Wednesday 22 December 2010

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.


Michael James said...

Generations before us have, on average, seen significant reductions in standard of living in retirement. This is particularly true later in retirement as inflation eroded even seemingly good pensions. Why is it a huge problem if it happens to boomers as well? I reject the idea that boomers somehow deserve to maintain their standard of living into retirement. I applaud those who have saved adequately for the retirement they want. But I don't see why my children should pay for any more than a modest lifestyle for those boomers who did not save.

CanadianInvestor said...

MJ, it's too late for the Boomers. The CD Howe study points out it is the Boomer children, those just starting out in the work world, who will suffer the most. Wouldn't it be nice for us to make changes today - CPP enhancement - which will pay off for them in 40 years? I would definitely think it appropriate to immediately increase the payout rates to present-day retirees and make the next generation pay it off. The other point is that long-past generations in the 1950s say, used to die around age 65. Rising life expectancy raises the length of retirement purgatory and the CD Howe study tells us it will get more and more like hell as the years go by. The other thing the Howe study indirectly says, by noting the huge difference (1.5% vs 2.5%) in net returns achieved by individuals vs even RPP plans, is that people saving diligently on their own, are bound to have much more modest lifestyles than collective schemes managed by professionals with the proper motivation (doing good for the investors, not themselves).

Michael James said...

It may be too late for boomers to have the retirements of their dreams, but I think they can retire at least as well as their parents, on average. I have no objection to enhancing CPP to increase benefits for those who pay in more.

I'm not sure if you wrote what you meant, but I strongly disagree that it is "appropriate to immediately increase the payout rates to present-day retirees and make the next generation pay it off."

The argument that older generation died younger says to me that the present-day retirement age is too low. I would say that 70 makes sense as opposed to 65 for many and 55-60 for government workers.

CanadianInvestor said...

MJ, thanks for the note. OOPS! I meant to write the opposite. I think it IN appropriate to increase CPP benefits now for all retirees. I do think people should save themselves for their own retirement and not expect others to pay.

Yes, it could be a good idea to raise the CPP age even further. The actuaries can help us figure out the trade-off between higher deductions and deferred age of CPP benefits.

Anonymous said...

Hi there CanadianInvestor. I am the principal author of this study.

William Robson's views are his own; I can only agree with you that most readers of the study would find a significant divergence between its findings and the views expressed in Robson's commentary in the Globe and Mail.

For what it is worth, the study takes an individual's RRSP assets at retirement age and annuitizes them using a real rate of return, so real RRSP/RRIF income will remain constant over the course of an individual's retirement; consumption replacement outcomes vary only modestly at older ages.

I agree with the general thrust of your comments.

CanadianInvestor said...

Thanks for the clarifications, Anon. Guess I need to ask William Robson why he wrote as he did should I ever have occasion to meet him.

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