Book Review: Pensionize Your Nest Egg by Moshe Milevsky & Alexandra Macqueen

 Pensionize Your Nest Egg exhorts retirees to ensure that a good chunk of their income comes from sources that promise to pay a regular amount as long as they live. That advice is easy to accept given that one of the main risks in retirement is outliving savings.

The next part of the book's advice - how to do it using a combination of three "products" 1) annuities, 2) portfolio of stocks and bonds, 3) guaranteed living withdrawal benefit (GLWB), a complicated insurance company product - is much iffier. This part of the advice is problematic for three reasons, first because of uncertainties around GLWBs, second because the list of retirement risks is incomplete, and third because the list of products or methods to handle the various risks is incomplete.

GLWBs are worrying because they are complicated. There are various inter-acting moving parts that make them a challenge for the consumer, like resets and ratchets on the payout amount, choice of under-lying fund, initial payout rates, and fees. How can a consumer compare offerings from various companies and know which deal is better? Quite competent folks like Peter Benedek's Retirement Action here, Joe Tomlinson on Advisor Perspectives here and Wade Pfau on Advisor Perspectives here have crunched lots of numbers and the best choice of what to do seems to depend a lot on assumptions.

A key tool created by author Milevsky and promoted in the book, the RSQ and FLV calculator, does not put a GLWB into the mix. It only includes an annuity and a stock & bond portfolio. Why not? We are told it is "beyond the scope of this book". The reader is told to consult a financial advisor. Yet on the same QWEMA website, there is an ad for the PrARI calculator, aimed at financial advisors which does include the missing GLWB component, as well it seems, as other missing pieces like unexpected lump sum expenses. The book and the free tool look more like an illustration of concept designed to drive readers to seek out financial advisors than a practical self-serve solution usable by a DIY investor.

A question I keep asking myself was why I should even be interested in a GLWB. There is an excellent little table on page 66 where annuities, stock/bond portfolios and GLWBs are rated for how they offset the three big risks of inflation, longevity and sequence of returns, and for their benefits of legacy value/liquidity, sustainability and growth potential. Annuities and a stock/bond portfolio have exactly opposite offsetting Yes answers where the other is No, while GLWBs are either similar to one or the other, or in between i.e. GLWBs look superfluous.

It's always interesting to think of the position of the product offeror (the old saying is if you are in a poker game and you don't who the chump is, then it's you), the insurance company that sells the GLWB. GLWBs may (it's hard to tell and that is worrisome - we could call it chump uncertainty risk) be a game in large about stock volatility risk. Benedek's simulations found that a GLWB customer was better off if stock volatility is higher. Similarly, this technical paper by Australian researchers from the insurance company perspective suggest that their profits would be highly sensitive to stock volatility, customer mortality volatility and interest rates. Another thought-provoking piece is about GLWB provider Ohio National's different and supposedly more effective and cheaper method of hedging its own risk. It raises the question whether some insurance companies might be headed for a big fall because they don't really understand and control the risks properly. The fact that Assuris covers GLWB income 100% up to $2000 per month and 85% above that (but this is only mentioned in the book with respect to annuities and not explicitly for GLWB payouts as well) helps on the income side but not on the legacy side if the insurance company screws up. Do we really want to be trying to also assess how well the insurance company will handle the investment account to pick a GLWB?

Retirement Risks to wealth and income surely include more than the three (inflation, longevity and market sequence of returns) the book lists. Unplanned events like one-time or chronic health problems, divorce, (grand)child care, elder care can create large negative financial effects. There may be a need for on-going higher cash flow, or a big lump sum. There is a greater requirement for liquidity and flexibility than only an end of life legacy goal the book discusses. Though the book's stated aim is solely to describe how to create a guaranteed lifetime income, the process it proposes excludes such other considerations. Those considerations cannot be separated when deciding how much to pensionize. If you pensionize too much in order to ensure long term sustainability you may suddenly be caught short. Some things like health risks can and perhaps should be handled with long term care insurance but perhaps not if a greater amount of capital is kept in a stock/bond portfolio or if a no-longer needed house can be sold to pay for LTC.

