Feedback on “Securing Our Retirement Future: Consulting with Ontarians on Canada’s Retirement Income System”     Peter Benedek, CFA, RetirementAction.com

Recommendations- Highlights

Of Canada’s three-pillar retirement income system, only Pillar 1 (OAS/GIS) is doing its job of minimizing seniors’ poverty. Pillar 2 (CPP/QPP) is failing due to very low replacement targets and low earnings ceilings, thus dramatically reducing the effectiveness for those with average and above average incomes. Pillar 3 (tax sheltered (RRSP/TFSA) and tax-unsheltered private savings) have been rendered ineffective by a combination of inadequate savings for retirement and corrosive effect of high investment management fees by Canadian fund and insurance companies. The highlights of my recommendation are as follows (with more details provided in the rest of my feedback):

Updating employment pension and tax lawsproposals fail to address the fundamental protection of already earned private sector pensions (deferred wages) in case an employer/plan-sponsor seeks bankruptcy. What is required is what almost all OECD countries offer: adequate pension guarantee funds or priority to pension plan shortfalls in bankruptcy.

Pillar 2- CPP: The proposed approach of building on the strength of CPP is positive. Increases of boththe replacement rate to at least 35% and the earnings ceiling to twice the current level are required. To achieve and even better these levels, it might require that a portion of employer and/or employee contributions to be made voluntary. The 40 year transition to the higher levels of benefits precludes benefit improvements for those in or near retirement; an option to buy-in to additional benefits should be provided. Option to buy-in to CPP should also be extended to non-working homemakers or to those temporarily unemployed. CPP expansion alone, as currently proposed, will do little or nothing for those near or already in retirement.

Pillar 3- Innovation:The report proposal here is for using innovation; the bad news is that the specifics are somewhat vague, but the good news is that they are sufficiently open-ended to potentially permit real change driven by: un-conflicted advice and low-cost retirement-appropriate investment products so that all Canadians can get a fair share of available market returns on their savings. The required innovations toward a more competitive and  investor friendly financial industry are: (1) fiduciary responsibility toward investor, (2) retirement funds to be managed under mutual rather shareholder  organized investment/insurance companies (e.g. like Vanguard), (3) allow voluntary contributions to be managed by CPP-like (or other similar) large-scale low-cost professionally managed funds, (4) offer low-cost pure longevity insurance option to protect against running out of assets before death, (5) auto-enrolment including “save-more-tomorrow”(with optional opt-outs) and (6) quarterly feedback mechanism on expected retirement income based on current savings and saving rates.

The details

This latest Ontario report and request for feedback is a remarkably well written and refreshingly layman accessible document on the arcane subject of pensions and retirement income. The document explains what works and what doesn’t in Canada’s current retirement income system (previously called pension system, but renamed since a rapidly decreasing minority of Canadians in the non-public sector still have access to employer pensions).

The report explains that Canada’s retirement income system is composed of three pillars: (1) OAS (Old Age Security) of about $6000/year supplemented by the GIS (Guaranteed Income Supplement) for those who need additional income to meet basic needs, (2) CPP (Canada Pension Plan) is earned via compulsory employer/employee contributions, with a maximum benefit of about $11,800 (but average is more like about half of that) and (3) personal savings.

What appears to work is Pillar #1 the OAS/GIS since data suggests that “Canadian seniors’ poverty to be one of the lowest in the world.”

What doesn’t work are the other two pillars: Pillar #2 the CPP (currently formulated to deliver a maximum of $11,800/year based on 25% of one’s average income up to current YMPE of $47,200), and Pillar #3 personal savings.

The report mentions some of the root causes of why things don’t work currently: disappearing private sector occupational pensions, inadequate savings rates to maintain living standards in retirement, and high investment fees which dramatically erode saving over one’s working life. (Not mentioned is that even already earned private sector occupational pensions (deferred wages) are unprotected in case of sponsor bankruptcy.)

To set the stage for the proposed changes, the report states that “government cannot replace investment losses nor guarantee future returns. What government can and should do is make saving and planning for retirement easier, more affordable and more secure”.

The report categorizes proposed changes into three areas and asks for feedback on the proposed direction.

