Time for pension reform

In Canada over the last five years, there has been an increasingly intense debate about pension reform. Three major themes have emerged:

1. Pension adequacy: Three-quarters of the private sector workforce does not have an employment-based pension plan, and that proportion is rising. At the same time, the need for retirement income is growing as we continue to live longer.

2. Cost-effectiveness: Every percentage point of additional annual costs charged to manage retirement savings (related to investment, administration, advice or distribution) reduces the ultimate pension by some 20 per cent. It is also a fact the total cost of pension/retirement savings management and administration varies greatly — there can be a two-percentage-point differential between the annual cost of managing a large-scale collective pension plan and the fees individuals pay when they place their registered retirement savings plans in actively managed retail mutual funds.

3. Defined benefit pension plan sustainability: Some 4.5 million workers are still members of defined benefit (DB) plans — 2.5 million in the public sector, two million in the private sector. Are these plans sustainable and, if not, what should be done about it?

At their pre-Christmas meeting in Whitehorse, the federal and provincial finance ministers announced there would be intensive consultations on these challenges, leading up to their next meeting sometime in late May. This in turn is a precursor to a full-fledged federal-provincial meeting on pension reform with the prime minister and premiers in August. The federal government formally joined this consultation process in March, announcing it would conduct a series of coast-to-coast town hall and roundtable meetings in April.

It looks like 2010 could be the year Canada moves from debates about pension reform to making actual decisions. So let’s take a look at the first theme — pension adequacy and how it might best be resolved. (Editor’s note: To read Keith Ambachtsheer’s thoughts on the other two themes go to www.hrreporter.com, click on “Advanced Search” and enter article # 7790.)

Pension adequacy

While the ideal pension systems allow people to maintain their standard of living after they stop working, the debate about how to translate that ideal into a target-earnings replacement rate continues.

Is it the traditional 70 per cent embedded in many DB plans and in the sales literature of the financial services industry? Or is 50 per cent a better norm in the presence of a mortgage-free family residence and the absence of work and child-raising expenses? This is not a trivial question.

A worker aged 30 who earns an inflation-adjusted $60,000 per year over 35 years will have to save about 14 per cent of pay to achieve a 70-per-cent earnings replacement rate — including the public Old Age Security(OAS)/Canada Pension Plan (CPP), according to a recent C.D. Howe Institute paper. The required savings rate drops to 11 per cent for a 60 per cent earnings replacement rate and to nine per cent if the worker retires at age 67 rather than 65.

There is a growing understanding 70 per cent is unnecessarily high for many people, and 60 per cent or even 50 per cent may be sufficient in many cases.

Yesterday’s retirement savings behaviour is not necessarily a good reflection of tomorrow’s. Similarly, the almost ideal investment environment of the 1980s and 1990s did not continue in the last decade and may not in the years ahead. In this context, a more relevant policy question is: What can we do today to ensure adequate savings rates tomorrow?

Or, more specifically, what can we do to give all workers a reasonable chance to achieve a post-work income target in the range of 50 per cent to 70 per cent of working years’ earnings?

Three possible responses

The public pension combination of OAS, CPP and Guaranteed Income Supplement by itself achieves high earnings replacement rates for low-income Canadians. A couple, both 65 with maximum government pension benefits, receives an inflation-indexed annuity of $34,218 today.

This implies “adequacy” policies should focus on Canada’s middle-income workers without pension plans. This group of 3.5 million Canadians is likely to work in the private sector for medium- and small-sized employers or be self-employed. An automatic, low-cost supplementary pension arrangement would be a useful tool to help these workers achieve post-work income adequacy.

Three proposals have emerged to achieve this goal:

Allow the market to work: Many in the financial services industry believe the adequacy problem can be solved by removing the legal restrictions that prevent providers from offering large-scale, multi-employer, multi-provincial plans that do not exist in Canada. More education and advice would lead to more informed participant decisions, and auto-enrolment into these types of plans would materially enhance coverage.

Create a national supplementary pension plan: Advocates see this plan operating under the CPP/Quebec Pension Plan (QPP) legal umbrella, on an arm’s-length basis from government. It would be low-cost, set a default-earnings replacement rate target, a consistent default contribution rate and a default age-based investment policy. All workers without a pension plan would be auto-enrolled to enhance coverage. Workers own their pension accounts. The plan is voluntary in the sense workers and employers could override any of the defaults if they wish, including opting-out altogether.

