Long form census

Ah, there's income tax returns, tax audits and then there's the long form census. And, with the long form, there's no H&R Block to help. No wonder people don't like it. It's too long, too detailed and it's not clear what all the information is used for.

Perhaps it is time for a change. A voluntary system has been proposed with a larger sampling base. The larger sampling base might compensate for the move away from a mandatory system, but it's hard to judge. The mandatory system undoubtedly contains errors as some filers emphasis speed of completion and guess work over accuracy. Presumably the voluntary system will mean those forms that are filed will at least be accurate. But who will be missed? The issue is which approach gives a better representation of the underlying population.

Another approach is to segment the form. All of the population completing a 20% segment may be more acceptable than 20% of the population completing the entire form. This approach could be coupled with a thorough review of the long form census to make sure each question contributes to some purpose. Statistics Canada should clearly explain why each data point is needed.

Target Benefit Plans for unrelated employers

A number of organizations have suggested that pension regulations change to create a better environment for the creation of defined benefit plans. These organizations include plan sponsors, insurance companies and various consulting and law firms.

These proposals include:

· Creating different rules for different types of plans in regulation or administrative policy (DB, DC, target benefit, etc.);

· Broadening the definition of plan administrator to permit an entity that is not an employer or a board of trustees to sponsor a plan (e.g. unrelated employers, professional associations, trade associations);

· Broadening the definition of member to permit a worker who is not an employee to become a member (e.g., self-employed);

· Permitting the creation of commingled asset pools for the participants in these plans; and

· Ensuring that there are no legislative barriers to features such as assigning default investment portfolios, escalating contributions to meet target benefit requirements, and scaling contributions by the age of the participant.

My concerns focus on three aspects of these proposals:

· The expansion of pension plans to include unrelated employer participation where there is no union or other bargaining connection between employees;

· The inclusion of target benefit plans as a permissible plan design in the above; and

· The establishment of commingled asset pools for the participants in these plans.

Plans with these aspects are analogous to plans that might be offered to the public by an insurance company or bank. However, insurance companies and banks are subject to sufficient regulatory backup to ensure that promises made are promises kept. The standards of oversight are well defined and enforced. Pension regulation by comparison is totally inadequate, as can be seen recently by the number of pension plan failures. There is nothing in any of the federal or provincial governments' pension consultation papers that suggests that pension plan regulation will be brought up to financial institution standards, despite the fact that pension plan assets are the largest financial assets of individuals.

In concept, target benefit plans are relatively straightforward. Each participant has a target benefit the plan is meant to achieve. Starting with the target benefit and working backwards to the contribution level needed to achieve the target benefit determines required contributions. If things go better than assumed in this calculation, benefits can be increased. If the results are worse then benefits are decreased.

This concept builds on what occurs in many MEPPs today. In times of poor investment returns, accrued pension benefits have to decrease. In good times, excess benefits can be granted.

Proponents suggest that target benefit plans share pension risks more evenly between plan sponsors and workers. Classical DB plans (as long as they don’t terminate) leave all of the risks with the plan sponsor, while classical DC plans leave all of the risks with the worker. Target benefit plans are supposed to change this. However, they don’t work this way; risks are shared not with the plans sponsor but with the retirees.

Under a target benefit plan the plan sponsor has no commitment to plan funding beyond a DC-styled contribution. The risks - poor investment returns, increasing longevity, unexpected member terminations, cost overruns, etc. - are shared between workers and retirees. For example, in times of poor investment returns, both pensions being paid to retirees and workers’ accrued benefits are reduced until liabilities match assets. In this case, the biggest hit is to the retirees, who individually have the largest liabilities and whose benefit reduction makes the biggest impact on the financial structure of the plan.

These risks are further exacerbated as pension regulation does not require plans to invest in assets that match the liabilities of retirees nor does it allow the separation of retiree liabilities from other liabilities. The practice of MEPPs has often been to optimize returns to support workers’ benefits. This risk has been compounded by poor governance, which is pretty much universal among the MEPPs that are in trouble. Granting benefits out of temporary surpluses, making or acquiescing in very poor and non-professional investment decisions, unbelievable incompetence and fiduciary duty failures manifest the poor governance. There is no reason to think that target benefit plans will do things differently.

