By Mark Yamada
There’s no doubt some things need to change in our pension system. Are pooled retirement pension plans the answer?Is it too late to avert a pension crisis? Governments have been known to rearrange deck chairs as ships take on water. Bill C-25 (41-1), An Act relating to pooled registered pension plans (PRPP), recognizes that Canadians aren’t saving enough for retirement and targets expanded pension plan participation. The evidence suggests if something is not done soon, regardless of one’s definition of crisis, we may have to break out the lifeboats.
Demographics are channelling more tax revenues to health care, already 38% of provincial spending according to the Canadian Institute for Health Information. But if an already burdened social-welfare system must also support successive and increasing waves of retirees with inadequate pensions, fiscal spending flexibility will be severely restricted. A perfect pension storm may be brewing. How will PRPP legislation impact coverage adequacy and what must happen to make pension systems work better?
Dark demographic clouds
When the Canada Pension Plan (CPP) and the Quebec Pension Plan were established in 1966, Canadians could expect to live to 72 with seven-and-a-half workers supporting them over seven years of retirement. Today, with life expectancy at 80-plus, there are only five workers to support each retiree over 15 years of retirement, double its original funding intention. By 2036, only two-and- half workers will support one pensioner. Sustainable? (For example, the Nova Scotia Teachers Pension Plan has 13,525 active members supporting 12,014 retirees and employee/employer contributions of $132.7 million a year compared with payouts of $348 million a year. The plan has a $1.655-billion deficit , $122,365 per employed teacher.)
CPP contributions have increased from 1.8% of salary (1966) to 9.9% (since 2003) with an annual maximum and the funding base has moved from pay-as-you-go to partial funding (targeting 20% funded status by 2014 and 30% by 2075). However, more is at stake than the CPP. It is the creeping liability to an aging population that is the real risk; too few taxpayers supporting too many retired people who have not saved enough.
Abandoning the pension promise
The private sector defined benefit (DB) pension plan, an obligation of employers to pay employees an income in retirement usually based on a percentage of salary, has burdened and influenced the restructuring of entire industries from auto and steel to railroads and airlines. It was a significant impediment contributing to the failed attempt by an investor group, ironically led by the Ontario Teachers’ Pension Plan, to acquire BCE Inc. The consequence has been an accelerating shift of responsibility for pension savings from corporations to individuals and defined contribution (DC) plans. DC plans are tax-deferred savings plans into which employees pay a portion of their salary, often partially or fully matched by the employer, with employees making investment decisions and, importantly, taking on the duty of providing a retirement income for themselves. Individuals are ill-equipped to handle this obligation. Exacerbating the problem, government caps on contributions make it beyond “reasonable hope” for DC plan members to accumulate half of what DB members can (“Legal for Life: Why Canadians Need a Lifetime Retirement Savings Limit,” James Pierlot, Faisal Siddiqi, C.D. Howe Institute, 2011).
It is bad enough that 60% of Canadians have no pension at all, but voluntary programs, such as the RRSP, have had disappointing participation rates. In any given year, only about 26% of tax filers contribute to one. Those fortunate enough to have a DB pension saw the financial crisis of 2008-2009 stress plans into deficit at best or a disaster, such as Nortel, at worst. Mercer’s Pension Health Index for Canada measuring the solvency condition of DB plans was at 63% at the end of the first quarter of 2012 versus the US at 82%; 100% is fully funded. Without new direction, these plans will drift in and out of deficit for years, making pension costs unpredictable. Not surprisingly, smart and well-bankrolled corporations such as RBC are shifting responsibility to employees by eliminating DB plans for new employees. If professionally managed DB plans have struggled to keep up, what hope have individuals?
Butchering sacred cows
One in five Canadians is a member of a public-sector union and 84% of them have DB pension plans guaranteed by taxpayers. Even these pension “haves,” who typically receive 70% of their best five years’ salary as income in retirement, indexed to inflation, may not be safe. If not fully funded, the increasing burden borne by taxpayers can’t continue without radical change. Canada Post, like RBC, is putting new employees into a DC plan to mitigate this risk.
A shrinking workforce makes change unavoidable even as the average public-sector worker retires at age 58 and the average private-sector worker at 62. An example from Bill Tufts and Lee Fairbanks’ Pension Ponzi: How Public Sector Unions are Bankrupting Canada’s Healthcare, Education and Your Retirement is illustrative. Taken from an Ontario Municipal Employees Retirement Service (OMERS) report, one of Canada’s largest pension plans, a member who retires at 60 with 32 years of service and a 70% of best-five-year salary pension ($33,600) over 32 years contributes a total of $50,000 to the plan, matched by the employer (the taxpayer). Assuming 2.5% inflation, OMERS values the benefit to the member and family at $960,000. Can you imagine a $50,000 investment inside your RRSP over 32 years growing to $960,000 in benefits? It’s possible because taxpayers unwittingly pay for it. The weight of the numbers means these deals will have to be revisited.
The pooled retirement pension plan
Federal and provincial governments have the responsibility for pensions in Canada. Evolving from employment-standards law, affirms Ken Burns, partner with Lawson Lundell LLP in Vancouver, the employer/employee relationship sets the legislative basis for pension law. The PRPP would shift liability from employers to financial institutions administering the plans (insurance companies or banks). Burns suggests this move is significant, akin to making the PRPP like an investment product (think RRSP), giving it broader application. He thinks the fiduciary duty of the carrier will be to provide an adequate roster of products from which plan members can assemble a portfolio. In a 2011 C.D. Howe report, Keith Ambachtsheer and Ed Waitzer urge more clarity about default options — a preselected investment for members who do not want to make investment decisions.
