned accordingly. Now their financial world has changed and they can't do anything about it.

All this begs the question: where were the regulators and what have they been doing to protect plan members? Judging from the Can West story, not much. I'm reminded of Captain Renault in Casablanca: "I am shocked, shocked, to find that gambling is going on in here!"

Pension regulation in Canada is based on a set of archaic laws and regulations that are doing nothing to help members of the Can West plans of this country. Some lip service is paid to the issue and a commission is established, but the landscape isn't changing. Harry Arthurs and the OECP produced the longest report, with the most recommendations, but, like the other commissions, completely failed to deal with the real issues facing pension plans and their members:

• pension plans are financial instruments that people count upon for financial security after retirement. They are not a gift, a statement of intent or some sort of risk transference device.
• trust laws do not provide an appropriate governance structure. They do not provide adequate protection of plan members.
• regulators must be able to take into account the financial status of plan sponsors in formulating supplementary funding requirements. At present, they bend over backwards to accommodate sponsors, often in ways that reduce plan members' protections.
• laws and regulations must be changed to deal with the excess surplus issue. To date, the courts have butchered any reasonable interpretation. This highlights the problem of using trust law as a basis for interpretations - laws that are not geared to handling pension risks, guarantees and their financing.
• pension plans should be given priority in sponsor bankruptcies, the same as deferred wages.
• pension plan regulation should be principle based, not rule based, i.e. regulated in the same way as banks and insurance companies. It's hard to imagine a bank or insurance company being regulated or governed as if it were a trust account - pension plans should be viewed the same way.

What is the likelihood of change? Hard to say. The Arthurs report seemed to say that if everyone just talked to each other all would be well. It did not deal with any of the fundamentals or even go so far as to say which of the current rules or regulations were no longer needed. The McGuinty Liberals recently defeated a Private Members Bill that would help protect the value of the Nortel Pensioners' share of their plan should it be wound up. Despite the amendment being very minor, and similar to what Quebec allows, it seems that Ontario wants to wait until it figures out what parts of the Arthurs' report it should implement (or, perhaps, the Bill was proposed by the PCs and the Liberals rejected it for that reason). Ah, the leadership of provincial governments.

I believe that any change will need to come from the federal government. OSFI has the competency, research capabilities and the experience with banks and insurance companies to make the needed changes. They could also set the framework for a desperately needed Canada-wide uniform approach.

Pension priority in bankruptcy (2)

Further to my last blog, here's a few points raised by colleagues:

• Defined benefit plans are deferred wages and should be afforded the same protection as other deferred wages, i.e. they should be fully protected.
• If pensions are given priority upon a future bankruptcy, the sponsor's borrowing costs would increase about 5 basis points - a negligible amount.
• There is at least one plan that has implemented a Pension Security Trust similar to what has been proposed by the Canadian Institute of Actuaries. Contributions to the Trust add to security of plan members but are refundable if it turns out they were not needed.
  

Interesting points, and worth exploring further.

Pension priority in backruptcy

An article in the November 11, 2009 issue of Macleans included the following comment on why bankruptcy protection could not be extended to pension plan members:

"Despite the calls from Nortel employees, Ottawa stopped well short of suggesting legislative changes to protect pensioners in the event of a corporate bankruptcy. While Liberal Leader Michael Ignatieff has said employees deserve to be near the front of the line as an insolvent company’s assets are being carved up, experts argue such a move could displace other creditors and, in turn, make it difficult for frail companies to raise badly needed financing, potentially forcing more bankruptcy proceedings. In short, pensioners may never be guaranteed a soft landing when their employer goes belly up."


Do CEO's and business leaders agree with the Macleans' experts? A recent Compas poll found that its panelists, CEOs and business leaders, are especially supportive of the idea of legal priorizing of pension rights in the event of corporate bankruptcy. In fact, this idea had more support other ideas such as expanding the CPP or giving tax incentives to build pension surplus. So, the question is: is prioritizing pension rights in a corporate bankruptcy really a bad idea?

There are at least a couple of ways of looking at this question. There is no question that pension plan deficits are a real headache for corporations and their CFOs, but let's assume that deficits are given priority in bankruptcy proceedings - what would happen? For a start, CFOs would have a strong incentive to improve plan funding, or at least put in place a letter of credit, to ensure that creditors are not concerned with the pension plan and its new priority status. A plan that is fully funded, or backed by a letter of credit, would not add to the list of unsecured creditors in the event of bankruptcy. There would be more inclination to match asset duration to liability duration, which would mean reduced equity investments. This would reduce the likelihood of surprise deficiencies in the future. Funding flexibility and the opportunity to take contribution holidays may be reduced, but true costs would be better known and pensions would be substantially more secure.

From another perspective, a creditor today must assess the risk of any loan. As the new accounting rules (IFRS) come into play, pension plan deficits will show up on the balance sheet. Even if the pension plan members are not given bankruptcy priority, the creditor and rating agency will know the risks. A big one is that it would only take a change in government to flip the situation. In other words, pragmatically, the creditor should be operating as if the bankruptcy protection was now in place. Not having bankruptcy priority for the pension plan will not do much to improve the chances of getting a business loan.

