CPBI Saskatchewan Conference – April, 2012 “Insight and Intrigue”
“The Blame Game – Who is Responsible for the Current Pension Crisis”

When I agreed to participate in this year’s CPBI conference, I faced a challenge. How do I link my field of expertise – namely, pension and investments, with the theme of the conference – “Insight and Intrigue”? I think that I get the “insight” part, but what was I to do about “intrigue”? The available definitions of intrigue, both as a verb:

  • “to arouse curiosity or interest of, to facilitate”; or as a noun,
  • “the secret planning of something illicit or detrimental to someone”

    did not provide me with much help. It was only when I dug deeper did I find a link between the two parts of speech, and the common word that I found was “cabal”!

    In the pension industry in Canada, I can think of several examples of cabals. For example, the organization of which I have been a member for almost 40 years, the Canadian Institute of Actuaries (or our version of the CIA), the Canadian Association of Pension Supervisory Authorities (CAPSA), or perhaps even this very organization, The Canadian Pension and Benefit Institute – the CPBI. Are we all cabalists?

    At any rate, this at least provided me with a starting point. Do these organizations, individually or collectively, share a desire to do anything detrimental to the retirement savings industry, and by extension, the millions of “hard working” Canadians who look to their pension plans to provide them with a large portion of their retirement income? Let’s take a closer look at these organizations, and the roles that they have played in shaping the pension industry over the past 50 years

    In terms of age, the CIA is the oldest body, having been created by an act of Parliament in 1965. While originally dominated by insurance company actuaries, the profession has evolved over the past half century and now encompasses a wide variety of actuarial disciplines. As of September, 2011, there were almost 3500 “Fellows” of the Canadian Institute of Actuaries, with the largest number (about 900) categorized as pension actuaries. Somewhat surprisingly, the third most populated group of actuaries (following life insurance actuaries) are actuaries who are now out of the work force!

    The pension consulting industry at one time, and possibly still, continues to be dominated by actuaries. The earliest data collected by Statistics Canada in 1973 revealed that well over 90% of pension plan members at that time enjoyed benefits that were created under DB plans. These plans, in turn, required the services of an actuary to evaluate the adequacy of the funding promise. The periodic, usually triennial actuarial valuation was both a reliable source of income to the actuary, as well as a means of demonstrating to the now growing number of provincial pension regulators that pensions were, in fact, being soundly funded.

    But somewhere along the line, something when terribly wrong. The “cabalist” influence in the profession took hold. During the decade of the 1990’s, with pension funds enjoying robust rates of return on their invested assets for an extended period, the profession may have strayed. Perhaps bowing to pressure from plan sponsors, who after all, paid the bills and in many ways, called the shots, “contribution holidays” became common place. Sponsors of DB pension plans were able to meet their funding obligations from the excess returns being generated from the pension assets. This was the “free lunch” that we had heard so much about. There was also an expectation that this environment would persist indefinitely.

    At this conference last year, I quoted from the biblical book of Ecclesiastes. This year, my biblical reference is from the earlier book of Genesis. Towards the end of that book, we encounter the story of Joseph (he of the coat of many colours fame) in Egypt where, as an advisor to the Pharaoh, he recommends the storing of crops during the seven fat years to make adequate provision for the seven lean years which are expected to follow. Unfortunately, to the best of my knowledge, few actuaries are biblical scholars and they unfortunately did not recall this story of prudence from many centuries ago. Even with the assistance of Tim Rice and Andrew Lloyd Webber, the message was somehow lost. How different the situation might be today if plan sponsors had acted prudently during the heady years of the 1990’s. Rather than take contribution holidays, as many did, plan surpluses might have been left to accumulate for use at a later date.

    Notwithstanding, the rules of Revenue Canada (now known as the Canada Revenue Agency or CRA) limited the maximum amount of surplus assets that a pension plan was allowed to store. This was also the beginning of the era that saw a great number of pension plans convert from Defined Benefit to Defined Contribution, with the generated surpluses under the DB plan being used to pay the employer contribution to the DC plan. Life didn’t get much better than this! In an era of declining interest rates and robust equity returns, we let the good times roll! Unfortunately, this all came to a crashing halt in the years following the “tech wreck” of 2000, and we have yet to recover. The financial collapse of 2008 exacerbated an already precarious situation, and 2011 wasn’t a stellar year either! 2012 isn’t shaping up to be a real winner either.

