Pensions as financial instruments

Sadly, the Nortel pension plan is being wound up. Retirees will get 59% to 70% of their full entitlement – depending upon their province of residence and whether they had an indexed pension. They will have to adjust to living on much less than they planned, or find some other source of income. The later is hard to do if you’re in your 70’s.

What is clear from all this is that pension legislation has done a poor job of protecting today’s or future pensioners. Perhaps this is not as surprising as it should be.

If we look back 50 years, pensions were often seen as a gift from a generous employer (or union), in recognition of many years of faithful service. But employees could never be quite sure these promises would be kept, and many weren’t kept. What if the employee didn’t stay to retirement, or the service was not as faithful as the employer would have liked – all possible cause for default on the promise.

Pension legislations changed everything. The first rules covered such things as benefit determination, vesting, death benefits, pension payment and funding. Actuarial valuations were to be done every 3 years. The legislation was enacted as an employment standard. Each of the provinces had a slightly different view as to what these standards should include, like other employment standards.

The important point is that the provincial pension legislations focus primarily on social aspects – setting standards as to what and when an employee is entitled to receive something from a pension plan. Plan financing rules are included in the legislation, but these rules are far from most important and they occupy much less of the legislative text than the social aspects. As well, despite the fact that nearly all provinces have made a review of their legislation, with input from numerous experts, provinces have made very few changes in the financing provisions of the plans. And, it is clear that the changes that have been made are intended to avoid placing a “burden” of plan sponsors.

But the Nortel situation illustrates what happens when plan financing is not top of mind. People suffer the consequences. Running a pension plan is not like running an endowment fund, where best efforts can be made to deliver the intended result. A pension plan, viewed by a retiree or future retiree, is a financial promise. It is similar to the promise made by an insurance company to an annuitant. And, it should have similar financial oversight.

Viewing a pension plan as a financial instrument would mean changing and strengthening legislation. For example, actuarial valuations should be done annually (many plan sponsors are doing this now) and minimum surplus requirements should be established (these could vary depending on plan maturity and investment choices). The timing to do this couldn’t be better. New accounting legislation is forcing plan sponsors to change how they report costs and liabilities. Pension legislation could piggy-back on some of these new requirements.

Members need confidence that promised benefits will be paid. Pension legislation has corrected many past “social” ills – it is now time for “security” to take over as the major focus.

Retirement Security

In a recent issue of The Actuary, an article titled "Retirement Security" tackles the risks of retirement and how those risks impact attaining a secure retirement in a defined contribution world. Although written from a US perspective, the issues highlighted are equally prevalent in Canada. I suggest the article should be required reading for all those trying to improve our retirement future.

The authors start by identifying a number of reasons why an individual's funds may not be adequate:

• Not saving enough money;
• Inadequate investment returns and poor investment strategy;
• Leakage—using funds too early, possibly as a result of cashing out savings as participants change employers, taking loans and not repaying them, or requesting hardship distributions;
• Premature death of the employee, leaving the family without adequate funds for retirement;
• Disability before retirement;
• Early retirement;
• Outliving retirement resources because they are used too quickly;
• Job changes, which disrupt the program of retirement savings; and
• Period of unemployment.

Some of these risks can be managed within the DC plan, but others require interventions or actions outside of the plan.

The authors conclude by highlighting some of the things individuals, employers and financial service providers should think about when helping individuals prepare for the future:

• More long-term planning;
• Encourage increased savings via communication and/or auto-escalation programs;
• Improve diversification and risk management in asset allocation defaults;
• Re-examining solutions for the payout period, and providing more options for structured solutions and a portfolio of options;
• Prepare people to work longer, and to keep skills up-to-date;
• More consistent focus on emergency funds so that retirement funds do not become emergency funds;
• Enhancing approaches to disability benefits so that when they work next to DC plans they support appropriate lifetime security. The disability benefit ideally should support continued saving for retirement until expected retirement age, but this is very rarely explicitly done when benefits are provided through DC plans; and
• Re-examining whether survivor and death benefits are adequate.

It's a good list - but, please read the article for more detail and background.