How should a CFO respond? Clean up the pension plan financing as quickly as possible. A plan deficit is like the proverbial albatross. A corporation's finances will not be helped by ignoring the security needs of pension plan members and retirees. The government could help by adopting the Canadian Institute of Actuaries proposal to allow a Pension Security Trust. This Trust would be attached to the pension plan, but allow for reimbursement to the corporations of funds no longer needed once a suitable solvency margin is reached.

Pensions as financial instruments

Imagine walking into a bank and being told that your $10,000 savings account was only worth $8,800 because they made some bad investments. Or, imagine your heirs being told by your insurance company that it will take 5 years to pay out the proceeds because some of their mortgage investments defaulted. Unthinkable? Then why does it happen in some pension plans?

For many people, a pension plan is their largest financial asset. Employees and retirees view the pension promise as a financial commitment made by the plan sponsor – something they can rely upon. Yet pension legislation doesn’t treat the pension plan as a financial instrument, it treats it as a labor contract. And that’s where the problems start – the contracts are frequently incomplete and depend upon an external value assessment if the plan gets into trouble. Or they are run like a mutual association, where the security of the retiree is often dependent on the desire of active employees to keep the faith.

I think it’s time to start managing and regulating pension plans differently. Pension plans should offer a similar level of security to members as insurance companies and banks offer to their customers. Provincial authorities need to move from rule based regulation to principal based supervision. Supervision would avoid rule of thumb funding and instead focus on the risk characteristics of the plan, member demographics, investment selection and the sponsor’s ability to cover shortfalls.

Plans might have to change to simplify designs, to remove contingent benefits that don’t involve predictable risks and to permit sponsors to withdraw excess funds once solvency is assured. But the end result would be more secure benefits for plan members and plan sponsors knowing exactly what they are paying for.

Fire prevention

In a recent article Lord Skidelsky, who is Emeritus Professor of Political Economy at the University of Warwick, made the following comments on Keynes, forecasts and economic models:

"Keynes’s major contribution to economic theory was to emphasize the “extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” The fact of their ignorance forces investors to fall back on certain conventions, of which the most important are that the present will continue into the future, that existing share prices sum up future prospects, and that if most people believe something, they must be right.

This makes for considerable stability in markets as long as the conventions hold . But they are liable to being overturned suddenly in the face of passing bad news, because “there is no firm basis of conviction to hold them steady.” It’s like what happens in a crowded theater if someone shouts “Fire!” Everyone rushes to get out. This is not “irrational” behavior. It is reasonable behavior in the face of uncertainty. In essence, this is what happened last autumn."

I think the implications for pension actuaries are clear - we need to spend much more time on fire prevention.

Coping with underfunded pension plans

Defined benefit pension plans in Canada are currently about 80% underfunded on a solvency basis. This means that today plan assets are sufficient to cover only 80% of the pension benefits employees and retirees have earned. Next year, if interest rates rise or the stock market improves, the percentage that is underfunded might decline. But it might not – there are a whole lot of other factors that can affect a plan’s financial position. Some of the factors that could make a plan’s financial position worse include a reduction in the workforce, a significant increase in average salaries, increased use of early retirement provisions, and an increase in inflation. These are all possible in our current economic climate coupled with a shrinking workforce.

These factors – workforce, salaries, retirement, and inflation – all lend themselves to scenario testing. Risk management methodologies can support this work.

Risk management can also help on the financial side. Here are a few ideas to consider:

Assets

• Keep the focus on risk. By 2007, the biggest risk for many plans was the possibility that the equity markets and interest rates could both decline. Unfortunately, too many sponsors and trustees accepted the efficient market hypothesis and correlations between asset classes. These theories suggested that, if you had a long enough horizon, you could afford to take on the volatility in equities. Sadly, it wasn’t true.
• Pension investing has always used a long lens to view the world but with the focus changing to solvency, a match of assets to liabilities is a better starting point.
• Consider borrowing money to fund the plan. It’s tax efficient and interest rates are low. It could also relieve some of the plan’s leverage on the corporate balance sheet if the money is used to better align assets with liabilities.

Contributions

• Recognize that current economic conditions may substantially alter the employer covenant and the funding of deficits. In this context, security is itself a benefit and as such has a cost – extra security in funding may lead to lower benefits.
• DB pension plans are maturing. In many plans, the retired population significantly exceeds in size the active population. In these cases, the plan’s expenditures may exceed its receipts. The cost of benefits for active employees is of less relative importance than making investments that match the pension payment outflows each month.
• Historically, pension funds have relied on the growing wealth creation of the sponsors to cover future benefit obligations. In many sectors wealth creation has slowed significantly and may not return to former levels. Now may be the time to bite the bullet and be honest about what the sponsor can afford.

