Monday, November 8, 2010

Demise of Defined Benefit Pensions?

Ray Turchanshy of Postmedia news reports, Too early to declare demise of defined benefit pensions:
Economist Jack Mintz from the University of Calgary got crowds buzzing at the western regional conference of the Canadian Pension and Benefits Institute, when he predicted that the defined benefit pension plan could make a comeback.

Defined benefit plans have been knocking on death's door, due to the huge cost and risk of investment loss to employers, compared with defined contribution plans in which the employee takes on the investment risk.

Mintz started his conference presentation by saying, "Freedom 55 is really when your kids turn 55."

He noted that the percentage of pre-retirement income that people need to live on during retirement, usually cited as 70 per cent, is often over- exaggerated, usually by financial industry people with investments to offer.

"If you have relatively low working income, just to survive you might need 100 per cent.

"On the other hand, when people do retire there are a lot of savings, like automobiles and furniture that you don't have to keep buying, and you don't have transportation expenditures to go to work, and can probably wear jeans instead of suits."

The median annual employment income of Canadians is $50,000 to $55,000, and the Organization for Economic Co-operation and Development says people making $27,500 require 70 per cent in retirement, workers making $52,500 need 60 per cent, and people making $105,000 require 50 per cent.

When it comes to saving for retirement, Mintz said Canadians hold $1.9 trillion in Canada Pension Plan, corporate pension and Registered Retirement Savings Plan assets. But they also have $1.9 trillion in home equity (which isn't taxed when you downsize); and $2.2 trillion in nonfinancial assets.

"So when people suggest we're under-saving, it's way over-exaggerated because they ignore these other assets. And we can be very proud in Canada that we have the lowest poverty rate of seniors in the world."

According to the OECD, the percentage of people age 65 and older living on half the average income ranges from 4.4 per cent in Canada to 30.6 per cent in Ireland, with a world average of 13.3.

"The big difference between the United States and Canada is that the U.S. economy has not only seen a massive erosion in terms of financial wealth, but also in housing wealth, which has not happened here in Canada."

Mintz noted a number of interesting trends:

* People without company pensions tend to work longer and therefore have more retirement income than those with company pensions, although retirement income of people without company pensions is much more variable.

* Women retire earlier than men and live longer, so they need to save more for retirement, especially if they're single or on their own. And we have more lone parents with children, another group in peril of having insufficient retirement income.

* People are working for the same company longer than they used to, from an average of 85 months in 1987 to 100 months in 2009.

But Mintz theorizes that an aging workforce will cause companies to lure and retain employees by dangling carrots like a defined benefit pension.

"Governments may correct some regulations. Perhaps defined benefit plans won't disappear, and in fact there may be a desire by many employers and employees to see some return of those defined benefit plans."

However, most people feel the cost and investment risk to employers will kill defined benefit plans in the private sector, and put pressure on government worker or public sector plans.

"When it comes to risk involving defined benefit plans in the public sector, that falls onto the taxpayers. And if these pension plan costs are high, what it means in the future is pressure on salaries in the public service, and some pressure to reduce services in the public sector.

"There will be a desire to outsource more work outside the public sector. And we'll see young people not willing to pay the costs of pensions to older workers."

Concern that Canadians retiring early and living longer are not saving enough for their extended retirements has produced various theories to revamp the system.

One is to create a government-sponsored defined contribution plan, such as a personal pension account like a group RRSP as a supplement to the Canada Pension Plan, suggested by Keith Ambachtsheer of KPA Advisory Services, or a series of provincial plans such as the proposed Alberta-British Columbia pension.

A second idea is to expand CPP, with increased contributions and investment growth covering liabilities, and with benefit increases phased in over time.

A third concept is a national privately delivered defined contribution plan.

And the C.D. Howe Institute proposes raising annual RRSP contribution limits from 18 to 34 per cent of income, to a maximum of $34,000 instead of the current $22,000.

Mintz said the federal government is looking at a very modest revamp of the CPP, like increasing the 9.9 per cent of pensionable earnings that employers and employees combine to contribute, or increasing the current pensionable earnings maximum of $47,200. The effect would be to increase the CPP's current aim of replacing 25 per cent of average working income in retirement.

Other suggestions coming out of the conference were to allow people to retain RRSP contribution room after taking money out, as is allowed with a Tax- Free Savings Account; to increase the age when people can take unreduced CPP benefits above 65; to reduce indexing of public and private pension plan benefits when the economy falters; and to make pension plans hold reserves for guaranteed defined benefits.

I agree with Jack Mintz that the percentage of pre-retirement income that the financial industry often cites as "necessary" to retire comfortably on is greatly exaggerated. I also think reports on the "death" of defined-benefit (DB) plans are also greatly exaggerated.

And I even agree that companies will use DB plans to lure employees. However, if you think about it logically, we shouldn't even have private DB plans. There should only be public DB plans which covers all Canadians. But there is a lot of money involved, and everyone wants a piece of the pension pie, so this will never happen (consultants, actuaries, financial services firms like banks, insurance and mutual fund companies all have a stake in the pension pie).

The ultimate solution is having everyone's pension managed by professionals working at large public DB plans. You need to get the governance right, and more importantly, you need to have realistic investment assumptions to make sure these plans are properly funded. This solution has the added benefit of pension portability, meaning that no matter where you work, your pension will follow you effortlessly. Of course, what's logical to me seems like a monumental undertaking. It's too bad because Canadians deserve better.

***Feedback***

Jonathan Jacob of Forethought Risk shared these points with me:

In your recent column you discuss the “ultimate solution is having everyone's pension managed by professionals working at large public DB plans”

While I may agree to a certain extent in theory, the practicality is frightening:

  • Creation of too big to fail in pensions – what if those professionals at DB plans had a brutal year – the impact on the public sponsor who must shoulder the shortfall be it provincial or federal will be significant and will ultimately impact every Cdn taxpayer
  • Alignment of interests – not creating a huge behemoth fund where executives expect huge pay packages that would be unacceptable to public sector employees.
  • In the end you are proposing some sort of expansion of CPP which is not a terrible idea as long as the funding for such expansion is explicit – no more “pay as you go” crap
  • This environment is difficult for creating a DB plan – but if you can afford to create one when interest rates are low, then you will be golden when rates rise again

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