Pension Reform and What Retirees Need

Pension reform in Canada seems to be gathering steam, a too-rare and laudable case of government taking action before, instead of after, the crisis hits. (Those who look at the fact that today's pensioners are doing relatively ok and that therefore no need for action exists should read the June 10 TD Economics piece Retirement Income Security Reform in which they project how things will evolve if nothing changes.)

Some proposals seem to ignore what a pensioner really needs, so here is my list of qualities that retirement income should have. It is based on the simple principle that a base pension needs to support a continuation of basic lifestyle spending, the everyday needs that are constant, non-discretionary, fixed, lifetime and that consequently the pension should have similar characteristics.

1. Guarantee / highest possible security - when it is your grocery money or your heating bill, it absolutely needs to be there. Retirement should be about peace of mind. So the question is, which organizational pension provider rates highest? Government might be that entity but can it keep its grubby hands off money set aside for the future if Canada goes back to the 1980s deficit and debt era? Is CPP and its associated investment body the CPPIB enough "arm-lengths" away to ensure no fast moves by future crimped governments? Are banks and insurance companies stable enough, even with guarantee funds in place?
2. Fixed frequent automatic payment - the income needs to be constant to enable family budgeting and money management, it needs to be regular and frequent, ideally monthly, at worst quarterly, and ideally automatically deposited into a bank account to make financial life easier and simpler to manage. In the accumulation years prior to retirement the saving process should be just as easy, automatic and regular.
   
3. Inflation-adjusted - this point is critical since the government policy rate of 2% inflation (actually 1-3% is the official range) will hugely undermine the purchasing power of a fixed amount over a 20-30 year retirement, which is the new norm due to rising life expectancy.
4. 40-45% Income Replacement - this level is a trade-off. It is deliberately a bit below the usual minimum of 50% pre-retirement income replacement to maintain lifestyle. People will be squeezed a bit, not far from the 50% goal so that the goal can be easily achieved by either a bit more saving during pre-retirement or a bit of work during retirement. Giving an incentive for people to work during retirement is doing them a favour since they will be healthier and happier.
5. Lifetime - ultimate peace of mind requires that people be assured of receiving the steady income for as long as they live, whether it is 65 or 105, and not have to worry (hope?!) about dying before the RRIF runs out.
   

The above list leads to a set of criteria and features needed in a pension scheme:

1. Mandatory participation - everyone must be in it for several reasons. The sad reality is that, left to their own volition and devices, too many people do not save enough out of their income for their retirement. The automatic default enrolment, with people allowed to opt-out, has pretty well the same effect since few people bother to opt out. Buy why beat around the bush - in exchange for the guaranteed lifetime inflation-adjusted income it seems a fair trade to be obliged to participate? The other reason is,
2. Large pool of participants for longevity risk sharing - a big challenge for individuals in financial planning of their retirement is not knowing how long they will live. Population averages, on the other hand, are known more or less to the decimal point of years. That allows much more precise planning and lower safety buffers for a fund than an individual must have. The "mortality credits" of those who die sooner allow higher payments for all than any cautious person could achieve using the commonly accepted 4% safe withdrawal rate from their own RRIF. The pension stops when the person dies. There is nothing to pass along to heirs. The purpose of the pension is not for a legacy, it is to fund lifetime living expenses. The people who die sooner than the average subsidize those who live longer. (Mandatory participation gets rid of the issue of adverse selection, whereby people opt out when they think they will die sooner than others.) But it is a fair exchange in my mind - give up the possibility of a legacy for certainty and the peace of mind of knowing the money will not run out. Families/children are saved the worry or actual burden of having to financially support parents in old age. As a result, big plans with hundreds of thousands, if not millions of people enrolled, are better. Actuaries can figure out the exact scale required and then the feasibility of private pension schemes can be judged. A national program obviously has the largest scale.
   
3. Low administrative cost - costs directly reduce money available to the pensioner, so a pension fund should max out at perhaps 0.2% of assets on the investment side - the CPPIB proves the investment side can be done cheaply as its overheads amount to under that figure. What costs are reasonable on the collection and payment side, I do not know. Can the private sector compete? Update 8 September2010 - It seems that the experience in other countries where mandatory enrolment retirement investment schemes have been set up, private sector fees are way too high, as FT reports in Why Proceeding with NEST is Crucial (hat tip to RetirementAction for the link)
   
4. Fiduciary obligation - a pension fund must first and last put the direct and quite narrow financial interests of pensioners ahead of anything else. That means ahead of private sector profits or other government policy objectives like economic development. A very large pension fund will want to (and probably need to because of its scale) go beyond Canada's borders to invest. There should be a high degree of transparency in all regards for such a fund. Again, CPPIB is a good model.
   
5. Long term investment view and perpetual investment horizon - individuals in retirement are critically aware (at least those who know what they are doing are aware) of their uncertain lifespan and their decreasing or expired ability to weather possible long periods of poor stock investment returns. As a result they must adopt a very safe portfolio, which in the long run means lower returns. A perpetual fund can be more ambitious and expect to ride out down periods of a decade or more. That will mean a higher allocation to equities and higher expected returns than an individual could do. It can also have access to, due to scale, to illiquid private equity and infrastructure type of investments, with the capacity to wait for fruition. Individual investors do not, and can never, have that capability.
6. Professional management - properly trained and motivated (cf fiduciary duty) professional managers have the capability to find and exploit market inefficiencies (which of course is the very mechanism that brings markets to be generally quite efficient). Very few individuals have the knowledge and even fewer have the scale of funds required to do the same profitably. Professional management have the potential to be less susceptible to the errors indentified in behavioural finance if good control systems are put in place. Professional management can have the knowledge to apply finance theory for critical tasks like asset allocation.
   
7. Portability - the pension should not be tied to a particular public, private or self- employer or province and should follow the person throughout their working life and through retirement. It should be a baseline pension, which individuals or companies can use to plan supplementary savings and investments.

In my next post, I will take a shot at rating how two pension options - the Canada Pension Plan vs a RRIF/LRIF - stack up against the above criteria.

Note that the above does not address health risk, which even in socialized medicine Canada, can have appreciable negative financial impact in retirement. A significant portion of retirees will end up needing to spend a lot more all of a sudden in a lumpy amount for a critical illness or for long term care.