The Advantages of the ICPP for Mid-Career Private Sector Employees

In this post I will review why the Ideal Canadian Pension Plan (ICPP) can be advantageous to Canadian workers who are in the middle of their expected career.

In our last post we concentrated on younger Members with a long time to retirement. As we stated:

“A primary advantage of the ICPP is that it provides the younger Member with support to help determine ‘right level of contributions’ needed to meet their individual retirement goals. In addition, since determining the ‘right level of contributions’ is not exact, the ICPP allows the younger Member to monitor the progress of their savings account and to make changes to the contribution level if and when it’s warranted…

…the most important reason that the younger member should join the ICPP, however, is to invest automatically in the ICPP Accumulation Fund—a fund designed to meet the Member’s needs.”

In summary, the right level of contributions paired with an effective monitoring system are important elements for eventual success.

In another post, we concentrated on older active Members approaching retirement:

“Why should a Canadian working in the private sector who is approaching retirement demand access to the ICPP or similar plan? The ICPP is a collective arrangement. There is likely to be substantial cost savings for any particular individual.

More than that, a pensioner should join the ICPP to gain access to the Collective Variable Annuity payout option offered under the ICPP.”

In summary, appropriate and optimal payout options are important elements for a Member’s success.

These same reasons hold true for a mid-career Member. The right contributions, ability to monitor, cost savings and optimal payout strategies remain paramount.

The primary advantage for a mid-career Member is that they will participate in the risk management strategies that are unique to the ICPP as they approach retirement. The ICPP has established investment strategies that are designed to meet a Member’s targeted benefit goals. In essence, the ICPP investments operate as a series of target benefit investment processes. The Member’s own investments are adjusted automatically each year so that their portfolio can be expected to match their selected retirement goals when they actually reach retirement.

The most important reason that the mid-career Member should join the ICPP, however, is to allow the automatic transition of the Member’s investments from the ICPP Accumulation Fund to the right “target benefit investment funds” at retirement. This transition of funds operates automatically at the critical time in a Member’s career and is essentially personal risk management that is an integral part of the ICPP design.

Background

The typical defined contribution Member in Canada is given a list of available investment funds. They are then asked to determine their personal “risk profile” and, based on that personal risk profile, to select a fund or funds to invest in. Few Members are comfortable establishing a personal risk profile or making this critical decision.

The Members are supported in their decision making through communications that focus on the investment funds and the short-term investment risks traditionally associated with the various investment funds.

The two most common approaches are often labelled a “build yourself” or “built for you” investment choice.

In the “build yourself” approach, the plan administrator offers the Member a series of investment options. Typically the choices include at least one Canadian equity fund, one Fixed Income Fund, one Short-term Fund, one International or Global Equity Fund and perhaps others. The nature of each fund and its short-term risks are carefully explained to the Member who selects the initial funds and transfers investments between the funds during the rest of their career.

It is left to the Member to decide which funds are best suited to their particular retirement needs at that point in their career. The Member is responsible for making changes when needed at their sole discretion.
Some Members manage this process relatively well. Others “forget” to monitor and rebalance the investments. Some members don’t really understand the process well enough to make good investment decisions, even at the outset.

As a result, the second “built for you” investment choice has emerged. The “built for you” choice is often labelled as a target date fund or a series of target date funds. These funds are designed so that the investment mix decision is taken out of the Member’s hands. The recommended fund is the fund that is designed to mature at the Member’s targeted retirement date, or as close to that date as possible.

Each “built for you” target date fund has a glide path associated with it. In essence, the fund starts with predominantly equity based investments that are transitioned to more and more fixed income based investments over a published glide path.

It is assumed the final investment asset allocation—the allocation at the maturity date of the fund—will be appropriate for the Member’s retirement needs. Some have final allocations that are balanced between equities and fixed income investments and others have final allocations that are predominantly fixed income. The devil is in the details.

The “built for you” choice is very popular when compared to the “build your own” choice and many Members select this option when available. In fact, the “built for you” option has become a more popular default option in traditional defined contribution pension plans.

The “build your own” option remains popular among some Members, especially executives. Research shows that many Members who use a “build your own” option obtain poor long-term results.

