A Tipping Point in the CPP Expansion Debate?

Surprise and initial disbelief was my reaction upon reading the headline "Canadians should be allowed to contribute more to CPP to ‘reignite a culture of savings,’ urges CIBC chief" yesterday in the Financial Post. But it's true - the head of one of Canada's banks has come out in support of an idea that has been portrayed by some as the stupid notion of an ill-advised anti-business left-wing labour movement but which actually makes a lot of sense (as I have blogged about comparing CPP to RRSPs and the like, in relation to retirees' needs, comparing to the proposed PRPPs). It is quite significant when a major bank head publicly expresses support. After all the banks make a lot of profit from RRSPs, mutual funds and would do so from PRPPs that are the private sector alternative to CPP. So kudos to CIBC and CEO Gerry McCaughey for saying something that may not be in their narrow best interest but which is good for Canada and average Canadians.

A fine but critical point of potential disagreement with what McCaughey said is that the voluntary participation in the expanded CPP should be made the default option i.e. people should be automatically included though they could opt out if they deliberately chose to leave it. That way, just about everyone would be in it. To offer participation as a voluntary opt in, where you have to take action to join, would be next to useless as too few people would join. People need a Nudge as Thaler and Sunstein tell us in the eponymous book.

Disclosure: I own bank shares directly and in ETFs (and so does just about every Canadian in their equity mutual funds or ETFs) and I will be getting CPP, though not any expanded benefits if it is expanded on a pre-funded basis as I believe it should be done.

Pooled Retirement Pension Plan Draft Legislation Revealed - Will PRPP Help?

Last Thursday November 17th, the Federal government announced and tabled draft legislation (Bill C-25) for creating Pooled Registered Pension Plans.

Will this help the target group - people who have no company pension and are not voluntarily saving through RRSPs or TFSAs? The answer is a mild "yes" in absolute terms and a resounding "no" in relative terms.

Yes, it does help somewhat.

• Anything is better than nothing - The most critical problem is that those people right now are not saving for retirement, so any program that gets them to save will help. Despite the provisions of the PRPP legislation that do not require companies to opt in and that allow individuals to opt out, the default auto-enrollment rule (par.39(1)), the default investment option rule (par. 23(3)) and a default contribution rate (par.45(1)) will be quite effective in getting more people to save. "Nudge" works.
• Cost and fees have a fair chance to be less than for mutual fund RRSPs - Why might there be a grain of truth to the confident assertion by Minister Menzies who told the Globe and Mail, subsequent to receiving financial industry assurances, that management fees will be "substantially less" than they are for RRSPs? 1) Money will be locked into the PRPP unlike the RRSP. You may be able to switch between funds but the fact that the investment management company knows the money will not be withdrawn means less need for cash balances and less urgency for short-term return-chasing by funds that undermine returns. 2) Marketing costs, which are embedded into management fees could well be less since the target market for the financial industry is not the individual consumer but small and medium-size companies. That should mean no glitzy TV ads. There will be no trailer fees to salespeople (aka financial advisors); in fact, the draft bill specifically bans kickbacks by fund companies to employer sponsors (par.33). 3) The regulatory structure should help to control the most egregious overcharging. Good 'ole politics might even have a bearing since the Governor in Council, i.e. the government, gives itself the power to decide what "low cost" fees means (par.76 (1) (j)).

No, the PRPP will NOT help, it may even do harm.

• NoHype Investing author Gail Bebee emailed me her comments, which I think are spot on, so I'll simply reproduce them with my highlighting):
  

  "1. Employers are not required to offer this, or any other, employer-sponsored pension plan.

  2. Employees will be able to opt out at will.

  3. The financial industry, the same folks who charge Canadians some of the highest mutual fund fees in the world, will be managing the pension funds and will have a major say on the fees charged to do so.

  4. More government bureaucracy will be set up to regulate this new program.

  5. RRSPs already offer a similar retirement savings option. The issue is that not enough Canadians participate."

• Wealthy Boomer Jonathan Chevreau's comments in the Financial Post gave some nuance to Gail's points.
• The PRPP will complicate and confuse - The retirement landscape is already tough enough to understand, what with RRSPs, Defined Contribution and Defined Benefit Pension plans and TFSAs. Another layer of complexity is added. How will people make intelligent informed decisions about which to choose under what circumstances? There is no advice-giving component included in the PRPP structure. Blogger Preet Banerjee was right on the mark pointing this out in a CBC article on the announcement. With each province being required to implement its own complimentary legislation, it's a sure thing Canada will add another patchwork of permutations and combinations in rules, all of it totally unnecessary. What will happen when people move to different jobs in different provinces or with different companies? The minister says the plans are portable and transferable but sure as to betsy a lot of folks will end up with several plans. I already have two different LIRAs that cannot be combined (one is federal, the other provincial) on top of an RRSP and a TFSA. Another possibility to add?! Gimme a break!
• Low pay workers will likely get scr***d - Tax-wise, the logic of the PRPP will work the same as an RRSP. In a couple of posts here and here on the HowToInvestOnline blog comparing the TFSA and the RRSP for retirement savings, it is quite clear that anyone earning less than $37,000 is better off using a TFSA. If such workers get auto-enrolled into the PRPP and they don't opt out (who is to tell them to opt out except for lowly bloggers that they never read anyway?), they will be appreciably worse off in retirement. Thanks for your help, government!
  