The Pension Gift

These are happy days for insurers and trust companies. On December 20, 2010 Canada's Finance Ministers have decided to introduce a private sector solution to solve Canada's pension problems. Before, the choices were narrowing: either expand the CPP (favored by people) or turn to the private sector (favored by business). The Ministers chose the latter. The question now is what will the choice mean for Canadians' retirement savings?

The choice does very little for existing pension plans. Despite years of study, reports, hearings and consultations, and a clear need for change, the governments have once again postponed addressing the fundamental problems affecting employer pension plans. There is no harmonization between regulatory jurisdictions, nor any effort made to solve security issues for members.

Saving rates are low, and not getting better. But the Ministers did not want to deal with this head on. The excuse is the economy and a fragile recovery. But as they wait for better times, the governments have failed to notice that the business of rewarding employees has changed. Companies no longer support the expansion and creation of employer-sponsored pension plans. Companies that weren't involved before are not going to start now. And, on cue, the government has made plan participation optional.

Flaherty's Pooled Registered Pension Plans (PRPPs) are false promises. They are supported only by the financial industry, who see a new money making scheme, and by businesses, who know they wont have to pay. Polls conducted on line by the CBC, CTV(Calgary) and the Globe & Mail all indicate that Flaherty has made the wrong choice. The Globe & Mail poll has 83% favoring the CPP choice. Numerous other polls say the same. People simply do not believe that the financial industry has their interests at heart and are not willing to trust them with their money. This lack of trust will not easily be overcome.

PRPPs wont resolve the country’s retirement income issues. Flaherty has done nothing to curb the financial industry's fees and administrative costs - among the highest in the developed world. He has not tackled the insurance industry's distribution problems and lack of control over its sales force. Nor has he signaled an equalization of saving rates between private and public employers' pension plans.

So we are left waiting for the next round of study, reports, hearings and consultations.

Target Benefit Alternative to DC - NOT

The Wednesday, November 24, 2010 Daily News Alerts of Pension and Benefits Monitor reported on the Target Benefit Alternative To DC.

"Defined Contribution pension plan sponsors who realize their members do not have enough to retire – and who don't understand that they don't have enough – may want to move to target benefit plans, says Jill Wagman, a principal at Eckler Ltd. In the ‘Target Benefit Plans – An Option for Single Employers’ session at the ACPM’s 'impACT 2010,' she said while they don’t really exist yet, the multi-employer plan concept uses a target benefit plan approach and they have been around for years. The advantage of these plans for employees is that they provide certainty over surplus ownership and give employees a say in the governance of the plan. For employers, they promise cost certainty and do away with solvency funding concerns because when there is a shortfall, the benefit can be reduced. The Ontario Pension Reform Commission has recommended they be set up. However, she said there are still some obstacles including an Ontario requirement which says an agreement with employees needs to be in place. At this time, that would seem to suggest that they would only be available in union environments where the terms of the plan could be set by collective bargaining."

A key point in the above report is the analogy to multi-employer pension plans (MEPPs). If the plan design works for MEPPs, it must be OK for non-unionized employee groups. What is not mentioned is that the reason MEPPs have some success is that the members of MEPPs actually retire from these plans. When they reach retirement age they tend not to terminate and cash in the pension to receive its commuted value.

If members decided not to take a pension from the plan but take the commuted value instead, the MEPP would collapse. This is due to plan benefit levels being based on the assumption that the MEPP will earn a high long term rate of return, which keeps the benefit high and the cost and value within the plan low. Commuted values, on the other hand, are based on a small margin over government bond returns, which produces higher values. The difference is significant. A plan that is financed on the first basis can't afford to deliver on the second.

The reason MEPP members chose retirement and a pension, rather than termination and a commuted value, often has nothing to do with the pension plan. Members who retire generally then quality for benefits such as medical, dental, life insurance and a variety of other benefits that their union decided are important for retirees. If the member terminates, these benefits are forfeited. In the absence of these benefits - non-unionized employers are not so generous - the member's financial advantage tilts towards termination and a commuted value. And, this advantage remains even if the commuted value is used to buy an annuity from an insurance company.