    So clearly the actuarial profession must accept at least some of the blame for the current situation. In an attempt to seen as the “good guy”, we perhaps lost sight of the long term goals of defined benefit pension plans and accommodated the short term aspirations of plan sponsors. But who could fault us – we were simply responding to the goals and objectives of our clients, and they after all pay the bills!

    Cynically, conversion from DB to DC was not in the long term best interest of the profession since DC plans do not generate the kind of revenue for consultants that DB plans do!

    Next on our lists of “culprits” are the regulators – those well-intentioned, but possibly misguided public servants who may have unwittingly contributed to the demise of the pension system. During the early years of pension legislation the provincial pension acts, and accompanying regulations were relatively benign. After extensive study in the 1970’s and early 1980’s, “Pension Reform” legislation appeared addressing the perceived shortcomings of the pension system. These reforms added additional layers of administration, cost and disclosure to an already, in most cases, voluntary arrangement. It is no coincidence that the growth of DC plans and decline of membership in DB plans followed the introduction of Pension Reform Legislation – particularly in Ontario. Earlier vesting, the 50% rule, mandatory spouses benefits – while all highly desirable features, placed a greater financial burden on plan sponsors. There were also additional requirements for disclosure, as well as for annual member statements. The additional costs created by these “improvements” were not insignificant, and many plan sponsors decided to head for the exit, rather than incur additional costs.

    The intention of reform legislation was laudable, but I can’t help but feel, with the benefit of hindsight, that the changes implemented did more to hinder than improve the pension landscape – particularly as it related to the conversion of plans from DB to DC. Ignoring the great number of IPPs that have been set up since the early ‘90’s, the number of pension plans, as well as number of people covered by those plans, has decreased.

    One other feature of Pension Reform was the introduction of the Solvency Valuation. Prior to its creation, the regulators relied on the funding or “going concern” actuarial valuation to determine the level of funding that was required under a pension plan. The focus of the solvency valuation is adequacy in the even to of wind up. While unlikely, nevertheless, it is a real concern – that there are sufficient funds available to provide all of the benefits promises under the pension plan. At the time of introduction, the solvency rates – based on long term bond yields – was greater than the interest rate being used by actuaries to prepare funding valuations, so such solvency valuations were merely an exercise in number crunching!

    With the gradual but continuous decline in interest rates over the next 20 years, solvency valuations replaced the funding valuation as the focus of plan sponsors, with the result that many plans, while adequately funded on a going concern basis, find that they have a solvency deficiency which requires additional payments into the pension fund. Bummer! It is only within the past two or three years that several regulators have adopted “solvency relief” for pension plans facing the added burden of making special payments to the fund. This may very well be another example of too little, too late.

    Revenue Canada, or the Canadian Revenue Agency (CRA) as it is now known, was also a contributor to the decline and fall of DB plans. While CRA is to be applauded for its generosity in creating a tax structure that favours prudent retirement savings, they are not without fault. In 1990, the Pension Adjustment (“PA”) was introduced into the pension landscape. Yet another reporting requirement, although some of the improvements introduced at that time were highly desirable – such as unlimited carry forward of unused RRSP room (rather than the use it or lose it approach which it replaced). A few years later, the PAR became part of the reporting package and RRSP room was restored for some employees on vested termination of employment.

    But perhaps the most troublesome rule that adversely affected the sound funding of pension plans was the maximum surplus rule. In order to avoid pension funds becoming depositories for large amounts of untaxed assets, CRA limited the amount of surplus assets that could be held in a pension fund. During the good years, employers were often forced to take contribution holidays in order to avoid excess surplus in their pension fund. Perhaps if those plans had been permitted to continue to contribute, the funding issues that many plans face today could have been avoided.

    This brings me to my next point – the treatment of surplus on plan wind up. The asymmetrical treatment of surplus has been a further contributing factor to the reluctance of pension plans to keep excess assets in the pension fund. Ownership of and distribution of that surplus on pension plan wind up was of concern to plan sponsors. Frequently, plan sponsors found it necessary to share such surplus with their employees when a plan was wound up – in whole or in part. This was even the case in plans which had been non-contributory – where the employees had not made any payments into the plan. Complete seminars have been given by persons much brighter than I dealing with the topic of pension surplus. Suffice it to say that this issue played a part in the conversion of plans from DB to DC.