• PRPPs pale in comparison to the CPP - The much debated alternative solution, that of expanding the CPP, as we have previously argued here and here, meets the criteria of what is needed much better. Over at Moneyville, author and pension expert Moshe Milevsky points out that the Pooled Retirement Pension Plan doesn't even live up to its name. It doesn't provide a pension - a lifetime of secure guaranteed income - at all, it is only a savings and investment plan that will go up and down with stock and bond markets.
  

Later addition: Commenter Leo's new blog PRPP Canada devoted to PRPP (the blog's mere existence is a sign of the additional complexity Canadians are soon to face) contains a link to lawyers McCarthy Tétrault's review of some of the ins and outs of C-25. From what McCarthy says, the law won't require that there be a default option if the PRPP offers a menu of investment (aka fund) choices that a "reasonable and prudent" person could use to assemble a retirement savings portfolio. That's one less small but critical nudge.

CPP Opponent William Robson Spreads Bafflegab and FUD

Today's commentary in the Financial Post by William Robson of the CD Howe Institute, CPP is a gamble, not a guarantee, attacks the CPP with bizarre arguments that indicate nothing about the CPP's riskiness, nor the merits of expanding the CPP.

Robson asserts that CPP proponents are going around claiming that the CPP is fully funded in the sense that all future obligations can be met with assets on hand, or alternatively that its promised benefit payments can be met at the current 9.9% contribution rate. Huh? One would have to be very ignorant of CPP not to know that the payments and contribution rates fundamentally and forever rely on a substantial continuing inflow of funds from current workers. The CPP will never be fully funded in the ultra-narrow, unrealistic sense that Robson defines as being invested only in real return bonds. It was not designed that way, it doesn't work that way and it would be stupid to do it that anyhow.

Whether one quibbles, as Robson does, about the use of the word guarantee, promised, targeted or anything else to refer to the likelihood future CPP payments will be met doesn't matter. What does matter is whether the whole CPP set-up as it is now structured, will be able to make those payments. Robson surely knows full well that the CPP gets regular health checks by the Chief Actuary of Canada. Go to the CPPIB website and read FAQ number one: "Canadians’ CPP pensions are not at risk and Canadians should not be concerned about their CPP pensions. In November 2010, the Chief Actuary of Canada reaffirmed through his triennial review that the CPP remains sustainable at the current contribution rate of 9.9% throughout the 75-year period of his report." Or, read for yourself the latest actuarial report here.

Robson says the CPP is a gamble because it relies significantly on investments across a whole range of asset types other than real return bonds to attain its required 4% real return. No private or public pension could or would ever follow an investment policy of exclusively RRBs, which Robson sets up as his acid test of riskless. Conversely, just about every pension plan invests with a mix of assets like the CPP. Besides, RRBs are only as good as the government backing them. It was not long ago that Canada's credit rating was in jeopardy. Now it's the turn of that other riskless asset, the US Treasury Bill to begin looking somewhat dodgy. So, strictly speaking, RRBs would be a gamble too. In an absolute sense, the CPP is a gamble, not a sure thing. But I'd say it's not a 50-50 gamble, more like 95+% chance of success. Robson must know that too and his use of the word gamble sure looks deliberately designed to overstate the risks of the CPP, i.e. intended to stop support of CPP expansion by spreading Fear, Uncertainty and Doubt (FUD) among FP readers.

One can infer some good news from this piece, however. If this is the best criticism CPP opponents can come up with, then CPP must be pretty good. Also, for it to be worthwhile to write and publish such an attempt to reduce CPP's public support, it must mean that CPP expansion is still being considered in the corridors of power.

Canadian Pension Fund Asset Mix Evolution - Ideas for the Individual?

The Pension Investment Association of Canada has a fascinating pull-down on its Publications page here that brings up the composite asset mix of its Canadian pension fund members for any year from 1990 to 2010. I've used it to compare the evolution from 1990 to 2000 to 2010. It tells an interesting story.

The Table
An asset class that wasn't there at all in the previous ten-years-ago period, or which has gone up, is shown in green while those going down are in yellow.


Fixed Income & Cash Down

• from over 60% of the total mix, these two asset classes together now occupy less than a third of the portfolio; in fact, with a negative cash balance, it looks like pension funds are actually using borrowed funds aka leverage
• is this because the pressure is on to gain higher returns now that the 20-year stock market boom of the 1980s and 1990s is long gone?
• mortgages are passé, real return bonds and foreign bonds have replaced them
  

Equities Up, then Down with the Ascendancy of Non-Traditional Assets

• hedge funds, private equity, infrastructure investments and other esoteric stuff are the new direction (fad?)
  

Real Estate Love-in Keeps Growing

• the pension funds are now almost 10% in real estate; we can be comforted when we go shopping knowing that we are helping fund someone's pension, quite likely our own (even when in Scotland as I am a lot, where the CPPIB has half ownership of Silverburn near Glasgow ... note to fellow Canadians, it seems to busy all the time!)
  

