Friday, January 22, 2010

Conventional wisdom

Recently, there has been a significant amount of press concerning whether or not a changes are needed in Canada’s retirement system. What follows are a number of precepts and why they shouldn’t be taken at face value.

1) Canada has one of the best retirement systems in the world

Canada currently spends around 4.5% of national income on pensioners. This is significantly below the OECD average of 7.4%. Canada depends on voluntary, private pension saving to lift overall replacement ratios.

For most Canadians, adequate retirement income depends primarily on personal or occupational saving schemes and sufficient economic stability to ensure that the expected benefits are actually delivered.

While Canada ranks thirteenth in the OECD in income replacement for people earning half the national average wage, it ranks 20th out of 30 OECD countries for those earning the national average wage before retirement, and 26th for those earning 1.5 times the average wage before retirement.

2) Mercer's Global Pension Index gives Canada a high score.

Mercer ranks Canada fourth, behind the Netherlands, Australia and Sweden. Canada scored second highest in their pension adequacy sub-index that looks at how much income is available to a retiree. This high rank is due to the level of minimum public pension and a relatively high net replacement rate of income for median income earners.

However, OECD studies show a somewhat different result. Canada has a strongly progressive mandatory retirement-income system. For low earners, the replacement rate exceeds the OECD average, but then the gap between Canada and the OECD average grows larger as earnings increase. At average earnings, the replacement rate from the mandatory schemes in Canada is 45%, compared to the OECD average of 59%. At twice average earning the replacement rate falls to 20%, compared to an OECD average of 50%. An adequate replacement rate can only be achieved by taking full advantage of tax-deferred saving opportunities over an entire career.

3) Canada’s retirement system has almost eliminated poverty among senior citizens.

Over the last 20 years, retirees’ incomes have tripled. This is due to the impacts of CPP benefits and the number of women working, who have contributed to the CPP. But following retirement, the proportion of income from the CPP has increased as inflation has taken its toll on other sources of income.

Poverty measures are both absolute and relative. In the1990s, despite the gains noted above, workers’ incomes increased faster than those of retirees. At present, approximately 35% of retirees are receiving the GIS – a good indication of the level of poverty or near-poverty found among retirees.

4) A 50% income replacement rate is a reasonable target for middle- income earners.

A good starting point to answer this question might be to look at current income replacement rates and the standards of living these provide. Unfortunately, Statistics Canada has not had sufficient data to conduct the needed longitudinal study. At a recent Standing Committee on the Status of Women meeting, Statistics Canada offered that they hope to do such a study in the future.

A UK survey indicated that desired replacement rates are around 70% for middle to high earners and nearly 60% for the highest income group. These rates have also been the targets of many defined benefit pension plan designs in Canada. However, these are well above the replacement rates that recent retirees have achieved.

The OECD takes as its benchmark the average replacement rate of its 30 member countries' replacement rates from mandatory schemes. This benchmark is about 60% for average earners and 50% for those earning twice the average. While the benchmark is based on mandatory schemes, the OECD extends its use to include voluntary private provision. As noted above, mandatory schemes in Canada replace only 20% of earnings at this level, which highlights the importance of private savings or plans in Canada.

Financial planners frequently use a target replacement rate of 50% when preparing financial work-ups for clients. For higher income clients, this will typically exclude pensions from mandatory schemes. Once the pensions from the mandatory schemes are added back in, the replacement target becomes 70% at twice the average earnings level, with a gradually decreasing overall target for higher earnings levels.

However, any target should come with a few cautions:

· Deciding when to retire is one of the most important decisions most people make. Standard economic analysis says that they can be depended on to plan with foresight and make sound decisions. But studies by psychologists, sociologists, and behavioral economists raise doubts.

· Recommendations from financial planners often tie into what people feel they can afford – many, if not most, underestimate their long term needs.

· As Andrew Allentuck reports, the odds of living to a very old age are increasing. Data from Manulife Financial actuaries show that one member in a couple, each of whom is 65, has a 99% chance of living to age 70, a 94% chance of living to 80, a 63% chance of living to 90 and a 36% chance of living to age 95.

· A person who retires with debt should add the amortization of the debt to the target replacement rate

· Income needs to be indexed or it will quickly lose value. If income is not indexed, a higher replacement rate is needed to enable saving to finance the impact of future inflation.

5) An expansion of the CPP will result in intergenerational transfers.

An expansion of the CPP can not be funded by intergenerational transfers. Bill C-36 (2007) requires that any amendment to CPP be financed on a fully funded basis, whereby each generation pays in advance for the additional benefits accruing to it. As a result any proposed expansion or doubling of the CPP would fully benefit only to those retiring after at least 40 years, not 7 seven years as has been reported.

6) There is no need to improve Canada’s current retirement system.

Edward Whitehouse’s report, prepared for the Research Working Group on Retirement Income Adequacy, set out a number of areas of concern about retirement-income provision for people of working age today.

· Coverage of private pensions, particularly among low-to-middle earners and, to a lesser extent, younger workers, is less-than-complete. While the lowest earners will be able to get by on public pensions, projected replacement rates for middle earners from public benefits are below the OECD average. The analysis here suggests that most workers with a full contribution history will fill this pension gap through voluntary retirement savings. Nevertheless, there are concerns that interrupted contribution histories will leave a retirement-savings gap.

· Contribution rates for people with personal plans (RRSPs) are often relatively small. For example, calculations carried out by Human Resources and Skills Development Canada show that balances in RRSPs for people late in their careers (and so nearing retirement) are significantly smaller than those of people with occupational plans (RPPs).

· Although the public pension scheme provides incentives to remain in work, labor-market participation rates for people in the years up to the normal retirement age of 65 are relatively low.

· Administrative charges for personal pensions (RRSPs) are high for people with individual plans, especially those invested through actively managed funds. Such charges can take a substantial proportion of people's retirement savings.

Mercer's report on their Global Pension Index adds a number of suggestions to improve Canada’s position in their index:

· Increase the level of coverage of employees in occupational pension schemes, possibly through a more efficient system

· Introduce a mechanism for ensuring that voluntary retirement savings are preserved for retirement purposes

· Introduce a mechanism to increase the pension age as life expectancy continues to increase

· Increase the level of household savings.

I believe pension reform should be focused on two key goals - improve the adequacy of retirement income and ensure that whatever retirement income is promised is secure. While most people are financially prepared for retirement, there remains a significant minority who are not. These people need help. Solutions include expanding the CPP, purchasing a CPP supplement, expanding the OAS or allowing retroactive TFSA savings. For others, people are willing to save more on their own. But, surveys indicate that they do not trust private enterprise to do the job and look to government to offer both the facilities and the security for savings. They want a safe affordable retirement option without the high fees and self-serving, questionable advice.