Voluntary pensions – upsides, downsides

Several proposals have surfaced recently that call for the government to develop and offer some sort of voluntary pension plan (VPP). Any such plan would combine workers from multiple employers and set an entry level minimum contribution formula for employers and employees (while also offering higher contribution options). The plan, as proposed in most provinces, would allow employers and employees to opt out.

There are several arguments in favour of a VPP:

Economies of scale: Efficient and effective administration is a fundamental element of the implementation and ongoing success of a VPP. Administration would be most efficient if contributions were collected and submitted via existing payroll systems and it provided cost-effective access to high-quality investment management expertise. The goal would be to deliver plan administration services at a cost comparable to that currently enjoyed by the largest pension plans.

Additionally, though the magnitude is completely speculative, basic economic rationale would support the argument that savings levels could increase if investors saw evidence their savings produced higher levels of income.

Enhanced harmonization, pension portability and labour mobility: A desirable feature of a system of VPPs, if harmonized across all provinces, would be the elimination of a significant portion of the paperwork upon termination of employment to manage pension entitlements. If an employee moved from one employer to another, and if both employers participated in the same VPP, the member’s account could remain unchanged except for the identity of one of the contributors.

The drafting of careful rules for VPPs in itself could be an important exercise in improving harmonization. Similarly, all provinces might be able to agree, as most of the provincial expert panels recommend, that vesting of employer contributions should be immediate in order to simplify administration.

Reduced distraction from employers’ primary goal: Employers have argued their involvement in the management of pension plans takes attention away from their primary business of delivering goods and services to customers. While a VPP would require management attention to establish the role the new program should play in a compensation program, this requirement would be an occasional rather than a continual one. Overall, the availability of a VPP on a purely voluntary basis should allow the employer to retain needed flexibility in the design of compensation programs for employees.

Payroll taxes are identical to those of registered pension plans (RPPs): One advantage touted for VPPs, because they would operate as a registered pension plan, is participating employers would face smaller contributions to payroll-based assessments for Canada Pension Plan (CPP), employment insurance, workers’ compensation and other earnings-related programs.

Also, standard labour economics say, over time, an employer will adjust total compensation so the costs of any benefit ultimately are borne by the employee. That may generally be true, but it is difficult to confirm, especially in the part of the labour market where minimum wage laws apply. Where such constraints are binding and wages cannot be decreased, employers almost would certainly prefer an option that permitted them to avoid payroll taxes.

Increased insolvency protection: Participation in a large-scale pension savings program, possibly with government backing, would provide significant confidence to employees about the continuity of their pension plan. The portability of the benefit when a worker changes jobs would be one factor contributing to this confidence.

Another factor is participants could actually experience less risk than they might have faced with a single-employer pension. Realistically, since a defined contribution RPP requires only that an employer remit contributions to the plan, the participants’ financial exposure — if the sponsoring employer gets into financial difficulty — typically is limited to only those contributions due with respect to recent payroll.

The reality of this risk exposure, however, might not be the same as employees’ perceptions of the risk. If employees did not distinguish between defined benefit problems featured periodically in the media and their own defined contribution plan, some might hesitate to participate in the plan because they perceive the risk to be greater than it actually is.

Increased diversification: Any VPP would incorporate diversification as an important element of its prudent investor requirements. The participant in a VPP would be further protected, by the size of the fund and the separation of its investment management, against non-diversification risk created when an employee invests in his own employer’s securities.

Address investor inertia: While automatic enrolment would do nothing to force employers to offer pension plans, the negative consequences of demand-based inertia could be addressed partially by legislation that made participation automatic when a pension plan was available in a workplace; making participation mandatory would go even one step farther.

Overall, participation rates for pension plans would likely increase if a VPP were available, and pension coverage is positively correlated with adequate retirement income. Therefore, the “average” Canadian would be expected to be better off. However, the correlation between these two factors is less than perfect, and the reformed system would have uneven effects on Canadians who are not “average” and likely at least a few who are not better off. Any measure of retirement savings adequacy that relies solely on the pension coverage rate is limited in its applicability.

Primary risks of a VPP

The primary risks identified with the VPP proposal are listed below:

Concentration risk: Both the growth in the VPP and the reduction in the size of other savings vehicles would contribute to a more highly concentrated investment market. How much concentration is desirable and what are the risks of further concentration? Assigning investment responsibility for a significant amount of VPP contributions to a government entity could shift concentration dramatically, as measured by standard indices.

Further concentrating investment management certainly would reduce diversity, so consolidating assets through a VPP to create economies of scale in the pension system is a process that could be pushed too far. While further concentration could reduce administrative costs, it could also increase systemic risk of the type (though not of the scale) that caused the effects of the United States sub-prime mortgage crisis in 2008 to be so rapid and widespread.

Acceptance and participation: The principal reason the VPP concept might come into being relies on advantages that emerge from broad participation, especially its economies of scale, without which a VPP could not become substantial enough to support state-of-the-art governance arrangements and investment management services.

But what if the necessary levels of participation do not materialize? How would employers and employees receive a VPP?

Implicit liability for insolvency: The flipside of the confidence provided by government involvement is the possibility it could be perceived as offering assurances about returns on investment or benefit levels. Although expert panels do not advocate direct government sponsorship or investment management by government bodies, they generally agree a VPP would require some resources from government for its launching. If the anticipated results did not materialize, however, would participants expect government to make up the difference?

In the final analysis, two key arguments provide the most compelling reasons to consider the establishment of large, economically efficient VPPs. First, assets could be managed professionally and efficiently, leveraging economies of scale. Second, they would reduce the distraction from employers’ primary goals.

Neither argument, however, offers convincing evidence that government, rather than the private sector, should develop such funds. The removal of regulatory barriers to the development of “superfunds” in the private sector could achieve many of these same benefits while also maintaining choice and reducing systemic risk.

Ultimately, the marketplace will determine whether the additional option of a VPP is needed and whether it is offered on terms that make it more attractive than the other available alternatives.

Norma Nielson is a professor in insurance and risk management at the Haskayne School of Business and director of the Risk Studies Centre at the University of Calgary. She can be reached at [email protected]. The above article is an excerpt from the paper “Should government facilitate voluntary pension plans?” from the School of Public Policy at the University of Calgary. For the full paper, visit http://policyschool.ucalgary.ca/files/publicpolicy/researchnielson.pdf.