Inflation-Protection Assets (Real Estate, Infrastructure, Real Return Bonds) Growing Too

• we've had 15 years of 2% inflation so why would pension keep moving in that direction? ... I would guess because increasing longevity makes the long-term cumulative ravages of "low" 2% inflation a big factor for funds that aim to maintain their member retirees' standard of living

Foreign Equities Almost Double Canadian

• probably that's due to the small overall size of the Canadian investing pond and the vast amounts of capital the pension funds need to deploy, along with the goal of diversification and the possible attractive returns in new markets, plus perhaps the fact that it is easier and easier to be a global investor
  

Ways to Apply this to an Individual Portfolio

• Doug Cronk of the Institutional Investing for Individual Investors blog, who works for a pension fund and on whose site I found the link to the PIAC site, recommends an example portfolio, show here. It's missing real return bonds, available in ETFs such as ZRR and XRR or directly as individual bonds, also doesn't have any extra infrastructure per se (it is already within equities to some extent) and is much heavier on equities, but it is a good start.
• Another view, from my other blog HowToInvestOnline, is How to Invest for Retirement Like a Pension Fund by Using ETFs, which suggests an ETF line-up modeled on the three biggest pension funds in Canada - the CPPIB, Ontario Teachers' Pension Plan and Ontario Municipal Employees Pension System.
  

Who Controls Financial Markets in Canada? Individual vs Institutional Investors

Have you ever been annoyed at those breathless news reports on market moves? You know what they are - "investors today have been spooked/cheered by the quarterly inflation figures / credit crisis in Greece / nuclear incident / trade figures / royal wedding / hurricane / terrorist killing" etc (in fact, often it seems that the person writing the text merely attaches the market result, whatever it is, to the current headline news item of the day, good or bad. For those who believe that markets are random, the random association of events to ups and downs makes a certain sense I suppose.)

Anyhow, on reading these news reports, I find myself muttering that it wasn't me, I didn't do it! I have a portfolio apportioned amongst fixed percentages of various passive ETFs and I only trade when rebalancing, taking money out, or buying more. Even when I do trade, my amounts are so puny and I almost always place orders at market price, it cannot make a jot of difference to move markets up or down.

So who does have enough heft in the market to influence things, individual or institutional investors? Are there a few super-rich individual investors with enough money to manipulate things, or is it the mass of ordinary Canadians? Are the mainstream mutual funds the heavyweights or is it the pension funds? It seems to be really difficult to find out through simple Googling but here is what I found out, with admitted uncertainty through some of the guesstimation I've had to do. This is all 2009 data, which seems to be the most common recent data available. The grand total of financial assets in 2009 was $1713.3 billion. Here is the breakdown of who more or less controls or decides how to invest the money (as opposed to who it may belong to or for whose benefit it is being invested).

1) Pension Funds - $898.1 billion 52% share
This is only the top 102 funds - the 100 biggest from the Benefits Canada 2010 report plus the two biggest funds of all in Canada, the Caisse de dépôt et placement du Québec ($131.6 billion in net assets) and the Canada Pension Plan Investment Board ($105.5 billion). Interesting fact - these two plus the top 10 of the Benefits Canada list are all government or public servant plans and together they control about 1/3 of total financial assets in Canada. Reminds one of an old joke ... "what is the difference between capitalism and communism? ... capitalism is the exploitation of man by man while communism is the reverse".

2) Mutual Funds - $595.2 billion, 35% share
(source IFIC reports)

3) The Mega-Rich $140 billion and the Quite Rich guesstimate. $40 billion, combined 11% share
The Mega-Rich cutoff in 2009 was $1 billion for the 55 richest Canadians (see Wikipedia List of Canadians by net worth). For the Quite Rich I had to guess that the next 100, down to about $200 million in assets, might hold around $40 billion in total at an average $400 million each.

4) The Hoi Polloi (that's you and me the retail investor) - $40 billion, 2% share
I'm being optimistic here I think, assigning an average $1200 in directly held investments of stocks, bonds and ETFs (i.e. not owned within pensions or mutual funds) or so to each of the remaining 33 million Canadians. For comparison, consider that the total market value of Canadian ETFs in 2009 was $33.7 billion according to TMX Money.

Let's put a personal face on it. Today when the TSX go down or up we can point the finger at Michael Sabia (Caisse CEO), David Denison (CPPIB) or maybe Jim Leech (OTPP). One thing for sure, it wasn't me.

PS came across figures for the USA ... John Bogle said in the Wall Street Journal in Jan. 2010 that insititutional investors control 70% of US shares, with mutual funds 26%, private pension plans 11% and government pension plans 9%.

Conservative Election Majority: Three Implications for Personal Finance & Investing

Yesterday's election results gave the Conservatives a majority. My take on three things that will (not) happen as a result:

• CPP expansion is dead in the water. Pension "reform" will take the form of the PRPPs. The parliamentary majority that takes the pressure off, combined with the justification provided by opposition of some Provinces, and by "there is no problem" deniers allows the Government to say to the official opposition NDP that more urgent matters concern Canadians. Besides, the problem is not a pressing volatile crisis and will only manifest itself gradually.
• Banks, insurance companies and financial companies are back on the profits bandwagon. They who benefit from the pension savings flows can rest easy and go back to making steady money. Some of these outfits, where the managers do not take all the money for themselves, will be good investments for individual investors. Corporate tax cuts will help too. (Disclosure: I own some shares directly & ETFs with those shares ... who doesn't in one way or another?)
  