    Let’s not forget about the accounting profession when we are looking at possible guilty parties. Over the past twenty five years, the accounting profession has taken a much keener interest on the impact of pension costs on the financial statements of corporations; moving from an environment of simple disclosure of such amounts, to having their impact felt on the profit and loss of the entity. The new IFRS reporting standards, which are now required of all publicly traded corporations, have a much more direct impact on how pension expenses, as well as “actuarial gains and losses” are reflected in the financial statements of a corporation. While details of the calculation are often buried in some obscure footnote to the statements, they are there for the entire world to see. Amortization and smoothing techniques – once the salvation of many corporations – are things of the past.

    In the 1885 Gilbert and Sullivan operetta “The Mikado”, the title character sings a song dealing with having suitable punishments fit the crime. Earlier in the same operetta, the exalted Lord High Executioner produces a list of “Society offenders who might well be underground and who never would be missed”. I think that it is only fitting that I attempt to replicate the efforts of those two characters with my list, and suitable punishments that fit the crime.

    For example, for all those actuaries and pension consultants who, during the 1990s have encouraged their clients to take contribution holidays, or implement conversions to DC, I sentence them to a pension based on the current fund balances of DC participants. For our elected members of parliament, whose gold-plated fully indexed pensions are payable at age 55 for a lifetime after as few as six years of service, and whose cost has been estimated to be several hundreds of millions of dollars; participation in a PRPP is suggested. And for money managers, who have gotten very rich while their clients have suffered with anaemic returns, exchanging their cars and homes with those of their long-suffering clients.

    So far, we have heaped blame (and scorn) on the actuaries, the regulators, CRA, and the accountants. Surely, I can’t let the fund managers get off scot free can I? You may recall that in the early days of pensions, the insurance companies were the risk takers – they set premium rates, and under group annuity contracts, eventually paid the pension promise. With attractive rates of returns available (so it would seem) from both equities and fixed income investments, investment manager firms were created and flourished. Judging by the recent number of such firms that have sold out to banks and insurance companies, it was a very lucrative business to have been in. If only the rewards had been as great for their clients! While fund managers have prospered, their clients unfortunately have done less well.

    So where do we go from here. Let me assure that all is not lost. As the late Dr. Seuss said in his classic book “If I ran the Zoo” – I’d make a few changes – that just what I’d do! (How often do you get references to Dr. Seuss books in these types of presentations!)

    I’d start with the Canada Pension Plan. Setting aside the petty power struggles and posturing by the various provinces and focusing rather on what’s right about the CPP, I’d gradually implement improvements to the plan. It has stood the test of time from inception in 1966 to today. It is reasonably soundly funded, and unlike similar plans in other countries elsewhere in the western world, there is, I believe, a high degree of certainly that it will provide the benefits that have been promised without placing an additional burden on the taxpayers. Periodic actuarial valuations confirm that the current level of funding is sound and sustainable for the foreseeable future. Several experts have recently come out in favour of such an expansion, and I will add my voice to that chorus. Unfortunately, politics being what it is, a national consensus on this has not been reached.

    The expansion can take place both horizontally – by providing benefits, perhaps on an employee-elected basis, for earnings up to 50% greater than the YMPE, and vertically – by increasing the benefit – gradually – from 25% to 37.5% of the final average indexed earnings. This is not a new proposal. In fact, it was considered, and rejected as far back as the 1970’s by the then labour minister in Trudeau’s government. Perhaps it’s now time to revisit this idea. CPP provides “defined benefit” payouts (which experts and actuaries seem to feel is what we need), together with professional investment management and low cost administration. What’s not to like about the CPP!

    Financing of the proposed changes can be accomplished by increases in contributions from employees and employers, with the “excess” benefit financed by employee contributions. Yes – we will pay more, but we will be saving for our retirement, which we are all told is a good thing. Many small businesses have objected to the possible added burden that an increase in CPP funding will place on their profitability. I argue that there is no “really good time” to implement such a change, so it might as well be now.

    The recently proposed PRPP legislation from the federal government, in my opinion, will do nothing to remedy the current ails of the pension system. It is a problem where there are already several viable solutions available. While possibly a windfall for insurance companies, mutual fund and investment firms, I honestly can’t see how such a system will succeed when the Group RRSP has already been available to possible plan sponsors for many years. I hope that I am proven wrong – time will tell. It also requires enabling legislation from the various provinces in order to cover employees other than those who work for employers that fall under the definition of “Included Employment”. What is being proposed is a completely voluntary arrangement with no requirement for any employer contributions. That is a recipe for failure if I ever saw one!