The proposed PRPP targets small and medium-sized businesses and sole proprietorships for whom pension plans are an expensive luxury or not available at all. Theoretically, by allowing financial institutions to pool assets from different employers, plan members will benefit from the economies of scale and get to keep more of their own money rather than pay 2.5% mutual fund fees annually. Larger DC plans charge 0.8% to 1.75%. Savings could be significant. The plan for PRPPs is to cap fees at an as-yet-undisclosed level (perhaps 0.5% to 1% per annum). Ambachtsheer seeks legislative clarity about fees and about conflicts of interest for carriers pushing their own products. If low fees are mandated, most current DC plan sponsors must seriously consider transitioning to the PRPP format. Practically, Burns says plans with more than 250 to 300 members are likely to stay with existing carriers, although pricing pressure may be exerted. While PRPP economics for carriers is not good with a capped fee, Burns adds that an annual administration fee per member may be a practical compromise.
Moving fiduciary responsibility to carriers is meant to encourage small businesses to support the plan. Employers currently held to this duty for DC plans are not entirely off the hook because they need to administer payroll and work with carriers on employment records.
The PRPP as proposed is mandatory with a 60-day opt-out provision. Apparently we are so lazy we won’t take the trouble to opt out even if there is money involved. Matching employer contributions is not mandatory, a real drawback for participation.
Quebec has been more aggressive with participation. Its voluntary retirement savings plan (VRSP) is moving forward, requiring implementation by employers without an existing plan with as few as five employees with one year of uninterrupted service. No employer contribution is required, but employee contributions are auto escalated from 2% in 2013 to 3% in 2016 to 4% in 2017. The default investment is a life-cycle (target date) fund with no more than five other investment choices permitted. In a significant departure from the proposed PRPP model, member contributions may be withdrawn prior to retirement (less deductions). This gives the VRSP flexibility.
Forcing members to save for their own benefit is good, and restricting access to funds, as the PRPP does, is best for long-term accumulation. But PRPPs must compete with RRSPs and access to funds for many is important.
Why not expand the CPP?
Some politicians, union leaders and others have lobbied to expand the CPP instead of introducing the PRPP. They argue that administrative mechanisms and economies of scale already in place will allow for scale and better returns. But consider the liability. In 2012, the combined CPP and OAS replaces about 39% of the average annual Canadian salary of $46,000. This proportion is similar to public pension schemes in the US, New Zealand, Germany and Sweden. Countries with high levels of public pension income replacement are Greece, 95%; Luxembourg, 85%; Spain and Austria, 80%; Turkey, 70%; and Italy, 65%. Alone, this list is reason for pause.
For countries already running budget deficits, large pension liabilities can be destabilizing. Witness the turmoil over reduced pensions in Greece and Italy. Directly sharing the responsibility to fund retirement with those who benefit from it makes most sense.
Converging for a perfect pension storm is an aging population that is not saving enough and a corporate sector off-loading financial and fiduciary pension responsibility onto employees who lack the knowledge, time or inclination to make effective investment decisions. Legislative limits on savings are widening the divide between a growing cohort being relegated to DC plans and DB plan haves, the majority of whom are civil servants who will retire on pensions funded by the have-nots. Add a financial services industry lurking with pricey options, DB plans struggling for solvency and expensive long-term public-sector retirement deals struck by politicians and bureaucrats with a short-term focus. Troubling winds become palpable.
Designing a better ark
There are five ways to weather the storm.
- More savings: there is no substitute for starting early and saving more. To the extent the PRPP can expand participation through a 60-day opt-out provision that employees may be too lazy to act upon suggests potential. Auto contribution escalation, as Quebec has proposed, would be a positive add-on for other provinces to consider. Limits on lifetime savings in DC plans need to be raised to compensate for the shift from DB plans. Tax incentives for contributing employers are the best way to get their attention and support. To get employees to participate employers need
to put something on the table, which may be the most effective way to encourage participation.
- More workers: extending the age of retirement and OAS eligibility should be no surprise. Shifting a current liability to a deferred liability doesn’t eliminate the problem but buys time. Coordinating immigration policy by encouraging younger workers is an example.
- More effective investment choices: Canadian investment product providers need to offer better, not more, solutions. A life-cycle default, such as Quebec’s VRSP proposes, is a good idea because it does much of the investment decision-making for plan members, although it has several glaring flaws (see “What DC Plan Members Really Want,” by Ioulia Tretiakova and Mark Yamada, Rotman International Journal of Pension Management, 2011). Limiting product offerings is good because choice confuses people.
- Better DB plan governance: DB plans are governed by theoretical assumptions. Like steering a ship by the stars and ignoring the radar image of the icefield ahead, DB plans need better guidance systems.
- Lower costs: save more by spending less. Introduce more product competition. Use low-cost exchange-traded funds rather than high-cost mutual funds. More providers, foreign asset managers and administrators would help domestic suppliers become more globally competitive and reduce overall plan costs.
As the PRPP now stands, only two of the five goals above are addressed: more participation (perhaps) and lower costs (maybe). Pension reform should consider doing what is best even for reluctant employees. Like requiring everyone to wear a life-jacket, passengers won’t sink immediately, but will be forced to take more personal responsibility if their ship goes down.
Mark Yamada is president and CEO of PUR Investing Inc., a registered portfolio manager and software development firm specializing in risk management and disruptive technology for pension plans, investors and advisers
Technical editor: Garnet Anderson, CA, CFA, vice-president and portfolio manager, Tacita Capital Inc. in Toronto