• TFSA doubling promises and other deficit-dependent promises won't happen (see several mentioned by Michael James). With a majority, the Conservatives are likely to relax and the economy / financial conditions are not likely to force its hand on deficit-elimination like it did during the (in)famous 1990s when Chretien and Martin did the job that has made Canada's fiscal life good since then. The bureaucrats are more likely to convince the Conservatives those measures would be too expensive anyhow.
  

CPP "Diseconomies of Scale" Study by Fraser Institute - Spreading FUD

FUD, for those unfamiliar with the acronym, stand for Fear, Uncertainty and Doubt. It is a familiar marketing technique to make people doubt and prevent them doing something. In this case, the Fraser Institute is applying FUD against the idea of expanding the Canada Pension Plan.

The FUD is found in Should the Canada Pension Plan be Enhanced? by Neil Mohindra, published and downloadable on the Fraser website here. The Fraser summary blurb says:
"The study concludes that diseconomies of scale present a risk to the CPPIB’s investment performance. The actions that the CPPIB is taking to offset diseconomies of scale in investment returns will likely become less effective as its assets continue to grow."

The first sentence is true, the Mohindra study does arrive at that conclusion. The problem is that neither the research it presents, nor other facts, support the statement in anything more than the sophistical (as in sophistry = plausible but fallacious argumentation) sense - yes, if diseconomies of scale do arise, then there is a risk, although not a certainty, that the CPPIB's investment performance will suffer. Mohindra delves into a series of research papers that address aspects of diseconomies of scale/size associated with investment funds and pension funds. Here is why I think we can dismiss the alarmist rhetoric of the Fraser report:

1. If diseconomies of scale were inevitable, the CPPIB would have hit the wall long ago. As Mohindra belatedly notes, "A limitation in applying existing literature on economies and diseconomies of scale to the CPPIB is the sheer size of the CPPIB in comparison to the size of funds covered in the literature." The CPPIB years ago had assets that dwarfed any funds in the literature. Why did CPPIB not exhibit diseconomies of scale long ago? The rise in costs that Mohindra documents about the CPP/CPPIB has become apparent only in the last two years (look at his table A1 on page 34).That rise has less to do with scale than other reasons.
   
2. The higher admin/expense numbers of the CPPIB can just as plausibly be interpreted as temporary, a result of the financial crisis and markets' recovery process combined with the investment mix of the CPPIB. It all hinges on the considerable amount of private equity, real estate and infrastructure investments that the CPPIB has deliberately made since 2006. While stocks on public markets such as the TSX rebounded sharply in 2009, the other stuff has lagged and the higher overheads that go with those other types of investments has driven up those costs as a percentage of assets. It's possible the CPPIB may be fundamentally wrong about investing in such other assets (along with many other pension plans out there, like the Alberta Teachers' Retirement Fund Board whose 2010 annual report announces that it has switched its investment policy to go in that direction). However, the explicit aim of the CPPIB is that such assets present the opportunity to gain higher returns that more than offset the higher fees. It is ironic that Mohindra quotes a speech by CPPIB CEO David Denison where Denison sets out a vision for using scale as a competitive advantage. If scale is a reality, I think I prefer the "glass half full" view (opportunity) from the CPPIB over the "glass half empty" picture (diseconomies) of the Fraser Institute.
3. The pursuit of private equity, real estate and infrastructure by the CPPIB, rather than being a symptom of incipient diseconomies as Mohindra claims, is in fact the appropriate response and strategy to keep costs low and maintain superior risk-reward results. One of the studies cited by Mohindra, that of Dyck and Pomorski confirms that the CPPIB is following the successful path of other large funds: "In their private equity and real estate investments large plans have both lower costs and higher gross returns, yielding up to 6% per year improvement in net returns." Furthermore, most of the increase in operating expenses of the CPPIB during 2009 and 2010 came from the ramping up of internal management capability to replace external managers, another factor that Dyck and Pomorski say is a significant source of cost savings for bigger plans. It looks more like like CPPIB is on the road to exploiting increasing economies of scale, not butting up against diseconomies.
   
4. Governance matters a lot more than scale. Small organizations can be poorly run as easily as big ones. A much more convincing explanation of what determines the success of a pension/investment fund comes from Keith Ambachtsheer of the Rotman International Centre for Pension Management. Pension organizations properly aligned with the interests of the pension benficiaries, proper definition of roles between a board and professional management, appointment of financially knowledgeable and independent individuals to boards, effective risk management processes - those are what get good results.
5. The CPP's overheads, if they were to stay at current total all-in levels of about 1% (total operating expenses in 2010 of $498 million Government of Canada plus $236 million CPPIB plus $466 million in external investment management fees on average CPP total assets of $120,721 million per Volume 1 of the Public Accounts of Canada with CPP data starting page 171 of the pdf), or even rise further, are still small compared to the all-in costs of alternatives, like TFSAs and RRSPs. Start adding up the costs of mutual funds where most people place their retirement investments, or even of the best case lowest fee ETFs around, then add fees like deregistration/withdrawal fees from RRIFs, or the implicit charges when buying an annuity to turn the savings into retirement income (read Peter Benedek's series on annuities on this page of his RetirementAction website to see how poor a deal they are). The average person will be losing more in various costs than 1%. This ignores the "costs" from investing mistakes that so many people make along the way when left to do it themselves in TFSAs and RRSPs.
   