If employees are thinking about buying into the target benefit promise they really need to look at the whole picture. Without a union and promises of post retirement benefits, the plan may not be able to deliver anything close to a favorable long term outlook. Instead, the plan will be left financing the delivery of commuted values. The result - a very complicated DC plan.

Pension Bill of Rights

On October 1, 2010, Judy Sgro (York West) introduced a Private Members Bill titled “An Act to promote and strengthen the Canadian retirement income system”. Enactment is intended to create a "Bill of Rights for a retirement income system that promotes the goals of adequacy, transparency, affordability, equity, flexibility, security and accessibility for all Canadians".

Bill C-574,It was first read on October 1st; 2nd reading is expected to take place on November 23.

Here's an abridged version of the Bill:

Every individual has the right to accumulate sufficient pension income in a retirement income plan to provide for a lifestyle in retirement that the individual considers adequate, subject to any reasonable restrictions imposed by a federal law…. reasonable restrictions do not include a restriction based on age.

Every individual shall have the right to determine how and when to accumulate pension income, except that an individual who participates in a workplace plan may be required by that plan to save for retirement.

Every individual shall have the same opportunity to accumulate pension income as any other individual, without regard to age, sex, national origin or occupation.

Every individual who participates in, contributes to or receives benefits from a retirement income plan should be entitled to receive full disclosure of any material risks to the individual under the plan, including non-payment or reduction of benefits, and of the options available in the event of the non-payment or reduction of benefits.

Every individual shall be entitled to receive investment advice from an advisor who has no conflict of interest in terms of providing advice.

Every individual who participates in a retirement income plan shall be entitled to receive, in clear and concise language, all the information the individual requires to understand his or her rights, obligations and choices, including regular disclosure of all costs, regular disclosure of investment gains or losses pertaining to the individual’s entitlement, timely information regarding investment options and timely disclosure of any options or elections available to the individual.

Every person that administers a retirement income plan shall exercise the standard of care a prudent professional would exercise; may retain professionals to assist in the administration; and shall appropriately supervise the work performed by such professionals.

Every federal law that governs the establishment or operation of a retirement income plan shall promote individuals’ access to training in financial literacy and retirement planning.

Every federal law that directly or indirectly applies to a retirement income plan shall be interpreted, construed and applied so as to promote and give effect to the principles and rights set out in this Act.

The Bill is interesting for a number of reasons, but principally as is may present a preview of the Liberal Party's pension policy should they have the opportunity to form the next government.

Here's a few thoughts on the Bill and its implications:

• pension legislation is generally within the purview of the provinces, except for industries falling under OSFI and tax rules under the CRA. The Bill is limited to matters falling under the Parliament of Canada, so it is likely limited to tax issues, pension plans of federally regulated industries and RRSPs.

• the Act gives the right to accumulate sufficient pension income subject to any reasonable restriction imposed by federal law that is not based on a personal characteristic, such as age. This could be achieved by setting a lifetime contribution limit for tax deferred retirement savings. The person could then use this limit up as funds are available. The CRA could impose annual maximums on contributions, however it would have to prove that doing so would not unreasonably limit an individual's plan to achieve an adequate retirement income. Given that age must be taken out of the equation, this may be hard for them to do. This would be a major change in our system.

• the individual is entitled to disclosure regarding the material risks to the individual under the retirement plan. This sounds good but in practice may be challenging. Material risks could include all the various investment risks, mortality risks, inflation, variations in expense levels, value splitting on marriage breakdown, corporate bankruptcy, membership declines within negotiated plans, target benefit valuation failures, fraud, and on and on. Lawyers will love this one.

• there are a variety of disclosure requirements. These would generally reset pension plan regulation under a financial instrument model. The disclosures sound similar to those required of insurance companies or of other financial instruments. This could be good for the consumer but, this type of model has not been adopted by any provincial or federal jurisdiction.

• the Bill requires any federal law connected to retirement income plans to promote training in financial literacy and retirement planning. This would force the CRA take on a training role that it doesn't assume in any other circumstance.
  

• the requirements for risk disclosure, investment advice, broad financial information and training will complicate pension plan administration and may significantly increase trustee liability. These could be handled by safe harbour rules, but the changes would be a significant jolt to the system. Sponsors may bail out and close plans.

