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.