Social Pensions

The World Bank recently published an analysis of demographic and pension coverage throughout the world in a book called called "Closing the Gap". While focused mainly on underdeveloped and developing countries, the book devotes a chapter to social pensions in the 30 member countries of the OECD - these are the high income countries.

Some of the key indicators of the OECD countries include:

• an older population structure than the rest of the world,
• relatively high life expectancy (at birth, age 75 for boys, age 81 for girls),
• the male/female gap in life expectancy has persisted,
• 90% of the labor force contributes to the compulsory pension scheme,
• most OECD countries have a system of credits that enable coverage for those outside the labor force - unemployed, working-age students, people caring for children and older family members, and
  
• the countries usually have some kind of floor for old-age income.

Compared to the OECD averages, Canada has a slightly younger population, longer life expectancy for both men and women, a narrower life expectancy gap, and slightly better labor force coverage of its programs.

The chart below shows the taxonomy of the pension systems. The World Bank analysis focuses on the first and second tiers, which are the mandatory components. In Canada, the first tier includes the OAS (basic) and GIS (resource-tested), and the second tier includes the CPP and QPP (public - defined benefit).




The first tier programs are called "social pensions". These pensions are worth, on average across OECD countries, about 29% of national average earnings. About 18 countries are bunched around this average, providing social pensions worth 25% to 35% of average earnings. Canada's first tier programs are worth about 31% of average earnings.

A number of the OECD countries made major changes in recent years to their social pensions. These changes tended increase the linkage to earnings for average earners, while increasing benefits for low earners. However, some former communist countries abolished their minimum pensions, in the belief that this would help to reduce labor market distortions. These changes place more emphasis on second tier pensions.

Compared to the other OECD countries, Canada places more emphasis on first tier benefits than most. All of the G8 countries, except the UK, place a greater emphasis on earnings related pensions. This may argue that, if Canada were to change its social pensions, its starting point should be a review of the CPP and QPP benefits, rather than the benefits provided by other programs. For example, is Canada competitive in the coverage of those who are not in the workplace? Should more be done for those caring for children and older family members? Should a mandatory program be introduced to cover employees who do not have an employer sponsored plan?

Housing and retirement

The Society of Actuaries' Committee on Post Retirement Needs and Risks has just issued a new monograph containing papers that provide varied perspectives on housing and retirement issues of concern to financial professionals, policymakers, and homeowners, among others. An overview provided by Anna Rappaport and Steve Siegel highlights key takeaways under various topics: wealth, spending, options and types of housing, fraud and improper loans, housing related to the financial crisis, and use of equity and products.

Here's a sampling of takeaways:

• Housing assets are an extremely important component of total wealth in both the United States and Canada, particularly for middle income households. Home equity is greater than the invested financial assets of many older adults and it has been often converted to cash and used to finance other spending, sometimes leading to financially detrimental results and longer term problems.
• Housing is a major part of spending and the largest item of spending for most retirees. Traditional ideas about what is affordable have been displaced in recent years by a “spend more and borrow more” philosophy.
• Many of today’s retirees get by on a combination of a paid for house, social security and some emergency funds.
• Housing values do not always increase and in fact, can decline a great deal. Housing bubbles and over inflated prices are not new, and a review of financial history would have warned that upward housing prices are not guaranteed.
• Reverse mortgages may offer significant income potential to some households, but at relatively high cost and risk. They may help older households remain in their homes, but they limit future housing choices.

The studies included in the monograph demonstrate that housing issues must be considered alongside other critical issues including longevity risk, potential changes in health, and inflation. Combining these and other factors, accompanied by the decrease in housing wealth, dramatically increases the instability of financial security in retirement. This situation poses significant challenges to financial professionals engaged in retirement planning.

Challenges for pension actuaries

In a speech given by Superintendent Julie Dickson (OSFI) to the Actuaries Club of Toronto, she concluded with 4 points that, while directed towards the work of actuaries for insurance companies, apply equally strongly to pension plan actuaries:

• The bar is rising in all areas of risk management, and that includes actuaries;
• Stress testing and capital planning are two areas where more is being demanded from actuaries;
• Introduction of IFRS – especially phase 2 – presents challenges that the profession should embrace. There can be a very important role, under IFRS, for the CIA and the ASB to maintain solid practices in Canada while still following IFRS standards that are principle-based; and
• The global financial crisis provides actuaries with a tremendous opportunity to demonstrate value and expand their influence, effectiveness and impact.

Dutch pension plan for western Canada?

If the federal government does not move quickly to create a national pension program, the premiers of Canada's three westernmost provinces have pledged to push ahead to develop a regional pension plan in 2010.

The premiers of British Columbia, Alberta and Saskatchewan expressed concern that too few people have adequate retirement savings, noting that only two in 10 employees in the private sector have a company pension plan. They also noted that the number of retirees will increase rapidly as baby boomers stop working.