Alternative products and methods to address income/lump sum needs are incomplete. The single best inflation protection product is inflation-indexed aka real return bonds, yet they are not discussed or incorporated into the planning.

The historical stock & bond return and volatility characteristics in the book are taken as given and baked into the RSQ-FLV calculator, yet new portfolio construction methods offer convincing promise to significantly lower volatility (e.g. see this individual investor Smart Beta portfolio). The pension fund and institutional investor world has moved to controlling risk/volatility to improve the return vs risk ratio and individual investors can too to some degree. Even a traditional but more diversified portfolio (i.e. more varied asset classes) will improve the return vs risk figures used by the authors. Changing the  historical assumptions about an investment portfolio's performance can appreciably reduce the likelihood of running out of money using a systematic withdrawal plan, improving its attractiveness in the product allocation structure the book presents.

That's what the book is missing in my view.

What the book does discuss is really well done and worth reading. The writing aims at a general audience. It has lots of good illustrations, clear uncomplicated explanations without difficult technical or mathematical material, very much like Milevsky's other excellent books that simplify and explain potentially confusing subjects. The free online RSQ-FLV calculator still provides insight despite its limitations. Another calculator created by Milevsky the book refers to, the Implied Longevity Yield calculator on Cannex, is very helpful for trying to decide whether current annuity payout and interest rates are propitious for buying an annuity now or later.

The book is to be applauded for forcefully making the critical point many people do not seem to realize that an RRSP balance (or the proposed PRPP) is merely a savings plan, not a pension, since it produces no automatic, guaranteed lifetime income. And they also make the equally critical point that most people need and should have real pension income (except those like Warren Buffett who has so much money he could never possibly run out).

Bottom line: pensionization via product allocation is a worthwhile approach but what the authors leave out is too important to make the book's content good enough for practical retirement income planning. 3 out of 5 stars.

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.

"Something Will Work Out" Retirement Planning

Benefits Canada reports in Retirement income adequacy still a problem for pension plan members some scary results of a survey of pension plan members by pension consultants Towers Watson. That people "just aren't getting it" and not even using such retirement tools as employers make available and just hoping and trusting that "something will work out" for retirement doesn't augur well for the future. The article also notes the continuing shift from Defined Benefit pension plans to Defined Contribution retirement savings plans, which places more onus on the individual to both save enough and to invest wisely. Towers Watson goes on from these to talk of other warning signs. Is all this likely to work out well?

Meanwhile, the progress (recently tabled federal legislation) on the federal government retirement solution for the private sector, the DC-type Pooled Retirement Pension Plan, is revealing some interesting features of the PRPPs. The banks and insurance companies are apparently objecting to established pension plans like OMERS trying to get in on the action claiming that OMERS has unfair advantages on costs and regulation. Hmm, so now we see an admission that PRPPs run by banks cannot and will not do as good a job (costs, planning assistance etc) as traditional DB pension plans run by purpose-built organizations for public servants. Is there something wrong here?

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.

Government Moving Ahead on PRPPs - Financial Industry is "Salivating"

The Financial Post's Jonathan Chevreau article on the plans of the federal government to proceed with Pooled Registered Pension Plans (PRPP) contains the all-too-telling mention that "Naturally, Bay Street is salivating at the prospect. This is a giant potential opportunity for the nation’s banks, mutual fund companies, insurance firms and a growing number of manufacturers of exchange-traded funds." One is "naturally" led to wonder who will benefit most from PRPPs, ordinary Canadians trying to build a pension, or the financial industry. I cannot tell for sure but I own shares in the financial industry.

Also no doubt salivating are the financial planners and advisors Mr Chevreau also mentions, since the added complexity of another retirement savings layer with the PRPP will require more figuring out.

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.

Book Review: Pension Revolution by Keith Ambachtsheer

Why should an individual investor read a book about how to fix the pension system that is addressed to pension fund managers and legislators who make the pension rules?