The bottom line - if the Act passes, a government sponsored supplementary pension plan may be needed as a private plan substitute, as corporations speed up the closure of their plans. A lifetime contribution limit, replacing current annual limits, may be a plus.

"Innovative" retirement savings plans

Over the past several years there has been a growing demand for "innovation" in retirement savings and pension plans. As the private sector reduces its commitment to defined benefit plans and people are placing more reliance on individual retirement savings, the feeling has emerged that innovative plan designs will allow individuals to replicate both the benefits and security previously afforded by traditional designs. These are good thoughts, but the question remains - how do we know that the new design will actually do the job? Here are a few questions that might help analysis:

- how should we measure the effectiveness of ‘innovation’ or what would be a minimum requirement for a credible innovation - increased benefit, lower cost, improved security, clearer communication/understanding/transparency?

- what might constitute an acceptable expense level? A minimum requirement for such a plan might be an annual cost of less than 0.5% of assets for a balanced portfolio (the CPP cost is of the order of 0.3%). A slightly higher cost might be justified due to smaller scale and some additional administrative costs - but the total has to be way lower the expenses typically charged today . Should the cost be federally or provincially regulated - say, by something similar to a rate board?

- what are reasonable income drawdown strategies during retirement? Does the innovative design allow for the construction of portfolios to achieve this? What are the trade-offs between investment risks and return? Can these be easily explained? When or should annuitization occur? Is the approach supported by the annuity marketplace?

- what tools could be made available to specify on an ongoing basis the required contributions to achieve some level of retirement income, as well as the expected retirement income given current level of contribution? Is guidance and feedback continuously available? Do the tools explain what are the risks and what can be done about them?

- is a longevity insurance option available to protect against exhausting assets if one lives too long? Should a new retiree purchase a life-contingent lifetime income stream starting at, say, age 85? Does the new design provide such an option or does it offer a better alternative?

- would TFSAs be a better choice than RRSPs (or RPPs) as a saving vehicle? Does the new design allow for such funding choices?

The intent of the above is to push the discussion from generalities to specifics. I hope others will take up the challenge.

Long-form census II

In a strange twist the Statistical Society of Canada has launched a petition to bring back the mandatory long-form census. Strange, because the long-form is not really a census, which by definition involves universal enumeration within a geographic area. The long-form is a survey, which, regardless of care, will introduce some bias into the results.

Surveys are much more than a statistical exercise. And, an important starting point is to note that all responses are voluntary regardless of whether the completion of the questionnaire is mandatory or not - if the survey is not user friendly it will, by its nature, introduce biases.

A fundamental question is whether the data collected is actually useful relative to an information need. Census information should focus solely on information to enable efficient and effective government. More than this is an abuse of the public. Just because a religious group would like certain information, to be able to better target its missions, does not create a need. The group can find other ways to get the information. It should have no say in the matter.

Canada's long-form has been around for some time. Some of the questions now sound dated and are open to interpretation. The survey perpetuates ethnic and social profiling and connects it to housing and incomes. Does this really measure social progress? The survey fails to deal with many important emerging issues including the financial, social and activity issues of pensioners, volunteer activities, early childhood development, adult educational, and so on. These issues could give a better indication of life in Canada than questions on commuting times or number of rooms in a house.

Is a mandatory survey the best way to get information or would special studies provide more? Many commentators support a mandatory survey because they feel we will lose coverage of low income earners, new immigrants, aboriginal peoples, people not fluent in English or French, and the elderly. However, one has to question coverage quality when all of these groups are faced with completing a very technical 40 page survey. I suspect that a large proportion of the surveys returned on behalf of these people were not completed by those targeted.

The survey is simply too complex. It assumes that all members of a household share freely information. It assumes that people keep detailed records of expenditures. It requires too much effort to complete. Unlike members of the Statistical Society, we perhaps don't get quite the enjoyment out of all this. I think that it is fair to ask why the information is so important.

Other countries have given up on long-form surveys. They are collecting data through special studies that focus on specific issues. Canada should do the same.