Many suggestions have been pressed on the federal government as to how to improve the national programs. These include:

• doubling the CPP pension benefits
• increase the OAS from about 15% of the average industrial wage to 75%
• allow non-working spouses to gain entitlement to CPP benefits, either on a purchased or government sponsored basis
  
• introduce a Dutch styled supplemental plan to top up the existing CPP and OAS
  

Of these a Dutch styled plan may be the most amenable to regional adoption. The Dutch styled plan is a collective DC plan that would suit as a company pension plan. Under these plans, the sponsor’s contribution rate is fixed for at least five years but, the pension benefits are denominated as a career average DB plan. Benefits earned each year are expected to be indexed, as are retiree benefits, based on a combination of targeted contributions and fund performance. While the basic benefits are very likely to be paid, they along with the indexing are not fully guaranteed.

Basic plan benefits are funded on a solvency basis. The plan must be more than 105% solvent before partial indexation can be provided, and more than 130% solvent before full indexation can be provided. The sponsor may not recover surplus. Contribution rates may be reset every five years, but current contributions cannot be used to cover past shortfalls. The plan structure means that the sponsor avoids having to realize liabilities on its financial statement. Individual account DC plans are rare in the Netherlands, due to their high administrative costs and bad publicity about their risk.

It will be interesting to see whether the premiers adopt a similar pension plan.

Rethinking Foundations

Paul Krugman, a NY Times columnist and winner of the 2008 Nobel Memorial Prize in Economic Science, writes in this Sunday's NYT about how did economists get the recssion so wrong. He has some important conclusions:

"So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics."

"When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right."

Similar comments can be made about the need for actuarial profession to rethink its foundations. Fortunately, as per my last post, steps are being taken to do that - at least in the area of pension plans. But until this happens, how can we ensure that we don't repeat past mistakes?

Nassim Taleb, author of The Black Swan: The Impact of the Highly Improbable, offers ten principles for a Black Swan-proof world. Of these, three seem particularly important for pension plans:

• Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.
• Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products.
• Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

Retirement 20/20

Retirement 20/20 is an initiative of the Society of Actuaries to find a new retirement system that better meets the needs of stakeholders than existing DB/DC models. The SoA has issued a call for models of voluntary retirement systems that fit within the context of the social insurance system, culture, work patterns and social values in Canada or the United States. The new models should align with the principles outlined in its Retirement 20/20 initiative.

The principles identified for successful retirement design are:

• Strong governance framework
• Alignment of roles with skills
• Presence of self-adjusting mechanisms
• Solidarity among plan participants
• A degree of independence from the employer
• Use of groups, i.e. allow groups to participate in a larger plan
  
• Use of nearly default free discount rates for measurement

Some of these principles may be challenging to meet. For example, the presence of self-adjusting mechanisms is intended as a risk sharing mechanism that would permit the plan to adjust benefits or contributions based on plan experience. It should allow the plan to increase its investment risk and if, say, equities outperform risk-free assets, the members could enjoy higher benefits or lower contributions. But current mechanisms for doing this have showed that they are not robust enough to withstand significant market corrections. The mechanisms are based on old efficient market theories that need to be reworked. Adjustment mechanisms may also fail when an industry plan faces a major decline in its industry.

Some of the solution may come back to stronger governance. Here Retirement 20/20 makes a number of suggestions:

• Independent boards made up, in whole or in part, of retirement and investment experts.
• Board members chosen by employees or employers, but who do not act as representatives of those choosing them.
• Having pre-set rules about how to change contributions or benefit levels.
• Contribution rates are set by the board and are not negotiable - members may have to contribute any extra that is needed.
  
• Benefit levels that are common for all members.
• Where members are union members, benefits are not subject to negotiation (benefit levels are set by the board, on which the union has representation).

A presumption made by Retirement 20/20 is that DB plans are a form of insurance for individuals, paying fixed benefits to a retiree for life. DB plans provide guarantees both as to amount of payment and for as long as the retiree lives. On the other hand, DC plans are an investment, building wealth to be used to meet retirement needs. The choice is then between insurance or investment wealth, or a regulatory approved combination.

Assuming that DB plans are a form of insurance, sponsors and trustees should view the plan as if it is a captive annuity writer and manage the risks accordingly. Unfortunately, in Canada, this is seldom the case. The courts have been very lax and treat a DB plan more like an endowment fund rather than a financial instrument, which would be more consistent with members' views. Trustees and plan sponsors bear little or no responsibility for plan cutbacks or failures, regardless of the degree to which they overstated promised benefits or failed to ensure proper securitization. I suggest two changes need to happen to correct the situation - remove the market as the prime excuse for losses, and have retirees intervene in court proceedings.

Retirement 20/20 stands a good chance of moving the bar in the right direction - to-date the start is good.

How Much Retirement Income?