“First, we need to update our own employment pension laws” (pension and tax legislation)

Recommendations: This part of the traditional pension infrastructure is in “systemic failure” and so far the most fundamental protection of private sector pensions (deferred wages) has not been addressed in case an employer/plan-sponsor seeks bankruptcy. These pension plans, established under Canadian/Ontario laws are overseen by (fundamentally flawed government regulations/regulators), and leave pensioners unprotected when the employer/sponsor becomes bankrupt. Without the fundamental protection of (not future, but) the already earned occupational pensions, which is commonly provided in just about all OECD countries in the form of either pension guarantees up to the level of about $50,000/year or priority in bankruptcy for pension plan shortfalls, all other proposed changes are just shuffling the deck-chairs on the Titanic.

“Second, we must build on the strengths of the CPP through a modest expansion of benefits”

The report explores modest (i.e. modest increase in the replacement rate of 25% and/or the earnings ceiling) and gradual (full benefit impact only achieved over a 40 year transition period) changes which might be used to expand the CPP benefits.

Recommendations:Building on the strengths of the CPP (compulsory (tax), payroll deduction, (mostly) secure and inflation protected benefits for life, low-cost and professionally managed) is a very positive approach. Recommended areas of further improvement include:

–CPP enhancement: increase both replacement rate (from 25% to 35%+) andearnings ceiling (from $47,200 to 2 x $47,200) with the objective to typically achieve 40-50% replacement rate up to average Canadian income; voluntary contribution above that level should be allowed for those desiring to purchase additional CCP-like benefits.

-decouple who pays (i.e. contributors) from benefits that can be purchased above current benefit level. This would allow setting the compulsory portion of the employee/employer contributions to what is an affordable and politically acceptable level and still allow voluntary contributions to the requiredlevel to achieve desired retirement standard of living

-all benefit expansions (compulsory and voluntary) should be done on a fully paid/funded basis (i.e. no cross-individual or cross-cohort/generational transfers)

– as indicated in the report, retirees (in addition to market risk) are exposed to significant longevity and inflation risk. Given the “gradual” nature of the CPP expansion with fully expanded benefits occurring only after 40 years, the proposed changes will have little or no benefit to those close to retirement or already retired. Consideration should be given to allow those over age 55 to voluntarily purchase additional CPP benefits

-similarly, Canadians choosing to be home-makers or had years of unemployment, should be allowed to buy-in to the CPP benefits on a fully funded basis.

-having a voluntary contribution option, it will encourage taking personal responsibility for one’s retirement, after all there are differences in levels of  individual savings preferences and willingness for deferred gratification.

“Third, we need more pension innovation” I will not discuss the changes contemplated by the Minister to level the playing field for all Canadians (employed, self-employed or home-makers) in matters of taxation and pension rules. Those changes are both necessary and urgent. As to building upon Canada’s world-leading “private sector expertise”, which n the past has not necessarily been deployed to the benefit of investors at large, I have serious reservations. Canada’s financial industry has not earned the trust and respect of Canadians and currently is not structured to operate in an investor friendly mode. As to large pools of capital (that are mentioned in the report), these are necessary, but not sufficient to “reduce cost and help improve investment returns”. Recommendations addressing each of the specific topics raised in the report are provided below; also discussed below are a few other related recommendations pertaining to financial industry’s corporate ownership structure and essential products required to maximize the retirement income of Canadians.

Recommendations:

–Investment management via mutual vs. public corporate ownership structures: encourage/create/seed “mutual” (fund investor owned like Vanguard, the largest and lowest cost investment fund manager in the U.S.) rather than “public” (shareholder owned) corporate organization for managing retirement assets. This would eliminate conflict of interest and insure fiduciary responsibility toward Canadian investors rather than investment company shareholders (e.g.  minimizing fees in particular, running investments at cost and creating product which are profitable for those saving for retirement, rather than the financial industry). The same ownership structure is recommended for insurance company providing longevity insurance product discussed later on.