    Employers will not be required to offer or contribute to PRPPs. No minimum level of employer contribution will be required, as is the case with defined contribution pension plans. Membership by employees will be voluntary. Other than offering the convenience of payroll deduction at place of employment and POSSIBLY having access to lower cost investment products, there isn’t much to argue for the PRPP. As Shakespeare said: “Much ado about nothing”! Currently the proposed legislation only affects the 5% of the population that fall under Federal jurisdiction.

    In January, a survey commissioned by an insurance industry association revealed a positive attitude among small and mid-sized employers to the proposed PRPP. If there is such a ringing endorsement of the PRPP as this survey would suggest, one would question why heretofore those same employers have done nothing to provide retirement benefits to their employees when other options (such as a group RRSP) were already available!

    Going one step further, in the March publication of the Institute for Research and Public Policy, Rob Brown and Tyler Meridith espouse the merits of a Pooled Target Benefit Pension Plan or PTBPP. Under this “voluntary” arrangement, involving mandatory contributions from any participating employer, as well as from self-employed persons, a “target benefit” of 50% income replacement could be achieved. Gentlemen, we already have such a plan in existence, and it’s called the Canada Pension Plan. Why are you reinventing something that is already working well?

    A recent article by Wells Fargo in the US (November, 2011) suggested that the average American worker must now expect to continue in employment until age 80, (80 is the new 65) or two years beyond the normal life expectancy for a male. So much for “Freedom 55”! In fact, a recent cover story in the Toronto Globe and Mail considered the implications of increasing the age for eligibility for OAS from 65 to 67 as a means of reducing the cost of this universal and unfunded programme. We should also remember that when OAS was introduced over 50 years ago, the age for eligibility was 70, not 65 as it is now. I’d be curious to see, as Dr. Phil would say, how that works out!

    The move from Defined Benefit to Defined Contribution continues, with at least one of Canada’s largest chartered banks now making the switch. Even the major actuarial consulting firms, that supposedly encourage DB plans, are themselves implementing DC plans in a clear instance of “Do as I say, not as I do”. If they were to lead by example, they would have kept their DB plan, but clearly, business reasons etc. have come into play, and they too have now chosen to go the DC route.

    Overall membership in pension plans in general, and defined benefit pension plans in particular, has decreased over the past forty years, with no likelihood that this trend will not persist.

    Life isn’t getting any easier for members of DC plans. The anaemic returns from the equity markets over the past few years have greatly reduced the account balances of many DC plan members. Even the new “Target date funds” with their sophisticated glide paths and, in some cases, over-engineered structure, have done little to enhance the rate of return of plan members. It is becoming increasingly difficult to convince members that their money should not be invested in the money market fund where it will earn next to nothing, when instead, it should be invested in a balanced fund (returning a small negative return) or an equity fund with its double digit negative return! Plan members are now pining for the good old days of defined benefit pension plans where the employer was on the hook for the pension risk. Recent studies by the TD bank confirm what is widely know – Canadians are ill prepared financially for retirement with most Canadians having less than $100,000 in retirement savings and 15% claiming to have nothing at all saved for retirement. Fully 7% of the population expect to finance their retirement from lottery winnings.

    To quote Ernest Thayer: “The outlook was extremely dismal for the pension plan members that day”. As 2012 unfolds, the outlook continues to be extremely dismal, with little signs of improved returns on the horizon. What are members of Defined Contribution plans to do so as to have their funds grow sufficiently to produce a “reasonable” income in retirement?

    The first step in achieving better income in retirement is perhaps the hardest. That is to maximize contributions to retirement savings plans – whatever type of plan that may be. In an environment of greatly reduced expected rates of return, more of a person’s retirement income will arise from the contributions made to the plan, and less from investment earnings thereon. For many years, I taught that 70 cents of each dollar of income received in retirement arose from investment income while only 30 cents came from the actual contributions. That statistic was based on a 30 year contribution period and a 7% annual rate of return. At 5% however, only about 56% of the retirement amount will come from investment income, and 44% will come from contributions. So we need to rethink our financial commitment to retirement savings. Expressing this another way, we would need to increase our annual contribution to our retirement savings plan by over 40% in order to achieve the same amount of assets at retirement. Furthermore, this calculation doesn’t take into account the reduced payout that that is now being generated in a lower income environment. If that is considered, the amount necessary to achieve your financial goal would increase by a further 20%.