How much pension income should I have when I retire? This is one of the most difficult questions facing individuals and their advisers. How much income will be needed to cover basic needs? unexpected costs? fun? gifts? dreams? Clearly, the more one has made prior to retirement the more they are likely to want an adequate amount for fun, gifts and dreams. And, this has frequently led advisers to a replacement ratio focus. Perhaps a target of 70% to 80% of pre-retirement income, with all sources combined - employment retirement plans, social security, personal savings and part time income. For those without DB retirement plans, financial advisers often suggest that individuals should personally save towards a capital fund sufficient to provide 50% of pre-retirement income.

Are people saving enough to meet these targets? The answer, by and large, is no. People at the lower end of the income scale, who will depend heavily on social security, are not saving anything. Those higher up the income scale are simply not saving enough. A rule of thumb is that a person's pension income should be based on no more than a 4% to 5% withdrawl from their capital fund. For example, a person who earned $100,000 pre-retirement, with a target pension of $50,000 (using the 50% rule), will need a capital fund of $1,000,000 to $1,250,000. This seems like a lot of money, but investment earnings above 4% or 5% will be needed to cover future inflation and investment fees. While the person can still add social security to the personal pension of $50,000, they will still be some distance from their pre-retirement income level. All this may not have mattered as much years ago when life expectancy was much shorter, but people today are retiring in good health, may be dividing pension with a former spouse, may still have partially dependent children and have a variety of other expenses. The pension income is needed.

It can be argued that building a capital fund is solely the responsibility of the individual, but if they are not doing enough does the government have a role in narrowing the gap? The Dutch have a system of compulsory personal pensions that top up social security. International organizations have advocated similar tiered systems. These may also help those at the lower end of the income scale.

At the lower end of the income scale, the replacement ratio method of assessing pension needs doesn't work. People living at a subsistence level cannot live at 70% of that level after retirement. Here are links to a report that looks at retirement income from a basic needs perspective: link1 and link2

From that report, here are the costs of retiree basic needs in 2001. Costs have gone up since then, but it is clear that a couple needs pension income of at least 50% of the average industrial wage. For those whose pre-retirement income is less than the average wage, current social security benefits fall short of what's needed. This might be a starting point for governments to focus their efforts.

Typical Elderly Living Expenses

City	Single	Couple
Halifax	$13,315	$18,848
Montréal	$13,945	$19,579
Toronto	$14,913	$19,998
Calgary	$13,862	$19,512
Vancouver	$13,618	$20,200

Correlations

This came from the Atlantic magazine. It's something actuaries have been fighting for years, but it's amazing how often unrelated correlations slip into financial and other models.

Every time you find yourself saying that there must be some causal relationship between two strongly correlated variables, you should go back and look at this graph:








As Atlantic Business contributor Derek Lowe, who contributed the graph, notes,

I've seen a lot shakier plots used to justify some sweeping conclusions, and if those were justified, well, then I'm forced to conclude that Mexican lemons have improved highway safety a great deal. The vitamin C, maybe? The fragrance? Bioflavanoids?

This is particularly tricky when you bring time into it, because things trend--as we get richer, we buy safer cars, get better emergency rooms, etc. We also import more lemons to make our chi-chi cocktails and lemon meringue pies. Overlay the two, and you've got a hell of a causal relationship.

But I expect that four years from now, we'll still be having the same conversations with proponents of "cancer clusters". What makes electric power lines cause cancer, but not the earth's vastly more powerful magnetic field? Well, maybe we don't know the mechanism exactly, but never you mind: just look at that bee-yoo-ti-ful correlation!

Defined Benefit Plans

Defined benefit pension plans are having a rough go of it. Watson Wyatt reports that half of British companies with defined benefit pension plans expect to close them to all employees by 2012. Similar activities are occurring in the United States, including some states increasing the retirement age on their plans to age 68. Canada is a little slower but the issues are the same. Many plans simply cost much more than their sponsors expected. That is not to say that defined benefit plans deliver poor value - they don't - the issue more relates to sponsors expecting high equity returns would keep the costs low. Dollar for dollar, defined benefit pension plans deliver more pension than defined contribution plans. But, defined contribution plans automatically adjust to lower benefits in a poor economy and defined benefit plans don't.

Employers and unions need to assess what level of benefit they can afford and make changes. The timing is good - new accounting rules will highlight all costs for both private and public sector plans and there appears to be a sea change in economic thinking.

A good starting point for change is to determine the size of current liabilities and costs using a near risk free discount rate. In other words, eliminate anticipation of an equity premium. There are a few reasons for doing this:

• pension plans are paring their equity exposure - some by 10% to 20% of assets, some by more - it's hard to say what will be considered reasonable equity exposure in the future.
• equities inject more risk into a plan than was once thought - the view that volatility is mitigated by time is being questioned.
• the efficient market hypothesis which encouraged equities for portfolio optimization is flawed (this is part of the economic sea change), but financial models have yet to find a suitable replacement other than scenario planning.

Continue to invest in equities, just don't count on excess returns ahead of time.