Instead of concluding that "the size of the assets the CPPIB will be managing even without expansion shows that diseconomies of scale is a reason not to expand CPP", Mohindra would be more accurate in saying that "the opportunity to exploit economies of scale is a reason to expand CPP".

The large size of the CPPIB portfolio is NOT a problem. As long as CPPIB governance and management continues to be good, the move into private equity, real estate and infrastructure provides opportunity, not rising risk. In the 2006 speech quoted by Mohindra, CPPIB CEO David Denison also mentioned that the size of private market opportunities is vastly larger than those in public stock markets. It is a good thing for CPPIB and for Canadians who have their money being invested there by the CPPIB.

One Investor's Wish List for the Canadian Election

Rob Carrick of the Globe and Mail published his wish list to politicians in the current Canadian election, so here is mine.

1. Expand the CPP by increasing pensionable earnings limits and raising contribution rates to target a 40% income replacement rate. If I could only get one wish, this is it. It is the best solution by far for what retirees need and in comparison to present alternatives or to the proposed PRPPs.
   
2. Triple the annual TFSA contribution limit ... ok, I'll compromise with doubling it. It is a simple, understandable, effective multi-purpose account but the $5000 is too little.
3. Start selling Real Return 1-5 year maturity Canada Savings Bonds as I wrote about here. Retirees without inflation-indexed DB pensions need them. That might reverse what the Globe recently described as their "long slow death".
   

CD Howe and Pension Study - The Proper Choice of Reno Tools

Head of the CD Howe Institute William Robson told us in the Globe and Mail last Friday to Fix pensions with screwdrivers, not sledgehammers based on the results of the Institute's newly-published study Sizing Up the Retirement Challenge: How Well are Canadians Preparing for Retirement?. With all due respect, since the study, of which Robson is an author along with Kevin Moore and Alexandra Laurin, is an interesting and worthwhile piece of work, after reading through it, I think we should be saying "Don't patch pensions with the wrong colour paint, cover the whole wall over ".

Through its reasonable, for the most part at least, assumptions the study projects that the likely pension income shortfalls cover such a broad spectrum and such a large and steadily growing number of future retirees that spot fixes like the proposed PRPPs won't do the job.

The study summarizes the future problems thus (my highlighting):

"The principal finding of this study, however – that is, a projected gradual increase in the proportion of future retirees likely to experience a significant decline in their standard of living upon retirement – persists even with differing assumptions for future real wage growth, inflation, rates of return, RPP coverage, and future saving rates." (page 2)

"... the proportion of newly retired individuals unable to replace at least three-quarters of their average pre-retirement consumption from the sources we model is projected to nearly triple over the next 40 years (see Figure 9). If current trends persist, by the 2046-50 period, about 45 percent of workers currently aged between 25 and 30 years would not meet our 75-percent threshold ... " (page 20)

"This decline in potential consumption replacement would be felt across the entire earnings distribution ... " (page 20)

We are just at the start of a long-term uptrend in inadequate pensions that is little affected by such things as increased saving in RPPs, which is essentially what the new PRPPs would offer to people working for small companies and the self-employed. Look at this chart from the study. Other charts in the study have similar inexorably upwards trends based on "business-as-usual" in pensions savings methods/plans.


All this looks like a pretty substantial problem to me.

Ironically, the following quote suggests an alternative:

"... the public pension system, which is mandatory and has nearly universal coverage, provides high levels of consumption replacement to individuals with low pre-retirement earnings. The higher a person’s earnings, the more voluntary saving by the individual (and/or his or her employer) through RPPs, RRSPs, home equity, or other instruments is needed to replace consumption in retirement." (page 13)

In other words, the combination of OAS/GIS and CPP have been doing a great job. When higher income income earners have to rely on the various other means, they fall short.

There is one problem with the public pension option, however. The beneficial influence of OAS will progressively wane. By being indexed to CPI inflation, it only maintains the standard of living at the moment of retirement. The standard of living slowly rises i.e. real wages increase and real consumption does too, faster than CPI does. Since the pension objective assumed in the study is to maintain a level of consumption, anything that goes up only by CPI will produce less and less consumption relative to new retirees. Here is the relevant study chart.

A couple of assumptions probably understate the future pension challenge.
1) Home equity drawdown - the study assumes as base case that 50% of equity in a home would contribute to retirement income. The methods for accessing home equity, like high-fee reverse mortgages, or downsizing, seem unlikely to happen for most people except under forced circumstances. To the authors' credit they run the model excluding that assumption and the difference is another 5% or so today, rising to about 8% in 2050, of the population with less than the target 75% consumption replacement rate.
2) Consumption replacement at age 70 - this number derives from actual government data based on what is used from various sources, including investment return sensitive limited capital RRSPs and RRPs from defined contribution plans. The study does not, that it says anyhow, model consumption to track adequacy all through the retirement years. What happens to the income at age 75, 80 and 85? Chances are it won't go up. Age 70 is likely the maximum income / consumption. One of my relatives has been using a RRIF to supplement her income but it will run out in a few years so she is facing a significant drop in income/ consumption. The model thus does not seem to attempt to evaluate the effect of longevity risk sharing, or not, (running out of money before you die).

