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[As submitted to Innovation, Science and Economic Development Canada, Dec 21, 2018].
Enhancing Retirement Security for Canadians: A Wealthy Society Approach for Financial Security and a Stronger Nation.
The Federal Government has committed to addressing and enhancing retirement security for all Canadians. This is an important goal, especially considering our aging population. The best way to enhance the financial security of Canadians in retirement is to create wealth to pay for the retirements that we all want and need.
If we are to make progress towards creating a secure retirement for every Canadian, we need to consider all the tools that can be used, with particular attention on the things that currently enhance or hinder retirement security. These include: economic metrics; government policy, regulation, and laws; monetary policy; the government’s approach to innovation; and education.
Government Policy: Is It Consistent with Retirement Security?
If enhancing retirement security is truly the goal of the Canadian Government, then its economic and monetary policies should be consistent with that goal. Currently, it seems that these policies are primarily focused on stimulating short- to medium-term “economic output”, which is mainly comprised of consumption.
Measures to raise economic output tend to encourage spending over saving, which conflicts with saving for retirement. We must decide what is the primary goal for Canadians. If the goal is to increase output and consumption, then no policy change is required; however, if retirement security is indeed the primary objective, then the current policy approach of encouraging consumption needs to change. After all, the same dollar cannot be spent on consumption and also be spent on retirement savings.
In order to set a Policy to support secure retirements, we need to develop a measure of wealth and/or retirement security, track it, and determine whether the goal of the Policy is being met. Useful metrics would measure Canadians’ financial preparedness for retirement by combining personal wealth, people’s pension savings, the amount of time to retirement, and other relevant factors.
Monetary Policy: Interest Rates and Inflation
The current objective of the Bank of Canada also appears to be the encouragement and stimulation of economic output. Interest rates are held at a low level to boost output, which then lowers the incentive to save for retirement. For example, people are much less willing to save if they earn 0% or 1% interest on their savings than if they earn 6%.
Low interest rates also depress investment returns on both pension and non-pension savings, meaning more money has to be saved to ensure an adequate amount for retirement down the road.
The rate of inflation can also work against efforts to build retirement spending power. The stated Bank of Canada policy objective is to target an inflation rate of 2%, even though there is little evidence to suggest that a 2% rate is economically beneficial. Any positive rate of inflation erodes the value of savings. Future retirees must earn (after-tax) investment returns of at least 2% just to preserve the value of their holdings, which will otherwise decline for decades at a rate of 2% per year.
Today’s monetary policy intentionally keeps interest rates low to encourage spending, but this also increases inflation and discourages saving. This policy conflicts with the goal of increasing retirement savings and the preservation of those savings. Indeed, monetary policy will continue to impair retirement savings until changes are made to that policy.
Taxation
Taxation on employment income reduces the amount of money Canadians have available for their retirement savings, and taxes on investments both lessen the rate of return on savings and reduce the incentive for saving. Note that taxes are applied to the returns on pension savings as well. While investment taxes are not applied to them, pension returns are paid out in the form of pension benefits, which in turn are taxed as income.
In order to save more for retirement, Canadians need more money in their pockets to save and more rewards for doing so. Lower levels of taxes on both employment income and investment income will achieve progress towards higher levels of retirement savings and a higher investment return on those savings. The continued trend of higher taxes on both employment income and investment income will inhibit the achievement of this goal.
Alternatively, a tax policy more consistent with retirement security would rely more heavily on consumption taxes. As savings avoid consumption tax, there would be a greater incentive for Canadians to save versus spend, and more money would be put away for retirement.
Investment Decision Making and Conflict of Interest
The individual future retiree relies on various other people, or “intermediaries”, such as advisors, portfolio managers and administrators to invest his or her savings. Obviously, the future retiree’s financial interest is to achieve the best financial outcome after all costs have been paid. In contrast, the financial interest of the intermediaries is to maximize their own income which comes from advisory and management fees. In the long run, these fees act as a significant drag on the compounded returns achieved by investors, and detract from Canadians’ retirement and financial security.
In recent years, financial products have been made widely available to allow individuals low-cost, efficient and intermediator-free access to many different asset classes. Efficient investment choices such as equity and fixed income exchanged traded funds (ETFs) are now available, even if they are not as widely used as they should be.
Rational and informed investment decision making is made more difficult by a near-universal lack of education in basic finance. As a result, individual savers face significant anxiety when it comes to making the “right” investment choices in financial markets, which are characterized by uncertainty and risk. This anxiety can lead to suboptimal investment choices, as well as an over-reliance on financial advisors, whose high fees reduce the returns to the investor.