Once costs are assessed, determine a level of benefits at a cost the sponsor can live with. Here are some suggestions:

• focus on the pension level/retirement age combination. If the plan is currently 1.5% per year of service at age 62, perhaps 1.3% at 65 would work.
• avoid integration with the CPP/QPP. These benefits are likely to change in some fashion and the change may affect the plan's liabilities. Plan integration is also hard to communicate.
  
• initially leave ancillary benefits out of the equation - benefits such as early retirement, spousal coverage, indexing, etc. can always be offered via a side fund paid for by employees who want the benefits.
• look at a benefit change date far enough ahead to avoid employment issues such as constructive dismissal. For existing employees, grade the current benefits into the new benefits from the change date. For new employees, start the new benefits immediately.

As a trustees, keep in mind that the current economic conditions may substantially alter the employer covenant and the funding of deficits. In this context, security is itself a benefit and as such has a cost – extra security in funding may lead to lower benefits. Don't be afraid to explain this to plan members.

Legal Ponzi Schemes?

Ponzi schemes have the defining characteristic that returns to the first batch of participants are paid from the money invested by the second batch. But, not everyone loses - those who get out early often do quite well. What ends up as a fraud can start off innocently enough with funds earning more than enough to meet the returns promised investors. It's when the promises continue unabated, and returns fall, that the fraud occurs. The new money is used to keep the old promises leaving nothing for new investors. A downward spiral begins, eventually the returns fail to keep the old promises, people want their money out and all collapses. The frauds have been going on for centuries, long before Ponzi.

A new concern is whether something similar is happening in some pension plans. An Economist article highlighted some of the concerns over public sector employee pension plans and likened them to Ponzi schemes:

"In Britain some national schemes are “unfunded”: that is to say, the government does not put aside a specific pot of cash to meet its liability to its employees. Instead, it vows to meet the cost out of future taxation. Such “pay-as-you-go” schemes, as they are known, are rather like the pyramid schemes made famous by Charles Ponzi, a 1920s swindler, in that they need a continuous stream of new investors to meet the claims of the old ones. (Of course, many basic state old-age pensions work in the same way.)"

This may overstate the case with respect to most public sector employee pension plans. A key element in the classic Ponzi scheme, apart from misrepresentation, is unsustainability. The reason Madoff Investment Securities finally collapsed was that it could no longer pull in enough new investors to supply the funds to pay off the existing participants. But, in the case of the public sector plans there is usually a contributor of last resort and that is the sponsoring government. While there have been a few cases in the US where the governments (or taxpayers) have said "no more", they are not common. The issue with public sector plans is their gross understatement of costs - not the security of benefits.

The plans where security is in question, and which probably come closest to Ponzi schemes are some target benefit plans. These plans typically have fixed contributions - by contract or union negotiations - and defined benefits. Some of these plans have attempted to maintain this balance using too high an expected investment return. These have had to cut benefits, some dramatically, because the combination of contributions and earned investment return was not sufficient to deliver the benefits promised. This combination makes the plans unsustainable at promised benefit levels and the reduction in benefits hurt members. But, like Ponzi schemes, those who left early enough, before things came to a head, did OK - they got a good settlement value. The issue is that those who stayed, whether active or retired, found their benefits cut and this came as a big surprise. The sponsors argued that they made no certain promises to members and that all was dependent on investment earnings, but I suspect Madoff said the same thing.

Math Education

Here's a great video by Arthur Benjamin on changing the focus of math education.

Target Benefit Plans

A Toronto Star artcle recently highlighted some of the problems of the Commercial Workers Industry Pension Plan. Covering some 300,000 workers and retirees in the grocery industry, the plan is one of the larger plans in Canada. Unfortunately, at the end of 2006 its fund had only 52% of the assets required to cover the settlement cost of the accrued liabilities. There is not much reported on what has happened since the end of 2006 - likely asset values and the discount rates used to determine liabilities have both fallen - but a good guess is that the finances of the plan have not improved.

The CWIPP is a target benefit plan. There are lots of these plans around, particularly in union settings. This type of plan provides benefits based on a pre-set formula, that takes into account the member's earnings and service or hours worked. The plan's source of contributions is limited to bargained or pre-set contributions from an employer or employers, and sometimes from members. The plan does not provide any benefit guarantees because under the contribution agreement the employer or employers are not required to make up any funding shortfalls. This means that the benefits formula and the contributions have to be carefully managed to make sure they are always in balance. For example, if anticipated high equity returns don't materialize, the plan may be short of funds, leaving contributions and benefits out of balance. It may be necessary to increase member contributions or to reduce plan benefits to achieve balance.

This need to keep plans in balance places significant responsibility on trustees, but the lack of a benefit guarantee also means that members need to know where they stand. Should they retire and take a pension or should they "terminate" and take a cash out. One of the commentators on the Star article said the latter was the preferred course. He was afraid that his plan pension might be reduced in the future. In retrospect he was likely right - better to take the money and run.

Here are a number of questions that trustees should be discussing with their actuary or, they could be questions that members ask their plan's trustees.