This return optimization will become even more important once the connection between workers and retirees, as exists with current MEPPs, is broken. For new target benefit plans to grow, they will have to promise very competitive benefits to workers. High rates of investment return are needed in order to maximize target benefits or minimize contributions. And, without regulatory constraint management will sacrifice security for growth.

The proposed way to achieve the highest return for plan participants is through a commingled asset pool. The view is that such a pool would have lower administration and investment expenses than anything available today. And, it could invest in assets that are beyond what mutual funds for individual accounts are capable of today. These could include private equity investments, e.g. golf courses, casinos, commercial mortgages, and so on, that offer high rates of return and are not subject to mark to market annual valuations. The room for abuse is obvious, particularly when very large amounts of money are involved, the knowledge to manage such schemes is limited and there is inadequate regulatory oversight.

In the face of this, the expansion of acceptable pension designs to include target benefit pension plans, with unrelated employer participation, is simply asking for trouble. Such plans will be subject to aggressive marketing by entrepreneurs seeking to expand the financial base of their offering. An aggressive investment posture, particularly involving private equities, will be used to justify high salaries for those running the plan. We have seen this before in other financial sectors. It is not in the public interest. It is akin to legalizing Ponzi schemes.

The problems identified above can only be corrected by treating target benefit plans, and any other plans being marketed to non-related employers, as if such were insurance companies and subject to the same standards. Given that regulations are unlikely to change to this extent, the better course is to not allow such plans.

Capital market, risk management traps

Zvi Bodie, Ph.D, in a recent article in the Journal of Financial Planning highlights a few of the traps that lie in wait for those trying to understand the nature of risk in the capital markets:

Stocks as a hedge against inflation. While many have argued that investors with long time horizons should own stocks as a means of hedging against inflation, there is no evidence that stocks offer an effective hedge, even in the long run. In fact, empirical studies show that stock returns are largely uncorrelated with inflation. Not only that, but stocks have often performed very poorly during periods of high inflation, such as experienced in the 1970s. The idea that stocks should be included in a glide path as an effective hedge against inflation is not justified by the facts.

The fallacy of time diversification. The idea that the risk of holding risky assets somehow decreases with the length of the holding period has perhaps been around as long as investing itself. That this is a fallacy is well documented. A simple way to understand this is to consider the riskiness of an asset, or portfolio of assets, in terms of the cost to insure that it will earn at least the risk-free rate of return over time. Bodie (1995) shows that the cost of this insurance increases with the time horizon, and the empirical evidence supports this conclusion. Such insurance can be replicated by purchasing a put option, and the actual prices of put options traded in the capital markets do in fact increase with the length of their horizons.

Reliance on probability statistics as a measure of risk. Probability theory has strongly influenced modern economics, including the area of lifecycle finance. In fact, we can learn much about its application—and limitations—from its 17th century founders, Blaise Pascal and Pierre de Fermat. It was Pascal who so famously reasoned that knowing the probability of an event was not enough. The consequences of the event matter, too. Thus, risk has two dimensions. One involves the probabilities of certain events. The other involves the consequences of those events. In terms of the defined contribution plan objective, we can think of this decomposition of risk in terms of (1) the probability that a given funding level objective will be met and, if not, then (2) the magnitude by which it could fall short of its objective. Any risk measure that does not address both dimensions is flawed. Risk measurement is not the same thing as probability measurement.

Budget 2010

"The current government-supported retirement income system in Canada is recognized around the world by such organizations as the Organisation for Economic Co-operation and Development as a model that succeeds in reducing poverty among Canadian seniors and in providing high levels of replacement income to retired workers." - only if you are making less than the AIW, otherwise you have to save to the max!

"In May 2009, the Minister of Finance, along with provincial and territorial Finance Ministers, launched a process to expand understanding of the issues. They received a report in December and are continuing their collaborative work, leading to a review of policy options at the next meeting of Finance Ministers in May 2010." - the report said there were no problems, why are they still talking? Was the report wrong?

"In preparation for the May meeting, the Government will undertake consultations with the public on the government-supported retirement income system, including the main issues in saving for retirement and approaches to ensuring the ongoing strength of the system. This process will be launched in March." - but, will they talk to real people?

Throne Speach

"Our Government will also explore ways to better protect workers when their employers go bankrupt." - I hope this includes giving pension plans bankruptcy priority.

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.