    In his recent book “Retirement’s Harsh New Realities” noted Canadian author and commentator Gordon Pape (himself a retiree of sorts, now aged 75) noted the following with respect to savings for retirement: When addressing the question as to why Canadians are not saving more money for their retirement he observed: “It is because we live in a consumer society and we’re constantly bombarded with exhortations to take more credit, to get out and spend, support the economy. ..It’s the world in which we live. It was easy to save money back in the days before credit cards became widespread. Now, with credit cards and debit cards out there it is too easy to spend money”.

    Finally, when asked: “What is the best advice he can give to help people in their twenties and thirties to save enough for their retirement”, he states: “The best advice that I can give is to start saving seriously. In Canada, we have the best government sanctioned retirement and tax savings programmes – the RRSP and the TSFA. I think that people should be taking maximum advantage of those two plans. One of the real tragedies in this country is that we have such a low participation rate in RRSPs”.

    Quoting for another financial commentator, Rob Carrick writing in the Globe and Mail, in “Ten new rules for building wealth”, he stated

  • You have to save more because fat returns won’t be there
  • Forget early retirement, since you likely can’t afford it, and
  • Keep an eye on your company pension (assuming that you are fortunate enough to have one).

    The recent (January, 2012) filing for bankruptcy protection by Hostess Foods in the United States is a case in point. Their largest unsecured creditor, in the amount of almost $1 billion, was the pension fund!

    In the book “Predictably Irrational” by MIT Professor Dan Ariely, he quotes a mechanism for saving developed by Dick Thaler and Shlomo Benartzi called simply “Save for Tomorrow”. Quoting Ariely:

    “Here’s how ‘Save for Tomorrow’ works. When new employees join a company, in addition to the regular decisions that they are asked to make about what percentage of their pay check to invest in their company’s retirement plan, they are also asked what percentage of their future salary raises they would be willing to invest in the retirement plan. It is difficult to sacrifice compensation today for saving in the distant future, but it is psychologically easier to sacrifice consumption in the future, and even easier to give up a percentage of a salary increase that one does not yet have.

    When the plan was implemented in Thaler and Benartzi’s test, the employees joined and agreed to have their contributions, as a percentage, increase with their future salary raises. What was the outcome? Over the next few years, as the employees received raises, the savings rate increased from about 3.5% to 13.5% - a gain for the employees, their families, and the company which by now had more satisfied and less worried employees.”

    Secondly, plan members need to be educated on the “long term” nature of retirement savings and embrace the opportunities available by investing in so-called “risky” assets such as equities. While bonds, GICs and money market funds may offer safety of principal, long term data suggests that the rates of return that these assets produce will do little to meet the retirement goals of most plan members. Perhaps removing a money market fund as an available option, and certainly as the “default fund”, will force members into making a decision. Far too many members often use this fund as a “temporary “parking spot for retirement savings. While risk profile and target date funds are laudable in their intent, their success to date leaves much to be desired. A recent article (March 2012) in “Consumer Reports” highlighted three costly mistakes to avoid in retirement planning. Besides underestimating the amount that is required to finance your lifestyle, the other two are investing too conservatively, and not diversifying enough. Sound familiar?

    Thirdly, as mentioned earlier, we need to revisit the role of the Canada Pension Plan in preparing for our retirement. Imagine where we would be today if this pan were not in place. For countless retirees, this source of income (possibly together with OAS) is the entire amount on which they exist in retirement. Serious consideration should be given to an expansion of this worthwhile programme – and not the PRPP!

    We didn’t get into this mess overnight, and we are not going to emerge from it overnight either. So what advice can you give to people who are not aware of their needs for a financially secure retirement? Here are a few ideas from a recent US publication which are equally valid in Canada:

  • Don’t panic now.
  • Don’t delay
  • Plan carefully, and
  • Don’t rely on government benefits to provide all the income that you need in retirement.

    Yes, there is certainly enough blame to go around. Actuaries and pension consultants, plan sponsors, regulators and the CRA have all had a hand in creating the current pension crisis. But all is not lost – at least not yet! Canadians need to make saving for their retirement a priority. And support for an expanded CPP would also go a long way to meeting our retirement needs. But the “baby boomers” are now reaching age 65, so time is not on our side.