One telling point founded on the actual past statistics is the fact that " ... the net real rate of return received by individuals in the future is roughly 1 percent for RRSPs and 2.5 percent for defined-contribution RPPs." That's a shockingly low return compared to the actual historical asset class returns of 4% averaged for a portfolio. The combination of fees and poor investment decisions by individuals trying to manage on their own really cuts deep. If the real return for investors could magically be 1.5% higher, it looks from figure 13 as though another 5% of Canadian retirees in 2050 would escape the inadequate income threshold of the study.

People need to assess the problem properly before deciding on how to fix it. Like a bad paint job, if you don't do it right the first time, you will soon be doing it again.

CPP Adequacy "Myth" in Greg Hurst's Financial Post Pension Article

In Pension Myths published Dec.2, 2010 on the Financial Post website private pension consultant Greg Hurst rails against what he says are myths about CPP.

Myth 1 according to Mr. Hurst is "Canada's pension system is insufficient for the delivery of adequate pension income." He then cites the Mercer Melbourne 2010 Global Pension Index as a source to assert that Canada is well positioned compared to the rest of the world with a number two rank on the pension adequacy sub-index. Fortunately, the Mercer study is available on the web here, so your faithful blogger, ever the nit-picking detail guy, happily dove into the Mercer documents to do a reality check.

The reality:

• Mercer doesn't say that Canada's system is sufficient, it merely says that Canada's system is better than most of the other insufficient systems around the world. No country attains an A grade from Mercer as a "first-class and robust" pension system on an overall level and though Mercer does not actually assign grades on its three sub-indices, Canada's 75 score on the Adequacy sub-index would put into the B grade of "a sound structure with many good features ... but has some areas for improvement"
  
• Canada's score fell from 2009 to 2010 in Total and across every sub-index (p.19). Is that cause for complacency and doing nothing?
  
• Mercer's Adequacy entails a miserly low level of income. The Adequacy sub-index doesn't just use the CPP, it uses ten questions to arrive at a rating. Canada does comparatively well because of its score on the two heaviest weight questions (attachment 1, p.64). Question 1 assesses the ability to provide a pension to the aged poor. Thus, in Canada OAS/GIS enables people to receive 32% of the average single person's wage (0.32 x $40,600 = $13,000), which is, according to the OECD, where Mercer got its data on this question, enough to keep someone above the poverty line set at 30%. Whooppee, happy days, huh? It is ironic that Hurst should cite Mercer whose conclusion on Adequacy relies on OAS and GIS when his myth 3 says that those two programs are at risk because they are funded from general tax revenue. Would an increase in tangible funding to CPP through higher rates not then make sense? Q2 deals with a target income replacement rate. Mercer says the net (considering taxes and deductions) replacement rate of lifetime average earnings for a median income single earner should be in the range 70-100% and Canada is reasonably close at 63.6%. Lest these numbers seem to be a high target, Mercer reminds us that the lifetimes earnings model from OECD (found in Pensions at a Glance 2009 - gotta love the sly humour in that name for a 283 page document) on which the scores are based assume no real (though it does keep abreast of inflation) pay increase throughout a working career and should thus be targeted much higher than a replacement rate based on final salary. A median Canadian worker thus would get 0.636 x 40,600 = $25,820 to live on. Would that support an active fulfilling retirement or one that entails working to supplement income? Mercer themselves comment that "A net replacement rate below 70% of lifetime earnings suggests a significant reliance on voluntary savings" (p.24).

This last point is the nub of the current problem and debate, one which Hurst himself acknowledges, and Mercer confirms (see its recommendations for Canada on page 57). The reliance on voluntary savings in defined contribution plans and RRSPs isn't working too well, it needs improvement. People are not saving enough and the trend towards types of plans where they have to manage their own investments with all the exposure to their own mistakes and high fees makes the future quite problematic.

As I have blogged before here and here, the CPP seems to offer a better solution to meet retirees' needs. Probably, changing the CPP by both raising the contribution rate and increasing the earnings limit on which CPP is deducted will both help. So what if "Expanding CPP benefits is a very complex undertaking that would likely have widespread repercussions for Canada's pension system overall"? Perhaps one of those repercussions might be a reduction in Hurst's pension consulting business as no-longer-so-necessary private pension savings declined. But is that a reason not to make changes?

His conclusion that Canada merely needs to deploy targeted solutions (harkening back to the notion that there is only a pension problem for a limited few, which I doubt, as expressed in this blog post) and leave aside CPP-enhancement, while somehow boosting employer-sponsored workplace pensions or individual retirement savings, ignores the failures and deficiencies of such options.

CPP enhancement certainly doesn't solve all pension problems. It only pays off gradually over many years as people work and earn a higher pension. Present-day retirees without sufficient savings won't get anything - we'll just have to keep working or buying lottery tickets and/or reduce our standard of living down towards that OAS/GIS level.

