by June Smyth and John Melinte
In 1993, Bill Webb was working for a Canadian bank when all employees were offered a choice between keeping their Defined Benefit (DB) Pension Plan or converting to a (new) Defined Contribution (DC) option. At the time, interest rates were high and with the dot.com boom, equity markets were soaring.
Bill had been at the bank for 10 years and wasn’t sure if he would stay there for his entire career. His brother-in-law was a financial planner and convinced Bill to take the lump sum value of this DB pension and start investing in the DC plan going forward. Now, Bill is 60 and ready to retire. He has seen his DC balance grow over time, but not to the extent expected back in 1993. He now has $750,000 in the account and is looking for help on how to convert that into a retirement income.
A brief history on retirement program in Canada
Defined Benefit plans have long been the standard for retirement programs in Canada. They provide a guaranteed income for life, based on hours worked, or career or final average salaries and service in a plan. However, since the 1990s, various forces have propelled plan sponsors to move away from their historic DB plans.
For one, investment returns skyrocketed in the 1990s, as did interest rates, and accounting rules required more disclosure on corporate balance sheets; all combining to cause many plan sponsors to drop the uncertain costs and Profit & Loss expense of a DB plan in favour of a DC or Capital Accumulation Plan (CAP) such as Registered Retirement Savings Plan (RRSP)s, Defined Contribution Pension Plan (DCPP)s and Deferred profit sharing plan (DPSP)s.
More recently (over the last couple of decades, up until about 2021), interest rates decreased drastically, causing sustained unexpected increases in DB plan funding liabilities. Combined with evermore onerous funding regulations, this continued drive plan sponsors away from DB and towards DC.
In many cases, plan sponsors set up hybrid plans where DB surplus covers the DC contributions for a period of time. Often, existing members, like Bill, had a choice between DB for all service (continues in the DB plan), DB for past service and DC for future service (grandfather the DB benefit as at a certain date and start contributing to DC), or DC for all service (what Bill did, take out the lump sum value from DB to invest in DC). New members were typically forced into the DC portion of the plan.
The chart below illustrates the decrease of active membership in private DB plans in Canada as a percentage of total active registered plan membership (shrinking from almost 90% in 1992 to under 70% in 2022), while the same metric for DC plans has more than doubled (from just under 9% to over 18%, respectively).
If this trend continues, 20 years from now, DC active membership will represent the majority of Canadian active pension plan members. This does not even take into account the very recent spike in interest rates (due to COVID-related inflationary pressures), which has prompted many DB plan sponsors to consider freezing, winding up, or converting their legacy DB plans into DC plans (in order not to miss what may be a temporary window to de-risk their financial positions on a fully funded solvency basis).
All of this means that there are (and will continue to be) more and more DC/CAP plan members, looking to retire and wondering how their lump sums accumulated will convert into income in their retirement.
Decumulation Options
Many DC plan members barely understood the decisions around how much to contribute, and in which funds to invest. The retirement industry has spent years trying to educate these members in the accumulation stage, but very little time or effort to help members in the decumulation phase.
We saw the introduction of the CAP Guidelines produced by the Canadian Association of Pension Regulatory Authorities (CAPSA), and these have been modified and expanded over the past 20 years. There is now a guideline on decumulation and another on risk, but many DC plan members do not even realize they do not have a guaranteed future income (the term ‘Pension Plan’ as in ‘DCPP’ can be misleading). Many external advisors encourage members to transfer their DC funds to them for management, promising strong returns and hands off investing. But since the financial planners are typically paid by commission on funds under management, conflict of interest is clearly at play.
Currently, DC plan members’ options often only limit to:
– Moving funds to a LIRA/LIF or RRSP/RRIF in a retail setting, OR
– Buying an annuity for all or part of their CAP balance
In most cases, moving the funds out (even if their advisor is able to generate strong returns) results in considerably higher management fees (compared to institutional pooled fees), which eat into these returns. Also, outside of an annuity, the member has to continue monitoring their investments, as well as determine how much to withdraw each year (there are legislated minimums and maximums), all the while not knowing how long they will live or what sort of long term care they may require in future.