• What funding method is used – unit credit (year by year) or a spread cost method? – is a solvency test made each year?
• Are the valuation discount assumptions based the investments of the fund or on bonds alone? In other words, are equity returns anticipated or does the plan only count them when they materialize?
• Frequency of valuations – annual? Prior to any contribution or benefit change?
• Is the plan actuary independent of employer(s) and unions who are parties to the plan? do the trustees and the plan actuary fully represent the interest of members - are there any conflicts?
• If economic conditions deteriorate the plans could be subject to significant cash-outs at an inopportune time – how will the plan protect the remaining participants from adverse financial consequences?
• If change are needed to contributions or benefits, which gets priority?
• What is the minimum or maximum size of change? – e.g. contributions plus or minus a performance adjustment
• Is there a benefit adjustment priority – e.g. add/remove contingent benefits such as early retirement features or inflation adjustment before changing the base benefit, change the base benefit for active members only or change for all members? How frequently and under what conditions?
• What is the expected volatility of changes, either in contributions or benefits, to maintain a fully funded plan? What is the target amount of surplus to minimize volatility?
• How will the trustees avoid surprise changes (any change will be a surprise to most members) – particularly with respect to decreasing retiree pensions.
• Plans create inter-generational transfers of value – what amount of transfer is appropriate? Is the plan benefit based on a career average formulae – perhaps subject to indexation dependent on investment performance?
• How are plan and fund risks communicated to participants?
• If the plan is replacing a prior DB plan, how will the employer contribution be determined – given that risk has been transferred to the membership? E.g. a plan which cost the employer 10% of salaries, with the employer assuming all risk and a 50% equity and 50% bond portfolio, should increase contributions to 14% of salaries, if the employer withdraws from all risk. The additional amount is the value of the risk saving to the employer or the additional amount members should receive to keep the deal even.
• Will the plan promote settlement by annuity purchase for retirees? Or, will it maintain retirees as members? What impact would this choice have on the investment portfolio?
• How will the asset mix change as the plan matures? Will younger members accept a more conservative mix?

Public employees' pension debts exceed all other government debt

A recent report by the British North-American Committee concerning Canada's debts for federal and provincial employees' pension plans presents a shocking result. Based on the new IPSAS 25 accounting measures, the net pension liabilities - i.e. total plans' deficits - exceed the rest of the federal and provincial governments' debts. In other words, our governments owe more for their own employees' pension plans than they do for everything else. BNAC estimates net pension liabilities at 27% of GDP - compared to an OECD forecast of non-pension debt of 21%. These numbers exclude CPP, QPP and other social security benefits.

The BNAC looked at two measures of pension cost:

• The net present value of all accumulated pension obligations less any plan assets. These are called the ‘net pension liabilities’.
• The annual running cost to the employer and employee combined of new promises incurred in a year, expressed as a percentage of salary. The actuarial name for this concept is ‘current service cost’, and is the annual pension contribution required to cover future liabilities.

The federal pension plans include the public (or civil) service, the military and the RCMP. The provincial pension plans include general provincial employees and teachers.

The annual running costs are 27.5% for provincial plans and 45.5% for federal plans.

Unfunded public pension liabilities represent a transfer of spending power from a future generation of taxpayers to the current generation of public employees. This decision is made by the current generation, but paid for by future generations. However, it appears that the financial impact of these promises is not known, nor understood, by either those giving the promises or those who will have to pay for them.

The BNAC makes several recommendations:

• transparency of costs in public bodies’ reports to taxpayers should be the first aim of the governments.
• pension liabilities which are promised by a public body should be valued (and charged for) at sovereign market discount rates. Any other discount rate is likely to understate the true cost of pensions, and will distort reporting between unfunded and funded pension schemes. This recommendation is in line with IPSAS25.
• net public pension liabilities should be amortized or monetized so that costs are explicitly recognized.

High frequency algorithmic trading

A former colleague recently pointed out 2 New York Times articles on high speed trading. She wondered whether this technique would add to risks in pension plans. Here are the articles:

Hurrying Into the Next Panic?
New York Times – 2009-07-29
... the latest fashion among investment banks and hedge funds: high-frequency algorithmic trading. On top of an already dangerously influential and morally suspect financial minefield is now being added the unthinking power of the machine.

Stock Traders Find Speed Pays, in Milliseconds
New York Times – 2009-07-24
... high-frequency trading ... is suddenly one of the most talked-about and mysterious forces in the markets.

While the articles are written from a US perspective, the same thing is happening in Canada. One of the biggest players is CIBC, which has grown its volume to over 20% of the market by using this trading technique. As the articles point out, the technique is not without criticism. Individual investors complain that they can't buy or sell fast enough to get current prices. And, what happens if the same technique is applied to bonds? Short term movements could have major effects on prices.

All this creates an interesting dilemma; what is the right price for long term investments (that pension plans hold ) when a sizable portion of the market is only interested in extremely short time frames? It also adds to questions as to whether the efficient market hypothesis is still valid.