1) To become an informed, opinionated citizen on a topic that is sure to affect you in a significant way, e.g. most recently in Canada, taking a position on the short-lived proposal to expand the CPP and the substitute federal proposal to start something called Pooled Registered Pension Plans (my take here ... written before I read this book, though reading it has only reinforced my opinion)

2) To get ideas to manage your own retirement income, such as probable investment returns, the risk premium for equities over bonds and most uniquely, the importance of matching the time horizon and riskiness of liabilities with assets / investment portfolio. Ambachtsheer doesn't intend to address the needs of individuals and he never explicitly says that the same principles should apply to individuals and to pension funds but they seem highly pertinent to me. As a foundation principle for people like me who must manage a personal pension fund of RRSPs/RRIFs/LIRAs/taxable accounts for themselves, the "match assets with liabilities" phrase makes much more sense than "match bond allocation age".

In other book reviews I have several times objected that the book title or sub-title doesn't deliver what it promises. Not this time. "Revolution" is not too strong a word. Ambachtsheer advocates drastic across the board change. He says corporate defined benefit plans were a disaster waiting to happen from their origins (what better supremely ironic example could there be than the fact that the very company that set the pattern for corporate DB plans after World War II - General Motors - in large measure was scuppered by the liabilities of its DB plan?). Corporate DB plans are good for neither companies nor employees, being riven with inherent unresolvable conflicts. Defined contribution plans are fatally flawed as well, for different reasons but the end result is still bad, an incapacity to deliver a good pension in retirement.

The Optimal Pension System - Revolutionary wearing-suit-and-tie Ambachtsheer (he is the director of the University of Toronto's Rotman International Center for Pension Management) proposes a solution, called TOPS (The Optimal Pension System) with the features below. The book dissects the issues that bedevil our existing DB/DC pension system and tells why and how his TOPS can be viable replacement system. TOPS includes:

• auto enrollment and set minimum contribution rate
• auto-pilot savings-investment process - no un-necessary choices (e.g. pick one of 20 mutual funds) for individuals to make
  
• auto-pilot conversion of financial capital into deferred life annuities all along during a working career (instead of suddenly needing to decide what to do with a RRSP at retirement)
  
• single -purpose pension plan co-ops (unlike DB plans where corporate goals and constraints interfere and DC plans where financial industry profit motives interfere)
• good governance and organization design (like appointing a board based on ability to help achieve the pension mission, not to represent a union or an employer), which he figures can add 3% per annum to returns!!
  
• economies of scale (yup, size matters and he's got the data to prove it - less than $2 to 3 billion - as of four/five years ago when he wrote the book - is too small)

Though much of this looks a lot like the CPP to me (yes, I am still on that hobby horse), Ambachtsheer cites a few other examples that comes close to his ideal - the Dutch national pension system e.g. one provider is APG and the USA's TIAA-CREF.

Investment Environment - Ambachtsheer devotes about 70 pages to investment topics that should interest every individual investor - the stocks for the long run question and the equity risk premium (ERP), which he says predictably varies up and down (metrics like P/E and dividend yield giving reliable indicators of future returns). His rule of thumb formula for the expected ERP gives sobering results these days: (market dividend yield + 80% of future real GDP growth - yield on real return bonds = 2.4% + 0.8*2%(?) - 1.2% = 2.8%. Ambachtsheer does not believe in the Efficient Markets Hypothesis. He thinks instead that skilled investment professionals can add considerable excess returns, especially over the long haul. He poo-poos people like Burton Malkiel (strange that Malkiel still writes a glowing blurb for the book at the front!) who apply simple mechanical investment rules and find no out-performance and then conclude that EMH works just fine - "Highly effective pension and endowment fund management teams know that there is considerably more to to generating excess return over time than applying simple decision rules to buying and selling stocks and bonds."

What's Good for Pensions Would be Good for the Economy - The book puts forward the intriguing idea that pension funds can exert positive influence on companies and on the economy through their long term investment perspective as knowledgable, activist shareholders with considerable clout. Ambachtsheer argues that better-managed pension funds will recognize that what he calls long horizon risky investing brings the biggest returns and in turn that depends on investee companies focusing on long run sustainable growth instead of short-term next quarter results.