The lack of a cost-effective alternative to annuities that allows the conversion of retirement savings into monthly lifetime income is creating a disconnect in the Canadian retirement income system.
The retirement industry is working to develop additional options for DC plan members. Ideally, it makes sense to pool risks and create ‘funds’ similar to DB plans. The basic concept is pooled longevity, pool interest rate risk and pooled investment risk, and finally lower fees due to larger asset pools.
Bonnie Jeanne MacDonald, a well-known academic actuary writes about Dynamic Pension Pools. A new report published by the National Institute on Ageing (NIA) and the Global Risk Institute (GRI), explains that “DP pools are already recognized as a powerful decumulation solution in other ageing countries around the world; however, they aren’t broadly available in Canada today”.
Pooling in retirement allows retirees to combine their registered savings plans and create guaranteed income in a more cost effective way than buying an individual annuity. These pools could work such that when members die, remaining assets remain in the pool to subsidize those who die later; very similar to a DB plan. All forms of risk are then pooled: longevity risk, interest rate risk, and investment risk. The pools would be able to retain a more optimal asset mix than in an individual LIF or RRIF. Lifetime income could be adjusted each year to reflect actual investment returns and the pool’s mortality experience.
In order to allow these vehicles in Canada, our governments must still make changes to legislation in order to allow pooling of all retirement assets.
Keith Ambachtsheer, an expert in pension design, governance and investing, writes and speaks professionally in a similar vein to Bonnie-Jeanne, saying that Canada could be a world leader in retirement systems if we worked to bring the ‘Canadian Pension Fund Model’ to the private sector. The Canadian Pension Fund Model is a pooling of risk in retirement; longevity risk, investment risk and interest rate risk.
He suggests that “Private Sector Financial Services Providers create one or more new Canadian Pension Fund Model offerings: The Common Wealth and Purpose Investments organizations have both launched services and investment options consistent with the principles of the Canadian Pension Fund Model. An important delivery consideration here is the structure of the 1.2 million Canadian private sector
employer market, out of which only 3,000 have over 500 employees. Again, other financial services organizations with expertise in designing and managing separate accumulation and lifetime pension payment offerings could join in.”
What can insurance companies, actuaries and other professionals do?
We need insurance companies to be creative in their offerings; encouraging options with pooling, and allowing external assets to be transferred in from outside the insurance company when members retire from a group plan. Most insurance companies allow external RRSP and LIRA money to enter the group plan and benefit from the same lower fees. But what happens when members retire and then remember that they have other money outside? Wouldn’t it be great if they could also transfer these funds and pool with other (former) members to experience lower fees, pooled mortality and better investment options?
So what did Bill Webb end up deciding for his retirement income? He took the good advice of his brother-in-law (still a financial planner) and bought an annuity for a portion of his retirement income. This (along with CPP and OAS) are expected to cover his monthly living expenses, allowing the remaining balance of $300k to provide additional funds for larger expenses like vacations and a new car. This way, Bill doesn’t need to worry about outliving his money. He still needs to make choices around investing and withdrawals but some of the burden is removed with a lifetime annuity. Bill also wonders about those who stayed in the DB plan at the bank. Now they are retiring, they could use some help in understanding those option forms, and how their DB pension intersects with their CPP and OAS, personal savings, other plans in which they may have entitlements, their home equity, life insurance, etc. As actuaries (especially those in the pension field), we could find ways to appropriately offer retirement consulting advice and services to individual plan members (rather than focusing only on the plans themselves). This may require changes to our codes of conduct to address such complementary (and potentially conflicting) services when also servicing the underlying pension plan sponsor.
Bio:
June Smyth, FCIA, FSA, FIA, is Senior Consulting Actuary & Practice Leader at Baynes & White Inc. She can be reached at jsmyth@bayneswhite.com
John Melinte, FSA, FCIA, is a pension and benefits actuary and the managing partner of Baartman Melinte Consulting in Toronto.
Footnotes / sources
https://kpaadvisory.com/userfiles/KPA_Policy_Paper_Making_Canada_One_Of_The_Worlds_Top_Pensi ons_Countries_April_2023.pdf
https://globalriskinstitute.org/publication/affordable-lifetime-pension-income-for-a-better-tomorrow/ 1 https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=1110013301