In this post I will review why the Ideal Canadian Pension Plan (ICPP) can be advantageous to a Canadian who is approaching retirement.
In our recent posts we have concentrated on a Member’s and a Participating Employer’s role in the ICPP. In essence, an overview of how the ICPP works from both perspectives.
In this post, we start the process of explaining why an employee—any employee—in Canada should request that their employer provide retirement benefits similar to those targeted under the ICPP.
As a reminder, the ICPP is designed to provide more complete and better retirement income options than are currently available to Canadians who work in the private sector. Canadians who work in the public sector are generally provided retirement benefits that are at least as good as those targeted under the ICPP.
Why should a Canadian working in the private sector who is approaching retirement demand access to the ICPP or a 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 the past, private sector workers in Canada received retirement benefits that were commensurate with those targeted under the ICPP. Unfortunately, this is often no longer true, even if they continue to receive any pension plan from their employer, and even if they are fortunate enough to continue to be a member of a defined benefit pension plan.
The majority of private sector workers now belong to defined contribution pension plans (or hybrid pension plans where future benefits are defined contribution), if they are provided a pension plan at all. According to statistics Canada, less than 25% of private sector employees are covered by a registered pension plan. Some private sector workers are offered a group RRSP instead of a pension plan. In essence, an individual defined contribution pension plan.
As a Member of an individual defined contribution pension plan they are faced with a decision at retirement. How do I ensure that I do not run out of money while meeting my retirement income goals? Should the Member:
1. Purchase a fixed-income insured annuity from a life insurance company; or
2. Self-direct an individual variable annuity on their own?
You may find it unusual that I refer to the second option as a self-directed individual variable annuity. They are generally not described this way but, if you think about it, what is a RRIF if it isn’t a self-directed individual variable annuity? What is a Life Income Fund? In either case, you self-direct an investment fund and pay yourself an income that varies over time.
For a member of a defined benefit pension plan in the private sector, there is limited or no choice. The member receives most, if not all of the Member’s benefits in the form of a collective lifetime annuity (i.e. a pension) from the pension plan fund. The defined benefit pension is paid for using the pension plan’s collective resources.
Traditionally, many pension plans provided ad hoc inflation increases to the pensions-in-pay from the pension plan fund. Due to the advent of new accounting disclosure rules and the financial meltdown that occurred ten years ago, the ad hoc increase process in private sector pension plans has been virtually eliminated. Ad hoc increases were paid out of the plan’s funds when the plan was able to afford them. In actual practice, this occurred regularly.
In today’s world, pensioners of private sector defined benefit pension plans typically receive a fixed-income pension (i.e. no inflation increases) for their lifetime, unless something very bad happens, at which time their pension is cut back. In other words, private sector defined benefit pensions are variable.
The ICPP will provide an Uninsured Collective Variable Annuity option to the ICPP Members. This variable annuity will be payable for the Member’s lifetime, with spousal benefits. It will also provide scheduled increases to the pension-in-pay (i.e. inflation protection) based on the pension plan’s collective experience. This is much like what used to be provided under many private sector defined benefit pension plans in Canada.
Why provide an Uninsured Collective Variable Annuity option with built-in inflation protection? Because that is what the Members need. A Canadian must have a reliable source of income in retirement that increases with inflation over time to meet their basic needs.
What is wrong with an Insured Annuity?
Nothing but cost.
Insured annuities are important risk management tools and play an important role for pension plans. They provide a guaranteed monthly income. The insurance company backs the monthly annuity payments using very conservative investment portfolios. The resulting very conservative reserves and Assuris (an insurer of the insurers) then backs the annuity payments should something happen to the insurance company.
Life annuities are expensive for a couple of reasons.
First, the underlying investments used by insurance companies to support annuities in Canada are almost exclusively bonds or the equivalent. This is in response to rules imposed on life insurers under life insurance laws and by regulators. These very conservative rules are based on the acceptance of the belief that bond cash flows match lifetime annuity cash flows, which means insurance companies must invest in bonds and only bonds.
While we can debate whether bond cash flows match lifetime annuity cash flows, there is no dispute that the regulatory regime is premised on this assumption. This leads to suboptimal, bond dominated, investment strategies, especially in low-interest environments. This in turn generates lower monthly annuity amounts, all else being equal.
Second, annuities are not priced using best estimate mortality assumptions. As in Las Vegas, the game is knowingly rigged in favour of the house. This also leads to lower monthly annuity amounts, all else being equal.