How Much We Really Need to Save - It is a shock to read that the riskless creation (i.e. buying only real return bonds) of a riskless lifetime inflation-adjusted pension would require a 25% or more pay deduction rate sustained for 35 years. Failing that strategy, we can buy into equities for probable higher returns but we have to accept investment risk and that could mean taking a lower pension. We also learn that the most expensive pension feature by far - and thus the one that pension providers (whether governments or corporations) are most likely to cut back in cases of under-funding - is inflation protection. Boomers should not be surprised if and when inflation-indexing gets cut, since there has been no change in our pension system since the 2007 publication of the book. Everything in the book is as relevant and topical today as then.

Unless inflation goes up in a huge spike upwards as in the 1970s, the current 2% or so rate will eat away slowly and surreptitiously at living standards of retirees. Unfortunately, most often it takes a sudden crisis to provoke fundamental change. Ambachtsheer does not attempt to forecast the likelihood of change in pensions. He only plays the role of the technician who tells us what is wrong and how to fix it.

The biggest downside of the book is a lot of repetition. The same ideas are presented over and over with a bit of new material in each of the very short (5-6 pages each) 45 chapters. The book also lacks an index, so it is hard to find subjects again, even when one takes extensive notes during reading, as I do. A consolidated reading and reference list would help too, though key papers and books, such those on the investing ideas, are referenced within the text.

The publisher Wiley Finance listing for the book includes the table of contents.

My rating: 4.5 out of 5

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.

Flaherty Decides to Build Wading Pool for Pensions

Federal Finance Minister Flaherty's proposal today to set up something called Pooled Registered Pension Plans is a disappointing timid response to calls for improvements to Canada's pension system.

The proposal only suggests a few minor improvements:

• small companies and self-employed workers would have access to portable group pension savings plans instead of being limited to personal RRSPs.
• contributions would seem to be locked in for retirement only, unlike RRSPs where people can withdraw funds anytime

PRPPs would have the following deficiencies:

• attempts to address only the first half of pension construction, the savings process and completely ignores how to turn those savings into a steady, reliable, inflation protected income that lasts as long as you live and pools those risks - that why it's more like a wading pool than a real pool
  
• it sounds nice for the proposal document to say low costs are an objective but there is no evident mechanism by which overhead costs will be kept under control
• the investment mechanism doesn't makes sense - how can the money be "co-mingled for investment purposes" with participants only having "personal accounts for record-keeping" alongside the idea that the plan administrators will offer a "manageable number" of "investment funds that permit a person to create an investment portfolio for his or her own objectives and risk preferences". I think the answer is that there will be a menu of mutual funds, like a DC plan, which, in fact, the draft document says on page 6. So the only real scale efficiency and risk sharing is what already exists in mutual funds. The proposal doesn't answer the critical question of who will be negotiating the lower fees with the portfolio managers and how the incentive scheme will make that happen.
  
• no mandatory participation, each province can decide whether to do so or not, thus ignoring the very big issue that too many people simply don't sign up when given the choice
• "tools" to enable people to make an informed choice. Har, har I can just see it now.... Mr Smith, would you like a Conservative Low-Risk Fund, a Balanced Fund or an Aggressive Growth Fund? On top of that, employers would have to figure out what contribution level to set for employees and themselves. How could employers have the knowledge and expertise to do this at all adequately? For the self-employed, they would have to do it themselves, or will this scheme include provision of expert personal financial advice supplied by advisors, working under fiduciary duty rules?

As the draft document says on page 8, PRPPs "will essentially be a new type of defined contribution RPP" catering to small companies and self-employed people. It's another addition to the already complex and confusing plethora of savings and retirement plans.

That this inconsequential and ineffectual proposal has been put forward tells us that Minister Flaherty has been convinced that there is no real widespread pension problem looming in Canada. Simple and straightforward CPP enhancement appears to have lost and if so, it will be business as usual for the financial services industry, which will continue to profit. Time to buy those shares 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 Income Shortfall a Problem for Only a Few - Is That So?

