Doomed Nortel Pensioners? Outside-the-box Pension Options and Path to Pension Reform
(Originally posted July 15, 2009 and retargeted to new platform March 2012)
In a nutshell
The pension system failed Nortel pensioners; it is now time to let pensioners control their own destiny. We are where we are and we need to generate the best going forward outcome for pensioners with the assets in the trust fund.
The current annuity only option legislated in case of windup is not necessarily the right answer. We need to pave the way now to outside-the-box options: commuted value (CV), Longevity insurance (LI), Pensioners’ Co. for investment management and insurance, in order to eliminate the additional 25-50% reduction in NPV of pensioners’ future income stream as a result compulsory 100% annuitization.
Canada’s/Ontario’s pension system failed Nortel’s pensioners. It is time to let pensioners control their own destinies. New options are needed, based on some Outside-the-Box thinking.
Nortel ‘estimates’ that at year-end 2008 the DB pension plan is 69% funded. While pensioners are hoping to see the current bankruptcy protection/restructuring (CCAA) process will lead to topping up of the pension plan to 100%, it now appears that the company is on the path of liquidation at fire sale prices and the pension plan will be wound up as required by legislation. (There is some hope given the groundswell underway to get the necessary changes in the BIA (Bankruptcy and Insolvency Act) passed to give employee related claims priority in bankruptcy. However what’s even worse is that it appears that there are little or no assets remaining in Canada to pay Canadian creditors’ claims, the largest of which are likely the two DB pension plans with an underfunding in the $1.0-1.5B range. Hopefully this is just opacity rather than a real issue; time will tell.)
As mentioned earlier, in “Systemic failure” none of the potential check-points, any one of which could have prevented the current pensioners’ disaster, did so. Also, on windup with a forced insurance company annutization the plan’s effective funded level will not be determined by an actuarial ‘estimate’ but by the insurance company annuity quote! In “Too little too late”I suggested that the effective funded level (i.e. the annuity purchasable as a percent of the promised annuity) may turn out to be in the 50-60% range rather than the indicated 69% without additional injection of funds; pensioners will be locked into a low annuity income stream due to a a low valuation and low interest environment, and all opportunity for an upside will be lost. And, with an insurance company sourced annuity there is also the counterparty risk (i.e. the risk of the insurance company may go bankrupt.)
But there is little value in discussing now how we got here; low interest rates and market swoon and/or combination of inappropriate/reckless risk-taking with pensioners’ assets in order to minimize company pension plan contributions; no doubt all of these contributed to the current situation. We are where we are and we need to generate the best going forward outcome for pensioners with the assets in the trust fund.
Exploring outside-the-box pension options
It is not too difficult to see how a little flexibility and some “out-of-the-box” thinking could potentially improve the likely outcome for pensioners.
For each $1 currently in the plan, annuitization is expected to lead to 25-50% lower NPV for pensioners because of a combination of conservative longevity assumptions, uncompetitive Canadian annuity market and high annual costs associated with annuities. Remember that a 65 year old pensioner will be forced to take an insurance company annuity, whereas an about to be fired/retired employee of the same age has the option to take commuted value (CV). What pensioners need is flexibility and options which maximize the value of the income stream derivable from the imputed CVs from the assets in the plan.
The new approach proposed here is some combination of the following elements:
- Commuted Value (CV): Imputed value available for annuity, investment pool, longevity insurance
- Staged and/or partial (joint) annuitization: option to annuitize part of the CV and invest balance in pool; for those choosing 100% annuitization, the option for annuitizing in stages e.g. 1/3, 1/3 and 1/3 at various points over 3-10 year period (I won’t discuss the annuitization option further, though staged/partial approach may lead to better outcomes than the required immediate annuitization.
- Longevity Insurance (LI): Insurance to provide lifetime income starting at age 85, for those living past age 85. E.g. each $1 of premium paid at age 65 will yield about $0.8-0.9 per year starting at 85 or about $0.5 inflation adjusted. A 65 year old may choose a premium equal to 4-8% of CV to buy an income stream starting at 85 equal to about 2-4% real of CV value at 65.
- Pooled asset management with endowment-like payout: ‘5-7%’ of current year asset value/year from a balanced portfolio (draw may be at the higher end of the range at expense of residual estate without risk of running out/very-low on assets/income stream because endowment-like model coupled with LI starting at age 85). Market risk (25-50% equities) can be traded off against income size/volatility and residual estate.
- Pensioners’ Co. to implement insurance and asset management (rather than insurance company): Low cost annuity, insurance and asset management with estimated 1.5-2.0%/year cost advantage. Pensioners’ Co. (the ‘group’ of pensioners) insures individual longevity risk, while the ‘group’ could self-insure the group’s longevity risk. Adverse selection risk can be mitigated by compulsory LI or minimum 50% annuitization of CV.