While the “built for you” option has become popular, some obvious flaws remain.

The “built for you” option is a blunt instrument. The target date funds often mature in five year increments and it is only happenstance if a particular fund is scheduled to mature close to when you want to retire. Of course you can always select two target date funds, one that matures before you expect to retire and one that matures after you expect to retire.

In addition, the final allocation of investments within the target date fund may not be appropriate for your particular retirement needs. You may need to insure a portion of your pension through the purchase of an annuity to manage your retirement risks. In that case, the assets dedicated to that purpose should probably be invested in an immunised portfolio of fixed income investments as you approach expected retirement. The “built for you” option will not necessarily do that.

It is very unlikely that a single “built for you” fund will actually meet your specific needs at retirement. The “built for you” option, is in fact, not built for you. It is built for a large cohort of Members who may, or may not, have the same retirement goals as you.

A Member’s retirement goals are unique. Investment management strategies to support retirement goals are necessarily complex and unmanageable for most pension plan Members. Traditional defined contribution investment solutions are not designed to reflect these twin realities. The solutions either:

(a) require a Member to manage the complex “build your own” investment strategies, or

(b) provide a Member with a simple “built for you” option that is just not right in the circumstances.

The ICPP provides a third approach. Members establish retirement goals and the ICPP administrator manages an appropriate investment process designed to meet those goals.

Advantages of the ICPP

1. Investments Related to Benefit Targets

The traditional defined contribution industry now often uses target date funds as a foundation for a defined contribution pension plan’s investment process. The target date fund is designed so that the investment mix is the right one should a Member retire on the target date fund’s maturity date.

Target date funds are based on an excellent idea. A Member should manage investments so that they are the appropriate investments at retirement. We certainly agree with that premise.

We think, however, that target date funds are only a start. The focus is solely on time to retirement and that is just not enough. What we need are “target benefit” funds—funds that focus on time to retirement and on expected payouts at retirement and beyond. A Member in mid-career needs to have help preparing for retirement and adjusting to any changes in retirement plans, if and when, the inevitable changes occur.

A target benefit fund should mature on, or at least close to, a Member’s expected retirement date. It should also mature based on the retirement benefits expected to be paid to the Member. That target benefit fund is a target date fund with benefit driven investment asset mixes at expected retirement. A Member can have many retirement goals each with its own unique payout strategy and therefore its own unique required asset mix at retirement.

For example, a Member could want to provide for a regular lifetime income that increases with inflation to meet all, or a portion, of the Member’s expected basic living expenses in retirement.

The money needed to support such a goal needs to provide relative safety of principal and investment returns that exceed inflation. Most modern portfolio solutions to this problem would provide for a balanced approach. That is, investments in both equities and bonds. The strategy should be to establish a “target benefit” fund that is invested in the right mix of equities and bonds at retirement.

On the other hand, A Member may need to ensure that a certain level of income is provided throughout their lifetime after retirement. The Member decides that purchasing an annuity at retirement to provide this income is the best strategy. In that case, the “target benefit” fund should mature on the Member’s retirement date by holding long bonds that immunise the Member from late changes in market interest rates. That is, the strategy should be to establish a different “target benefit” fund that is invested entirely in long bonds with the right duration at retirement.

The point is that all the elements of a Member’s retirement goal leads to their target asset mix at retirement, not just the timing of their retirement.

We considered all of the retirement goals that we could think of and narrowed down those goals to the five most common.

The first is to provide a lifetime inflation protected income after retirement. That led to an investment strategy that invested 50% in equities over the long-term and 50% in fixed income investments. The ICPP payout Fund was designed to meet this need.

The second was to provide assets to purchase an insured annuity at retirement. That led to an investment strategy that invested in an immunised portfolio of fixed income securities that protected the Member’s annuity purchasing power at retirement. The ICPP Annuity Preparation Fund was designed to meet this need.

The third is a goal to start retirement to provide a stable income early in retirement to allow the Member to continue in the same lifestyle, at least temporarily. This strategy requires investing in fixed income investments that are somewhat shorter term than those needed to purchase an annuity. The ICPP Bridge Fund was designed to meet this need.