Some pundits and politicians like Alberta's Finance Minister Ted Morton oppose the expansion of CPP to give a bigger assured retirement income to Canadians on the basis that it isn't a big problem because it is "... limited to a small sector of the Canadian workforce ..." (as quoted in this News 95.7 report from June this year).

Perhaps he was looking at data such as that in the Retirement Income Adequacy Research Report of December 2009 which was commissioned by the federal and provincial finance ministers. Tables 2 and 3 cite research showing that retired 70-72 year old men and women in 2006 had average income replacement levels from about 70% on up across every single income level. Looks good doesn't it since 70% replacement is the common rule of thumb for maintaining a standard of living. Furthermore, that result holds whether or not the retiree had been a member of a Registered Pension Plan or not and to complete the picture, in all but the highest income quintile, the non-RPP retirees had higher incomes than the RPPs. That's true even when the employment earnings of the non-RPPs (since non-RPPs, unsurprisingly, still are working and have much higher employment earnings) are subtracted. Got that? Retirees without a pension plan had higher incomes. Shocker! What retirement income problem?

As report author Jack Mintz writes, "The results are thus quite striking but need to be interpreted with care." Enter the nit picking detail. Note the word average in the above paragraph. Consider this dumb statement - if you have one foot in the freezer and the other in the oven, then on average your feet are a comfortable temperature. The Stats Can researchers Yuri Ostrovsky and Grant Schellenberg who put together the original data in Pension Coverage, Retirement Status, and Earnings Replacement Rates Among a Cohort of Canadian Seniors realized the hidden danger of using an average and have since done a revealing follow-up in A Note on Pension Coverage and Earnings Replacement Rates of Retired Men: A Closer Look at Distributions (no, they did not look at the detail for women) of July 2010. By looking at the breakdown of replacement income percentage, they found that the non-RRPs had a much higher concentration of men at the low end of the income replacement scale. The RPPs are clumped in the middle of the replacement spectrum. The average came out the same because of an offsetting bunch of non-RPPs at the highest end of the scale. A few rich people counterbalance a bunch of poor people and the average looks the same. The graph below from the study shows this for the middle income group ($45,700 to $58,200 / quintile 3).

If one cares to look, the phenomenon is the same in all three middle income quintiles, covering income of $32,800 to $76,100. In every income group except the very lowest (where OAS and GIS ensure that the bulk of men have pretty close to or more than their pre-retirement income) about half fall below 50% replacement rate of income. 50% replacement must be about the minimum for anyone to maintain a standard of living no matter how modest and probably it isn't near enough at lower income levels. Conclusion: pretty darn close to half the Canadian retired population of men must be unable to maintain their standard of living in retirement. A small sector of the workforce indeed, Minister Morton!

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.

Montreal Economic Institute Attacks Québec Public Sector Pensions

The Montreal Economic Institute, which describes itself as "an independent, non-partisan, not-for-profit research and education organization", has just published a brief 4-pager Are public sector plans too generous? Its answer is yes, they are. They are not the first ones to point out the fact that they are generous (e.g. Sherry Cooper shows the same in her book, The New Retirement, reviewed here), though the MEI's overtly political aim of influencing negotiations with public sector unions to reduce their generosity is perhaps not shared by everyone, especially public servants.

The interesting bit in this paper is the assertion that the main advantage for the public sector pension stems from the greater job stability and security in the public service combined with the defined benefit rule that the pension amount is based upon the salary of the five best years of service. They calculate that a hypothetical private sector worker who changes companies and pension plans three times in a career will, at the point of retirement, have fully 41% less value in his/her retirement plan. This is even assuming the presence of am identical private sector defined benefit plan (which most private sector workers no longer have of course) with the same final five best year rule and the same salary throughout a career!! As they explain:

"The job security that many public sector employees enjoy makes all the difference. The five best years providing the basis for the pension are those late in their careers, when their salaries are at their peak. In contrast, the salaries for the five best years in the three different jobs held by the private sector worker are necessarily lower. This reality means that public sector employees are able to get the full benefit of their defined benefit pension plan, which is not the case for private sector workers employees, even with an identical plan."