I'd like to see arguments more convincing and practical regarding CPP than what looks too much like self-interest or guilt by association from the fact that major labour unions are backing such proposals. Though the labour movement too often itself proposes stupid things merely for ideological reasons, we shouldn't make the same mistake should we?

Pension Reform: a Comparison of CPP(IB) vs RRSP / RRIF / LIRA / LRIF / LIF

There's been a lot of talk lately in Canada about pension reform, a very necessary and worthwhile subject, but unfortunately most of the analysis is from the viewpoint or from the self-interested position of government, regulators and the financial industry. Herewith I present a modest contribution to the debate by comparing two of the existing major options from the viewpoint of the retiree or pensioner, in whose interest all this reform supposedly is ultimately most important.

The two options:

• Canada Pension Plan (CPP) and its investment arm, the CPP Investment Board - thus my new acronym CPP(IB)
• RRSP / RRIF / LIRA / LRIF / LIF - the family of registered retirement plans available to individuals, first to save for retirement, and then to draw income from during retirement

The objective is to determine which best meets the first and highest priority of retirement income, the essential spending needs to maintain a lifestyle. I defined my criteria for this objective in my post of June 15 Pension Reform and What Retirees Need, so now I turn to the comparison evaluation as promised then.

First order analysis: What the alternatives deliver today, as promised and as possible. The CPP is very straightforward - once you are eligible and fill in the form to start payments, you receive a monthly cheque, indexed (increased but never decreased e.g. during deflation) for inflation, for the rest of your life. The registered plans are more complicated and the income must somehow be created from investments. I've assumed that the pensioner will follow what I consider to be the best available method to invest within the plans - a portfolio of passive index ETFs, possibly with annuities purchased at some point.

Below is a table with my comparisons and ratings. I haven't bothered with an overall score because the CPP is clearly and massively superior based on doing what it does now.


Second order analysis: drilling down beneath the surface, how sustainable and sure, and what are the risks of each alternative. Below is the table for those results. Again, the CPP is Victoria to St. John's distance ahead of registered plans.


Third order analysis: what investing challenges must be met, what effort and skills does each require to be successful. Big surprise huh? A pattern seems to have emerged as the CPP is again far superior to registered plans.


One could say that the CPP is the best thing since, and for, sliced bread.

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.

CPPIB Makes a Good Buy in Scotland

It's nice to know that the next time I go shopping at what is the nicest mall in Scotland, I will be helping out my own future CPP pension, after the announcement today of CPPIB's purchase with a British partner of Silverburn mall on the edges of Glasgow. I wonder if I can get a discount based on my 0.000006% (1 out 17 million CPP contributors) ownership share. The investment looks like a good buy to me. Silverburn has the neatest indoor parking, using an innovative guide that I wish other malls would emulate. On the ceiling above each parking space, there is a red (occupied) or green (empty) automatic detector. It is easy to spot empty spaces a good distance away and makes finding a space a skoosh, as they say in Scotland. All Silverburn needs now is a Roots store, which I daresay would do very well as all the Scots I know love their stuff, and a Tim Hortons.

A Good Idea - Liberals Propose Option for Individuals to Invest More in CPP

The Liberal party has proposed something that makes sense to me - an option for individuals to invest extra savings for their pension with the CPP. I could hardly disagree since I said more or less the same thing last year at the end of my review of the investing lessons of the CPPIB. Not only does the CPPIB seem to have been doing a fine job, it pursues worthwhile strategies no individual investor could hope to do on his/her own.

Inflation for Retired Canadians - Some Surprises

Back in May, my post Inflation Ain't What It Used To Be mentioned that inflation for US seniors / retirees has been consistently higher than for the average population by about 0.5% per year. I speculated that Canada might be similar but had no proof. I was taken aback a bit when Stats Can said they had no information on this topic. That's not true. I've now found some.

The May 2005 issue of Stats Can's CPI Review contains a research article Is Inflation Higher for Seniors? by economist Radu Chiru. Its overall conclusion about the period 1992-2004: "...the Consumer Price Index tracked very closely the inflation experienced by seniors as a group". Over the whole 12 years, inflation for seniors was 26.1% versus 24.4% for the Canadian average / official CPI, a difference of 0.11% per year. Apparently, things that cost seniors more or that they buy more of were more or less offset by things that went up less or that they use less. For instance, cable TV was a bigger ticket item for seniors and it went up far faster than most other items, costing seniors more, but tuition went up really fast too, and they pay much less of it.

However, an average can mask divergences - remember the old joke about putting one foot in the oven and the other in the fridge and being comfortable on average? This study's surprises:

• seniors renters (22.7% inflation) came out much farther ahead than home owners (28.1%); shelter is a much bigger chunk of spending for seniors; mortgage costs are not really to blame (few seniors have mortgages and rates were low) so the likely culprit is zooming property taxes! I note that the "renters are winners trend" has continued unabated as the latest annual CPI shelter costs show howmeowner costs racing upwards while rental costs crawl up, way below the overall inflation rate.
  