A Financial Times article included the following comment: "There is also growing acceptance that basic assumptions must be jettisoned. CFAs no longer believe that markets are efficient - meaning that prices incorporate all known information - or that investment returns follow a normal "bell curve" distribution. The search is on to apply biology and psychology to better understand markets."

Some of these basic assumptions are built into current actuarial models, in particular capital asset models used to assess pension plan risks. Perhaps its time to rethink the fundamentals.

Public Pensions Cook the Books

An article in the July 6, 2009 Wall street Journal, "Public Pensions Cook the Books." concerns how two public pension plans in Montana are handling their actuarial services. Doesn't apply in Canada - don't be too sure.

There was a lot of reaction to this article, largely focused on perceived overly generous public sector pension benefits. We are also seeing this type of reaction in Canada. But, one comment of a more actuarial nature grabbed my attention -

"All pension funds should be conservatively managed. They should not expect a long run return greater than the growth in GDP, or in a global economy the global equivalent. It was the outsized projections of returns that led to the underfunding. This affected private pension plans as well as public plans. Many life insurers and annuity providers made similar errant projections."

Growth in GDP has always been important in financing of social security plans, but this is the first time I've seen it tied to return assumptions for funded pension plans.

Pension plans need to change to meet new economic realities

Pension plans cannot safely assume that they will continue forever. Although wind up is seldom imminent, there is no guaranty that it will be foreseen well in advance of the event. The pace of corporate changes is increasing, with failures and mergers that would have been unthinkable only a few years ago. Public sector plans will also be affected as accounting rule changes highlight the real costs of these plans and taxpayers question why they should fund benefits that no one else can afford.

DB pension plans are maturing. In many plans, the retired population significantly exceeds in size the active population. In these cases, the plan’s expenditures may exceed its receipts. The cost of benefits for active employees is of less relative importance than making investments that match the pension payment outflows each month. Pension security for retired and nearly retired members must be given much higher priority in these plans.

Historically, pension funds have relied on the growing wealth creation of companies to cover future benefit obligations. In many sectors wealth creation has slowed significantly and may not return to former levels. Companies need to bite the bullet and be honest about what they can afford.

The hiring freezes that are occurring in business and government are far more troubling for DB plans than excess layoffs. DB plans depend on constant ins and outs to help keep costs stable year to year. A hiring freeze cuts out the new younger employees which are needed to keep costs down. While government assistance can mitigate layoff issues, the government cannot force firms to hire. In some industries new jobs have simply dried up. Great care will be needed to avoid having an aging plan membership making the plan's current financial situation worse.

Risky investments

There is an interesting table in the August 17, 2009 issue of Canadian Business that shows the investment returns earned by some of the largest pension plans in Canada. The returns are shockingly poor, particularly considering the amount of expertise hired by these plans to keep everything in order.

The last published one year returns, the 10 year average returns to the last date published and the yield on 10 year Canada bonds for the same period were:

Casse de depot: -25.0%, 3.6%, 4.9%
CPP Investment Board: -18.6%, 4.3%, 5.0%
Ontario Teachers Pension Plan: -18.0%, 6.6%, 4.9%

In a recent article in The Gazette, Alban D'Amours, who was the head of the risk management committee of the Caisse de dépôt et placement du Québec put part of the blame for their loss on tainted non-bank asset-backed commercial paper (ABCP). When asked about these risky assets, he stressed that the Caisse didn't take more risks than what was laid out in its risk policy. But one has to question why any investment at all was made in ABCP and how could a risk management policy for a “public” fund allow this to happen. The questions are the same for all of these plans: who is really bearing the risk of a financial shortfall and, if it’s the public who will have to pay up in the end, how are the potential costs to the public taken into account in the risk policy of the pension plan?

D'Amours, like other managers of the Caisse, refused to shoulder any of the blame for what they call a "perfect storm" that hit the pension fund by surprise. This reminds me of a comment by Warren Buffett, “it’s only when the tide goes out that you learn who’s been swimming naked.”

Here’s the view from actuarial researchers Lawrence N. Bader and Jeremy Gold from their paper, The Case Against Stock in Public Pension Funds:

“Current funding and investment practices are costing taxpayers dearly. We are not directly addressing the losses of the past few years, which we can all hope are temporary, but the poor decision-making that stems from failure to understand the risks of equity investment.”

Essentially, equity or similar investments by these plans involves many risks besides the market risks:

• intergenerational taxpayer conflicts (risk transfers masquerading as risk sharing),
• undercharges to employees’ compensation packages for the value of the pensions,
• employee claims on pension surplus, and
• higher governmental borrowing costs (once new accounting rules bring forth the real plan costs and liabilities).

This may be an opportune time to start dealing with these issues and to make sure the public interest is served in the process. If there are additional costs, which is likely, let’s deal with them now so as a country we can be more competitive for the future.