Wow! Who'd have thunk, huh? Merely switching jobs in an upward career path at different organizations could royally mess up your retirement.

In a strict sense the public sector DB plan isn't necessarily special or unique. Any such DB plan and career path, private or public, would give the same result. Portable years of service credits and the continuation of the five year rule are the key. Of course, there is a crucial practical difference in that almost all public sector jobs are covered by DB plans so portability agreements which preserve accumulated work year credits ensure that the huge payoff of the "five-best-years" rule is preserved. Transferring accumulated pension savings from a DB plan into a DC plan cuts off the magic of a pension that is calculated on the basis that you earned your highest salary during your whole working career.

The five-best-years rule both catches up for past inflation and captures real salary increases. My guess based on personal observation is that it is also pretty rare for public employees' salaries ever to actually go down - when someone achieves their Peter Principle level, they get shunted aside where they can do less harm and stay at the same "red-circled" salary level.

With the disappearance of DB plans in the private sector, the practical result is that very many private sector workers, even those earning more than public sector employees, and / or who save just as much, will never be able to achieve the same pension.

The effect of the five-best-years rule is akin to the oft-repeated example of the long term benefits of compounding that putting aside a small amount left to grow easily beats saving much larger amounts later.

It is clear that public sector workers' pensions are far ahead of those in the private sector. The debate about whether to redress the fact of the inequality of private vs public sector pensions by reducing the pensions of public servants, or increasing the pensions of private sector workers and the equity or fairness of any solution, will be hotly contested and is not properly addressed in this short paper. However, at least it reveals one of the key practical differences.

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.

Watching the UK Get Older - What Effect on Government Finances?

Found on the BBC website Maps chart UK's ageing population this brilliant animated map (compare the map to Statistics Canada's yawn-inducing text Population Projections for Canada, Provinces and Territories) that shows the steady ageing process as the years roll on. Starting from 1992 and projected to 2031, the inexorable slow ageing process is visually striking as the map gets more and more of the darker coloured areas indicating the ageing. Whether the measure is median population age or 65 and older, the pattern is the same. Increasing longevity is evident too as the over 85s triple their share of population.

One interesting phenomenon is that there was not much change through the 1990s but suddenly around 2002 the phalanx of those of State Pension Age or older begins to rise from 18.3% of the population to 19.5% by 2010. That's over 730,000 extra people potentially drawing State Pension. It surely doesn't help government finances. Just as a period of negative market returns is a bad time to start drawing on one's retirement portfolio, so it is for a country, except that the UK government has no choice.

DBRS says Defined Benefit Pension Plans not Doing Badly

With all the news about the woes of pension plans at Nortel and GM, it is encouraging that debt rating agency DBRS concludes in its August 2009 report Canadian Private Pension Plans - Losing or Cruising? that the state of DB plans in Canada is reasonable:
"From the review of the major private pension plans in Canada, there are three main conclusions that stand out:
• The outlook for pension plan funding remains manageable.
• Pension challenges are not expected to lead to rating events.
• The shift from defined-benefit plans to defined-contribution plans will continue."

DBRS includes metrics of 70 large private sector plans, so one can see varying asset mixes, past returns and funding gaps (see App.5), which is useful both for the investor and for plan member employees of those companies. Though the average is ok, I would be worried about Canadian Oil Sands Trust (42.7% under-funded) and Nexen (42.3% under-funded). Employees and shareholders of Bank of Nova Scotia (25.4% over-funded) and Great West Life (9.0% over-funded) need not worry about pension obligations.

Also of note,
Widely varying asset mixes

• equity averages 51% of pension plan assets but is as much as 68% (Canadian Oil Sands Trust) or as low as 16% (Sears Canada, which might seem conservative but what does Sears' 34% of "Other" consist of - Hedge funds?)
• fixed income averages 43% of assets and "other", defined mainly as real estate, averages 6%; the portion of fixed income has been rising
  

Return Assumptions Declining

• now averaging 7.1% for all plans, return assumptions have been trending downwards over the past decade due to greater fixed income, falling interest rates and lower equity returns. They are now 0.5% lower than in 2002.