• the lowest income quintile (20% of the population) seniors actually experienced lower price rises than the highest income quintile (maybe because they would mostly be renters?) - amazing, the poor became relatively richer and the richer became poorer!
• where you live makes a big difference - Alberta was the inflation champion of Canada with seniors CPI going up 32% and official CPI 30.4% in the 12 years and a quick scan through the CPI by province tables shows that trend continued through 2008. The good places with inflation 4% lower than the Canadian average (mainly due to energy costs, according to the Radu study were Quebec and Newfoundland / Labrador. Quebec had the smallest gap between official and seniors CPI. Through 2008, Quebec was still tracking below Canadian average CPI. If only income taxes (which are not part of the CPI numbers - the Your Guide to CPI says it so eloquently: "Income taxes are excluded because it is impossible to associate
  a specific amount of tax paid with a specific quantity of services received." - i.e. one cannot tell how much tax is wasted) were lower in Quebec, it could be declared Canada's retirement heaven.

The Stats Can conclusion is a start towards reassuring seniors and retirees who rely on its fairness for maintaining purchasing power of income or investments that are indexed to the overall CPI like real return bonds, Canada Pension Plan income, OAS and private pension cost-of living adjustments.

Another study published in the December 2006 issue of Canadian Public Policy generally seems to corroborate Chiru's conclusions - Matthew Brzozowski, Does One Size Fit All? The CPI and Canadian Seniors. The abstract says: "... the CPI inflation rate overestimated the average inflation rate faced by Canadian senior households during the 1970s and the 1980s but has accurately measured average inflation for such households during the 1990s."

That comment about the 1970s and 1980s reminds us the future might not be like the past - if CPI previously overestimated seniors inflation, in future it could underestimate the rate by a lot more than the small amount it did between 1992 and 2004. Items that seniors consume in much greater proportion like food, shelter and health care compared to the general CPI weighting (see Radu paper for breakdown) are the ones to watch in balance with the ones used a lot less, like cars, alcohol/tobacco and recreational equipment.

Book Review: Buying Time by Daryl Diamond

The "buying time" title refers to spending more money early in retirement to have fun and not end up with a big pile of money kept aside for fear of running out with regrets for all the things that never got done in retirement. The subtitle of this book describes better what it is about: "Trading your savings for income and lifestyle in your prime retirement years". The author is a professional retirement planner with his own website.

This book has great value in that there are few if any books (or info on the web it seems) that take an integrated, holistic view of retirement financial planning to show how the whole process starts with lifestyle priorities that then drive a number of complementary financial components and actions. There are many books or websites from which one can obtain precise and comprehensive information and guidance on individual elements such as RRSPs/RRIFs, insurance or annuities but none that put it all together. The book covers all the acronyms and keywords at various degrees of depth: RRSP, locked-in RRSP, RRIF, LIF, LRIF, CPP, OAS, pensions, insurance, annuities, probate, wills. estates, trusts, power of attorney, capital gains, dividends, interest, bonds, equities.

I found very useful Diamond's discussion of the critical lifestyle priorities, namely providing sufficient income throughout retirement (i.e. making sure not to run out money), especially considering major health care requirements for critical illness and long term care, and whatever desire there is to pass along wealth to family or friends (i.e. not the taxman). It was also very helpful to read the explanations of insurance and annuities, something I have not yet spent much time learning the ins and outs of.

The book's stated objective to provide introductory, conceptual level treatment is also, for the DIY person, a major limitation. Diamond's constant refrain is: "to work out an actual detailed plan, go see a financial planner". Is it really beyond the capabilities of an interested, reasonably intelligent person who takes the trouble to buy and read such a book, to go ahead on his/her own?

The other important caveat is that the book needs a major quality improvement overhaul and significant updates. Diamond may be a good financial planner but he needs the services of a good editor to improve grammar, sentence construction, explanations, organization/story line, labeling and such. Many times I found myself saying to myself that something was incorrect, only to think about it and figure out that it was just the awkward explanation. The update is needed for important changes that have occurred since the 2003 publication date: new tax rates for dividends, tax brackets, foreign content rules for registered accounts, RRSP maturity (in the brand new federal government budget) and the introduction of variable payout annuities, which are not mentioned at all (and which annuity authority Moshe Milevsky termed a development which has "... the potential to revolutionize retirement financing in Canada." in his paper How to Completely Avoid Outliving Your Money (about which I wrote a post a few weeks ago).

A pet peeve of mine is the short shrift he gives to Exchange Traded Funds, exactly 11 lines of text, while the whole body of his discussion assumes the use of mutual funds for equity holdings.

Among the interesting but puzzling observations Diamond makes is that the first ten years of retirement are the best ones. Now it makes sense that declining health will limit activities as one gets older. But what if I decide to retire in my mid 50s? Does it mean I will be worse off after 65 compared to someone who retires at 65 and begins to enjoy his ten best years? And in financial terms, will I need less from 65 on than someone who starts his retirement at 65?

It would be very beneficial for the updated revise edition to include four or five annotated case studies of a complete financial plan. Certain themes and situations must arise often enough to be relevant to a large portion of the public. With all his experience, Diamond would surely be able to identify them.

In sum, this is a useful but by no means definitive book on the subject of personal financial management in retirement.