A similar problem exists in the selection of high-cost retirement options by HR Benefits administrators who are tasked with singlehandedly selecting retirement benefits providers for their respective organizations. In many cases they lack the financial background or the administrative wherewithal to be able to select and deliver an efficient retirement package for their workforce.
It would greatly benefit most Canadians to be educated on investment basics such as compound interest, how financial markets work, and investment risk at the high school level. They would be less intimidated by, and more familiar with, saving and investing. Since solid retirement security depends upon good investment outcomes, educating Canadians on finance should be made a high priority.
The guidelines and standards of financial industry and pension associations, as well as governmental regulation of fees for various types of investments and portfolios, may be useful in addressing some of these issues, even though such additional rules may lead to added costs and constraints.
Innovation for Retirement Savings
What are the chances that a human, or a group of humans, can design, from scratch, a complex system that performs perfectly? Precisely zero.
In business, pilot testing a concept or program on a small scale is an essential part of staying in business. Before committing a significant part of their firm’s resources to an initiative, its managers want to know: how well does it work? Knowing that an idea works in practice, even on a small scale, greatly reduces the chances of making the very expensive mistake of committing to a large-scale program that does not produce the desired results.
Changes to the RRSP and similar individual savings programs, for example, can be “tested small”. If they produce the right behaviours and results, they can be expanded or made universal.
Canada’s public sector pension system has been suggested as a model for a mandatory universal pension system for Canadians. It is worth examining that proposal for its merits and possible flaws.
There is no doubt that today’s public sector pension plans deliver investment returns at or near the lowest cost available to an individual investor. This has probably been their greatest success, and it provides crucial insight into how to deliver investment performance to today’s retirement savers. That being said, one has to acknowledge that the magnitude of their returns has been aided significantly by the increased amount of risk that they can afford to take (versus the individual), as the government (the taxpayer) stands behind their “defined benefit” promises should pension shortfalls arise.
Many Canadians would like their retirement benefit to be structured as a lifetime benefit so they could avoid both the cost of “over-saving” and/or worrying about “outliving their money”. Major pension plans, with their large pools of members, can be fairly certain about what proportion of people will reach certain ages, and therefore are efficient at managing this “longevity risk”. The individual however currently has to pay a higher cost for this feature, by buying annuities, as he or she needs to compensate the provider with compensation for the uncertainty of his or her longevity. Innovation to pool this risk among large numbers of individuals, and thus lower the price for such uncertainty, is needed for such people who are not in a lifetime-benefit plan.
It is important to note that Canada’s public sector pension system is itself the end product of a lot of testing and not a clean sheet of paper design. For example, as recently as 1990, Ontario Teachers’ Pension Plan (OTPP) held only non-tradable bonds in its investment portfolio. Many years of trying new investment approaches, and discarding old ones, has led to the current successful pension plan it is today.
One of the approaches OTPP developed was so-called “liability driven investing”, which was copied, imitated, adapted and improved by many other pension plans. It has been the “competition” between the public sector plans – comparing results, returns, costs, and approaches – that has led to the “system” that Canada has presently.
Mandatory Pensions
One potential problem with a mandatory collective system is its non-competitive nature. The absence of competition, with customers forced to buy the product of a vendor with a legal monopoly, tends to work out much better for the vendor than the customer: There is very little, if any, incentive for the provider to improve performance, costs or convenience.
A rationale that has been used for mandatory pensions is that some people will likely “fall through the cracks” of a purely voluntary system. However, this potential problem can be handled in alternative ways as well. For example, if the retirement savings and wealth of Canadians as a whole is sufficiently robust, then one reasonable option might be to support those with inadequate pensions through social programs. Another alternative would be a “soft compulsory system” whereby you could leave if you could demonstrate that you had sufficient wealth to support yourself in retirement.
Finally, it is worth noting that a modestly enlarged universal workplace pension benefit (and cost) is on the way, with the Canada Pension Plan’s expansion starting January 1, 2019. What effect this new pension program will have on the retirement savings health of Canadians remains to be seen.
Corporate Pension Plans and Bankruptcy
One major risk to Canadian corporate pension plan members comes to light with almost every major bankruptcy: the losses to their pensions when their company fails.
The problem is that pension regulation is assumed to be sufficient to protect pension members in a bankruptcy – for example, by requiring adequate funding of pension plans. However, this has been proven over and over again to be woefully ineffective. When a company goes bankrupt, there is often a significant deficit in its pension plan. In such a case, the pension plan’s members are forced to compete in a complex legal process to try to recover the deficit. They often fall well short – leaving pensioners with significantly less retirement savings and income than they counted on.