The fourth is a goal to meet short-term needs only. The ICPP Short-term Fund is designed for short term needs.

Finally, some fortunate Members can defer retirement benefits substantially. They just don’t need the income right now or for the foreseeable future. The ICPP Accumulation Fund can meet this need. As a result, any money not needed for a specific retirement goal right away can remain invested in the ICPP Accumulation Fund.

In essence, the ICPP provides five “target benefit” funds. Each is specific to a Member’s stated retirement needs and each is managed to mature close to the Member’s selected retirement date as set out in the next section.

2. Automatic Glide Path Adjustments

A “built for you” target date fund has a “glide path”. The “glide path” sets out the asset allocation for the target date fund as time elapses and it approaches maturity.

For example, a typical target date fund maturing in 30 years would have an asset allocation that is almost all in equity investments; often more than 90% invested in equities with the balance allocated to fixed income investments. The target proportion of equity investments is lowered based on the scheduled “glide path” as the fund matures, so that the equity proportion is typically less than 50% of the assets at maturity. This change is accomplished by buying and selling the underlying assets within the target date fund.

The ICPP uses a different approach that accomplishes much the same thing. To keep things simple and illustrate how the ICPP works, we will assume that the Member we are concerned with is only saving enough to provide for his basic income through the ICPP. This Member therefore needs investments at retirement that will support a lifetime income with inflationary increases.

In the ICPP, this Member—who has established a target retirement date 30 years from now—will have all investments held in the ICPP Accumulation Fund. As the Member ages, the investments remain in the ICPP Accumulation Fund until a trigger point that occurs when the Member first has less than ten years until retirement. In September of that calendar year, the ICPP plan administrator will ask the ICPP fund manager to redeem one-tenth of the units held on behalf of the Member in the ICPP Accumulation Fund and will use the proceeds to purchase units in the ICPP Payout Fund at some point over the next four months. Since the ICPP Payout Fund invests 50% in equities and 50% in fixed income investments, the Member’s assets will now be invested 5% in fixed income once this change is implemented.

In the following year, a similar transaction occurs and the Member’s investment is now 10% in fixed income. After ten years, the Member’s investment is 50% in fixed income and 50% in equities. Very similar to how a target date fund works.

There are a few very important differences between how the ICPP investments are managed and the typical target date fund is managed:

(a) The ICPP plan administrator’s adjustment in investments for each Member in a year is independent of the adjustments made for other Members.

(b) The ICPP plan administrator determines the amounts to be transferred each year using plan rules.

(c) The investment transfers are used to support more than one target benefit and therefore target asset allocation at retirement (up to five potential retirement goals)—set in priority order by the Member.

This process is, of course, very complicated to administer—but the complexity is managed by the plan administrator. The Member simply sets targets and the adjustments are made using plan rules that are designed to meet those targets.

Unlike a “build yourself” solution, the Member does not have to remember to make changes; they happen automatically as the Member approaches retirement.

Unlike the “built for you” options, the ICPP solution is designed to meet the Member’s particular retirement goals, both with respect to maturity dates and form of target benefit at retirement.

3. Fluid Retirement Goals

The investment transfers mentioned above are also automatically adjusted using plan rules if the Member changes their target retirement age or benefit priority list. There are many reasons to change retirement plans, especially as a Member of a defined contribution pension plan. The ICPP can facilitate change.

A Member may decide to delay retirement for different reasons. For example, the Member may just not want to retire as early as originally planned, or their employer may request that they continue to work. A change in retirement goals will be in order and the ICPP services will be available.

These services will allow this Member to easily estimate the effect of the planned delay in retirement. Asset transitions will be automatically adjusted to reflect the revised retirement date. The funds necessary to support the delayed benefits will be recalculated. The Member just needs to decide: when do I expect to retire now? The ICPP plan administrator will then make all the necessary the adjustments.

The Member can adjust a target benefit, inform the ICPP plan administrator, and adjustments will be automatically made. The Member receives help, but controls the retirement planning process.

In the next post, we will begin our review on how the ICPP is governed and managed.

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