Expand the CPP/QPP: Advocates see this as the simplest way to enhance adequacy. Participation in the CPP (or QPP) is already mandatory and all of the relevant, low-cost investment and administration machinery already exists. There is still debate about what form any expansion should take beyond the current target to replace 25 per cent of earnings up to the yearly maximum pensionable earnings (YMPE) — which is $47,000 in 2010. Some believe the replacement rate up to the YMPE should be doubled; others believe the replacement should stay at 25 per cent but the YMPE should be doubled; still others believe both should be doubled. Whatever the formula, there does seem to be consensus it should be phased in over time on an actuarially fair basis.

The pros and cons

Allow the market to work: Letting the market sort it out sounds like a strong pro in principle but it requires motivated, knowledgeable consumers to work. With its “Free Choice” legislation, the John Howard government set Australia on an “allow the market to work” route in 2004.

The legislation is not producing the desired results of lowering member costs, found a 2008 study by The Australia Institute. The current Kevin Rudd government has acknowledged this market failure and launched a commission to study how the mandatory Australian superannuation system can become more cost-effective. A report is due in mid-2010.

Create a national supplementary pension plan: On paper, this approach promises extended coverage, targeting, flexibility and low cost in one package. A potential con is this kind of arrangement has never existed in Canada on a large scale. Fortunately, there are operational models to learn from.

Saskatchewan’s Co-operative Superannuation Society Pension Plan (CSSPP) has successfully operated a similar structure since 1939. The Turner Commission in the United Kingdom came to the conclusion in 2004 this was the right approach to extending pension coverage to British workers without a pension plan; and legislation was passed in 2007. The Pension Accounts Delivery Authority began implementation work in 2008, which continues. Operational testing is scheduled for 2011, followed by a full system rollout in 2012.

If Canada decides to go this route, it could learn a great deal from the experience in the U.K. At the same time, the CSSPP already has decades of successful operating experience in Canada.

Finally, there is no reason why some of the proposed national supplementary pension plan functions could not be outsourced to the private sector.

Expand the CPP/QPP: This approach also promises increased adequacy and a low operating cost in one package. But as it requires mandatory participation, it cannot offer flexibility — the chosen strategy will have to apply to all. However, some targeting is possible. If middle-income, private sector workers without pension plans are the right target group, expanding the CPP/QPP benefit beyond the YMPE ceiling (for example, doubling it from $47,000 to $94,000) would serve them best, and would require a six-per-cent-of-pay contribution rate on income between the old YMPE and the new one. Of course, middle-income earners with pension plans would be equally impacted, requiring equivalent benefit and contribution rate reductions in those plans to ensure overall pension benefits and costs remain the same.

All considered, it seems:

• simplifying and modernizing pension rules and regulations is a no-lose proposition

• the most direct, targeted but flexible route to enhancing future pension adequacy in Canada is to graft a national supplementary pension plan to the CPP/QPP foundation

• a grafted national supplementary pension plan could be combined with some modest, targeted CPP/QPP expansion.

None of these points requires any major upfront expenditures.

Keith Ambachtsheer is director of the Rotman International Centre for Pension Management at the University of Toronto and president of KPA Advisory Services, an international, strategic pension consulting firm. For more information, visit www.kpa-advisory.com.

Saving for retirement

How to make Canada’s pension system best in the world

Together with the government pensions, the adoption of these four measures would give Canadians the best retirement income system in the world:

1. Simplify and modernize the rules and regulations governing workplace and individual pensions to create greater flexibility.

2. Graft a national supplementary pension plan onto the Canada Pension Plan (CPP) and Quebec Pension Plan (QPP) in a way that enhances pension adequacy while maintaining employer and employee flexibility at the same time. This could be combined with some modest, targeted CPP/QPP expansion.

3. Create a task force mandated to find the best way for all Canadians to have the opportunity to access low-cost but expert pension management services.

4. Require fair-value accounting and positive risk buffers in defined benefit plans to bring their sustainability and transparency up to the same prudential standards set for insurance companies and other financial institutions.