Changes/approvals may be required in: (1) pension legislation (imputed CV vs. compulsory 100% annuitization); also staged and partial annuitization, (2) Canada Revenue Agency (CRA) approval of Longevity Insurance payments to be treated as compensation for adverse outcome (loss), (3) establishment of Pensioners’ Co. insurance and investment management company.
Putting it all together:
A Monte Carlo simulation of the 3rd option
Consider the following simulation of the scenario for a 65 year old couple, whereby 95% of the assets are invested in a balanced portfolio (50:50 stock: bond) with expected returns of 7% and standard deviation of 8.75%. The balance of the assets (5%) are used to buy a Longevity Insurance which for each $1 of one-time premium at age 65 pays an income stream of un-indexed $0.8 for life starting at age 85. Furthermore inflation is assumed to be 3% per year and risk medium to long-term risk-free rate is real 2%. The charts show the 10, 50 and 90 percentile outcomes from the Monte Carlo simulation. The simulation outcome is clearly a function of the parameters of the assumed normal distribution of the portfolio return; and by the way we have no guarantee that the distribution is in fact normal, as we found out in the latest market swoon. A joint annuity quote of 6.5% from one of the highest rated U.S. insurance/annuity providers is shown as a benchmark to compare simulation result against. I suspect that a Canadian quote would be 0.5-1.0% percent lower from an earlier attempt to get annuity Canadian quote.
A few point worth noting:
-all pictured data is in real dollars (i.e. same buying power as at age 65)
-Longevity Insurance works as expected as it kicks in at the 20 year point in the graphs (age 85)
-there is upside and downside to this approach, but the downside at least after age 85 is protected by the Longevity Insurance
-the expected residual value of the portfolio (the estate) bottoms out at 60% of the original buying power; the 10 percentile residual bottoms out at about 40%
-expected income stream starts about 10% lower than the annuity, gradually catches up with the annuity by age 85, and significantly higher afterwards demonstrating the power of LI and the equity component of the portfolio to protect investor against the ravages of inflation; the 10 percentile income point is at 84 and increase thereafter (while the annuity continues to decrease.
-The expected NPV (net present value) has a >30% advantage as compared to the annuity; whereas at the 10 percentile curve, it has a significant advantage to early 80s and a less than 10% disadvantage between ages 95-105.
-in fact the benchmark joint annuity would have to annually pay about 2.5% more or 9% (rather than 6.5%) for a similar expected NPV at the joint longevity age of 91 (This is because insurance company annuities are likely based on the risk-free rate while the insurance company assumes risk by investing in riskier assets; however, the annuitant don’t get any of the benefits of the upside)
Of course, different Capital Market Expectations and other assumptions would lead to different results.
Benefits of proposed options:
-Lower effective annual cost coupled with self-insured group longevity risk has eliminated an estimated 25-50% reduction in expected NPV.
-No required immediate annuitization in an unfavorable environment
-No Insurance Co. (counterparty) risk
-Partial inflation protection with a balanced portfolio
-Residual estate (unlike with 100% annuitization zero estate)
-Flexibility and control over resources
-The cost is assuming some risk, which may be acceptable for a large proportion of the pensioners (even those who choose annuitization will end up carrying the bulk of the inflation risk)
Federal and provincial governments conducted numerous pension studies, however little action has materialized so far. In the spirit of “never letting a crisis go to waste”, the approach described above would work for pension reform as well. All one really needs to add is mandatory (or at least default) participation/contribution during working years and one has the makings of a workable next generation pension system. Asset allocation could be a target-date type glide-path stock allocation of (120-age) up to about 10 years before retirement. As one approached retirement one would move to a risk-tolerance based asset allocation; the same approach would be used in the early years of retirement, to prevent a market crash from causing irreparable portfolio damage. In retirement the risk-tolerance based asset allocation may turn out to be balanced portfolio with relatively constant asset allocation over time or might even start slightly increasing stock allocation as one ages, after all the estate portion of one’s portfolio (should there be one) has a horizon of 50-100 years. The other elements of such a system, discussed in my Ontario Expert Commission on Pensions submission Pension Reform,in common with this proposal include: low cost, large scale management/administration, implicit portability and transparency, and market risk borne by employees. With private sector Canadians being herded from bad/dying DB plans to worse DC plans, this outside-the-box approach has a superior expected outcome.
The pension system failed Nortel pensioners; let pensioners control their own destiny.
We need to pave the way now to outside-the-box options: commuted value (CV), Longevity insurance (LI), Pensioners’ Co. for investment management and insurance) to eliminate the additional 25-50% reduction in NPV of pensioners’ future income stream as a result compulsory 100% annuitization. The proposed approach may also provide a framework for Canada’s much needed pension reform.