One remedy that has been proposed is to make sure that the pension plan’s shortfall is paid back first in a bankruptcy, before the company’s bondholders, lenders and other claimants.
But to put that into law tomorrow could lead to a shock to the market for corporate credit obligations, as their risk of loss in bankruptcy would increase significantly overnight. This is due to the fact that they would stand to incur more losses, as they would be entitled to a smaller share of company assets than they would in a bankruptcy under current law.
A better option - for pensioners and for creditors - would to be to apply the “paid back first” rule to the proportion of the pension benefits earned from a new law’s effective date. For example, if the pension shortfall in a future bankruptcy was $100 million, and 55% of the value of the pension plan’s benefits had been earned after the law’s effective date, then $55 million would be paid back first from the company’s assets to its pension plan. The other $45 million would be a credit claim to be considered alongside other creditors’ claims in the bankruptcy process.
The impact on markets would be minimal, yet over time (a decade or two) corporate pension plan members would enjoy much more certainty about their eventual pension benefits. Such a change would not be difficult to implement; a bankruptcy trustee could simply perform a straightforward calculation at the time of bankruptcy to determine the “paid back first” amount.
The Government’s request for comments on retirement security alludes to situations in which money, such as executive bonuses or dividends, is taken out of a company just prior to bankruptcy. Bankruptcy law can be changed to make such withdrawals subject to reversal if they proved to be made for the purpose of evading the full repayment of creditors.
Why Restrict How Well A Pension Plan Can Be Funded?
There is another troublesome aspect of today’s current pension regulatory system that needs to be addressed, which is the limitation on pension “surpluses”. A pension plan’s surplus measures the amount of assets in excess of that needed to cover its liabilities, expressed as a percentage of its liabilities. It can be written mathematically:
Surplus = (Asset Value – Liability Value)/(Liability Value).
Currently, pension plans are restricted from having a surplus greater than 25%. This regulation needs to change.
The 25% surplus limitation makes pension plans unstable in the long run, since it will eventually impair the compounded value of pension assets.
A pension plan’s surplus is certain to fluctuate significantly over time with financial market cycles, booms and crashes. From time to time, its surplus will hit 25%, and the pension plan will be forced to distribute assets out of its portfolio. Once taken out, these assets will no longer produce returns for the pension plan and will no longer be available to counter inevitable shortfalls in future returns.
Further, the calculation used by pension plans overstates their true economic surpluses. Pension plans use a different valuation method for liabilities than for assets, which significantly understates the liabilities in financial terms. As a result, the surplus calculation results in an inflated number; therefore, even when a pension plan has a 25% reported surplus, it actually has a negative true economic one.
At no cost to taxpayers, Canadian pensions can be made more secure by eliminating the surplus cap, or at the very least, setting it at a much higher level. Removing or increasing the regulatory cap will also provide less incentive for pension plan boards to voluntarily reduce surplus as it approaches 25%.
For a more complete discussion of this issue, please refer to the paper “Canadian Pension System: A Model to Follow – Or Designed to Fail?” available at www.investarchitect.com.
Other Wealth Building
Building a Wealthy Society that is self-sufficient in retirement goes beyond pension plans and personal investment accounts. Home ownership represents a very significant source of wealth that can be accessed in retirement through a sale of the home or with a “reverse mortgage”. Ownership stakes in private businesses or intellectual property (IP) also represent significant sources of wealth and income that can be used for retirement. Government policies to encourage investment in businesses and IP through both reduced taxation and de-regulation will increase the wealth of Canadian Society, ultimately strengthening the overall retirement system as well.
Conclusion
For the most part, this paper has tried to point towards approaches to increasing retirement security rather than specific policy prescriptions.
In order to set a Policy to support retirement savings, we need to develop a measure for its effectiveness, track it, and use it to modify the Policy when its objectives aren’t being met.
Current taxation and monetary policy work against retirement security. A reversal of the current low-interest rate monetary policy, and a switch in tax policy to lower income and investment taxes and (perhaps) raise consumption taxes, would encourage both pension and non-pension retirement savings and would help to preserve their value.
Reasonable and effective Guidelines and Standards for savings and investment products could mitigate many of the conflicts of interest and less-than-optimal decision making that impair building wealth for retirement. Financial education would also greatly assist Canadians in making smart investment decisions.
For corporate plans, non-disruptive changes to bankruptcy law can effectively address the type of bankruptcy-related pension disasters we have seen over the years. For all plans, a change to eliminate or raise the cap on the surpluses of pension plans would enhance their long run stability.
We should test all kinds of retirement savings and pensions ideas on a small scale and see which ones work best.
Finally, having a Wealthy Society not only makes retirements possible, it makes Canada a better and more secure country.