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.

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.