–Fiduciary duty: all individuals providing advice to and manage retirement assets of Canadians must be subject to fiduciary duty toward the owners of the retirement assets

– Fully funded CPP contribution rate volatility: CPP benefits  are not (really)guaranteed in the true sense of a guarantee, it is more like a target benefit plan since both compulsory contributions and benefits can be adjusted by the government to maintain financial integrity. Also since CPP is an only partially funded pay-as-you-go plan, contribution burden may shift over time between individuals, cohorts, and generations. While volatility of contributions and/or benefits is not desirable, volatility is better than cross-generational shifts in the burden; we do not want our children and grandchildren to pay for our retirements.

–Consideration should be given to the creation of another investment fund for the voluntary portion of the proposed enhanced CPP which could be run like the CPP assets (and possibly even run by the CPPIB from an investment perspective), but structured as individual accounts with portfolio assets owned by the individual contributors (i.e. asset rather than lifetime income oriented). These could even be made available for purchase as part of existing DC plans, in addition or instead of investment currently offered mutual funds. In addition, provide access for the voluntary portion of contributions to purchase units in a couple of large-scale pools of risky (equity) and risk-free assets, again structured as individual portfolios (with selectable allocations between risky and a risk-free or low-risk assets). An optional access to a longevity insurance pool to be described below should also be included (also managed by a mutual ownership based insurance company organization).

There are no magic potions, since there are very few parameters which ultimately determine the retirement income of an individual; and only some of these parameters are actually controllable:

–savings rates: we could have both a compulsory (tax-like) and voluntary portion (personal responsibility), but defaults should be set to opt-in to the voluntary portion as well)

–investment returns:here the bad news is that returns are not-controllable, but the good news is that markets offer the same returns to everyone. However, we must make sure to minimize costs, so that participants receive a fair share of the available market returns

–investment costs/fees:fees/costs are absolutely corrosive to outcomes, so we must aim for lowest possible friction due to costs. A 2% difference in annual costs (e.g. 2.5% mutual fund fee compared to <0.5% broad index ETF) can lead to typically 50% lower retirement income over a 40 year accumulation period)

–asset allocation:for the voluntary portion of the plan, asset allocation is a function of individual risk tolerance, and determines both volatility of and expected return on assets, which in turn determine retirement income. (A default option may be provided as well.)

–longevity insurance: this is a form of insurance whereby individual payouts are based on expected median life-expectancy, with the half living longer getting (mortality credits) benefits from the half which dies earlier than median (this makes sense also from a perspective of need). To handle longevity risk, immediate fixed annuities are the most common approach; other insurance products are available with different attributes such as indexed annuities, and variable annuities with income guarantees (e.g.GMWBs). These products tend be anywhere from expensive to very expensive. A better approach would be a pure longevity insurance, whereby at or before age 65 one buys for each single premium of $1 an income stream for life of about $0.90 starting at age 85 (unisex life expectancy at age 65 is just below age 85). Therefore with 10% of one’s assets at retirement one could secure a lifetime annual income starting at age 85 equal to the real buying power of about 4-5% of available assets at age 65, even with an annual inflation rate of 3%. This could largely remove the longevity risk from the list of concerns. (Such longevity insurance products are available in the U.S. for the last 3-4 years, though are not available today in Canada. Canadian insurance companies prefer to manage (earn high fees on) all your assets rather than just those needed to cover your post age 85 needs. Longevity insurance, just like asset management, would be best bought from a company organized as mutual rather public insurance company (in a manner analogous to and for the reasons discussed in the case of ‘mutual’ investment companies). The (more significant) individual longevity risk would be insured by the members of the longevity pool, while the (smaller) cohort longevity risk would be self insured by the individual members.

–Enrolment:automatic with no opt-out for compulsory portion and with opt-out for voluntary portion. An additional default should be set to commit employee to “save more tomorrow” (i.e. higher savings rate on salary increases)

–Contribution lock-in:yes for compulsory portion and no for voluntary portion

–Target benefit pension plansare better than no pension plans (which is what is fast becoming the reality as fewer and fewer sponsors will, and/or can be relied on to, bear the risks associated with pension plans’ market, inflation and longevity risks.

–Feedback: plans must provide continuous projected income in retirement based on accumulated assets and conservative expected returns after fees based on selected asset allocation; feedback should also include recommended savings rates and default asset allocations to achieve desired retirement income level