Third, life insurance companies in Canada who sell annuities are owned by their shareholders. The third party shareholders demand a profit. Paying a third party out of an annuity premium leads to lower monthly annuity amounts, all else being equal.
Finally, insurance companies express difficulty with underwriting future inflation increases. It’s hard to blame them given there really isn’t an accepted economic theory for inflation. Since the inflation risk is hard to understand or model well, insurance companies charge more (i.e. demand a relatively higher expected profit) to underwrite it.
The bottom line is that insurance companies offer insured annuities, without inflation protection, that start at monthly incomes that are about 25% lower than the Uninsured Collective Variable Annuity monthly incomes available under the ICPP. While a guarantee is important, we think it is overpriced in today’s annuity marketplace.
In fairness, we think insured annuities and their guarantees are important and can play a specific role in retirement planning for some individuals. Insured annuities are used as part of the ICPP payout strategies, but only on a voluntary basis and by Members who have already met their expected basic retirement needs.
What is wrong with an Individual Self-Directed Variable Annuity?
Nothing, for now.
A pension plan Member could realistically transfer all of the Member’s pension plan accounts to a Life Income Fund, or its equivalent, and pay a reasonable monthly income out of the fund. In fact, the pension regulator will set the maximum the Member needs to pay, and the tax regulator will set the minimum the Member needs to pay.
This Member has a looming set of problems though.
If the Member lives into his nineties, the monthly income collapses. The Member has outlived his savings. Even before that, the Member’s monthly income declines as compared to that available through an Uninsured Collective Variable Annuity, all else being equal.
The numbers can be staggering. A Member needs to start off, at age 65, with a monthly income of less than 75% of the amount available under the Uninsured Collective Variable Annuity in order to give the Member a 90% chance of not outliving the member’s assets. This fact is based on the assumption that the Member receives the same annual increases to the pension-in-pay as the Member would under the Uninsured Collective Variable Annuity, and that the Member invests as well as the ICPP Payout Fund portfolio over the long term. This is a fair “apples to apples” comparison.
We would rather start with 100% of the income and give ourselves a 100% chance of not outliving our assets, as is available under the ICPP collective variable annuity.
If the Member suffers declining health, dementia or any of the many other vagaries of old age, how will the Member continue to manage the life income fund well? And even if the Member retains good health, is it reasonable to expect the Member to manage the life income fund better than the ICPP Management Board manages the ICPP Payout fund with all the resources available to the ICPP?
The Individual Self-Directed Variable Annuity is simply not a good long-term solution, and certainly not as good as the Uninsured Collective Variable Annuity.
In fairness, the Self-Directed Variable Annuity will provide a death benefit upon the Member’s demise, while the Uninsured Collective Variable Annuity will not. The Uninsured Collective Variable Annuity is not an estate planning vehicle, it is a retirement income vehicle. In our opinion, there are better ways to provide an estate to your loved ones, including other payout strategies offered as part of the ICPP.
What is wrong with a Collective Variable Annuity?
Consider the following:
1. The ICPP Uninsured Collective Variable Annuity provides annual increases to pensions-in-pay based on the previous five year’s plan performance; investment, longevity and expense performance. This produces a stable, risk-controlled result. Averaging works. It has been used by actuaries for hundreds of years.
2. The ICPP Collective Uninsured Variable Annuity continues to pay a monthly pension during a member’s lifetime (and the Member’s Spouse’s lifetime). Beneficiaries do not run out of money.
3. The ICPP Payout Fund supports the Uninsured Collective Variable Annuity and is professionally managed with a published statement of investment policy (i.e. a balanced mandate invested 50% in equities and 50% in bonds). Why 50% equity? Because our research indicated that 50% of the fund would not be required to support payouts from the fund over the next ten years.
4. The ICPP Collective Uninsured Variable Annuity limits the monthly amount any one individual may purchase from the fund to twice the then current maximum monthly CPP payment to avoid any potential for anti-selection. No individual is allowed to select against the group in any material way.
5. The expenses for the Uninsured Collective Variable Annuity are set to support the reasonable administration of the Payout Fund and not to support third-party profit.
We intentionally avoid suboptimal solutions for the ICPP whenever they are identified. Our goal will continue to be to provide the best possible pensions to Canadians employed in the private sector.
In the next post, we will review why the ICPP will be of value to someone who has more than ten years until planned retirement.