In this post I will review why the Ideal Canadian Pension Plan (ICPP) can be advantageous to Canadian workers who have many years to save before retiring.
In our last post we concentrated on Members approaching retirement. As we stated:
“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.”
These same reasons hold true for a younger Member. Cost savings and optimal payout strategies are paramount in any retirement program.
In addition, a younger Member, especially one just starting out, should join a pension plan because they will be forced to start saving for retirement now to take maximum advantage of the “power of compound interest”. It is too easy not to save early in a person’s career. This, however, is a mistake. Very small contributions early on can make a dramatic difference in meeting a person’s retirement income goals.
Of course, all of this can be said about joining any pension plan or retirement savings program. What makes the ICPP unique?
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.
Finally, the younger Member will be eligible to participate in the risk sharing strategies that are unique to the ICPP prior to retirement. Particular investments are automatically adjusted to meet the Member’s selected goals. The ICPP investment process is not about risk profiling and individual fund selection. It is about contribution rates to meet retirement goals with risk sharing along the way.
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.
The typical defined contribution pension plan provides its Members investment fund choices through an insurance company or a trust company (often owned by a bank). The typical group RRSP also provides the Members investment choices through an insurance company or a trust company.
If you don’t have a workplace retirement savings plan, your option is to establish an individual RRSP that you typically set up at a bank.
By most measures, a traditional defined contribution pension plan, a group RRSP and individual RRSPs are the same from a Member’s point of view. In essence, they are all individual retirement savings plans. Each Member has their own accounts, pays expenses unique to their accounts and controls the investments for their accounts.
Importantly, the defined contribution pension plan Member carries all of the investment risks, unlike a defined benefit pension plan Member. If investments are not managed well throughout a defined contribution pension plan Member’s career, they suffer by receiving a lower, and sometimes a substantially lower, pension in retirement.
As a Member of an individual retirement savings plan a younger Member is faced with a decision: which of the available investment funds should I select to meet my retirement goals?
Unfortunately, this decision is often not clearly presented. The Member is told they need to determine their personal risk profile and risk tolerance in order to select the right investment funds for them. The risk profiles and risk tolerances are based on a short-term risk and investment paradigm. The definition of risk is misplaced; the Member’s investment decision is not related to the Member’s retirement goals.
This disconnect is a serious flaw that often leads to poor investment management. Members end up investing in funds that are not well suited to their retirement goals.
In addition, the cost of each investment choice is often not transparent, even with new laws requiring more disclosure. Many Canadians will tell you that they do not pay anything for their investment funds and, if they do they pay for investment services, they will often not know how much they are paying to support the fund.
For those who do know what they pay in investment management fees, they will often say something like: “I am paying about 1% a year. That is not too bad.” Not too bad? Paying just 1% each year is costly over an entire career. The compounding effect damages long-term asset growth and reduces lifetime pensions substantially.
Most Canadians do not realize that they are typically expected to spend more than 25% (and sometimes well more) of their assets over their working lifetime to support their financial services provider, either through advice fees, investment management fees or investment fund expenses.
Members must select investment funds from a list. Before making this selection they are told many things. To paraphrase, if you are more risk averse you should decrease your exposure to equities and invest in other asset classes since they are not as risky. They are not told many important facts that would actually help them in making a better choice for a long-term investment. They are not told that to maintain purchasing power in your retirement only equities can be expected to produce enough investment income over the long term. They are not told their risk is not having a pension that will meet their needs in retirement. They are not told that short-term volatility is not a risk to a long-term investor.
Equities have averaged an annualised 6.6% real rate of return over the last 200 years in American markets, while no other asset class has averaged more than 3.6%. Why aren’t Members being told this?
The 6.6% real rate of return has been remarkably stable over all long-term periods during the last 200 years, including periods that encompass the Great Depression and the Great Recession. Isn’t this important to know?
Equities are the only investment asset class that has maintained the purchasing power of the underlying investment over every 20 year period during the last 200 years. Isn’t that what you need to meet your long-term retirement goals?
We obtained the facts quoted above from “Stocks for the Long Run, Fifth Edition” written by Jeremy J. Siegel, a Finance Professor at the Wharton School of Finance University of Pennsylvania copyright 2014.
You should ask yourself: “If equities have the highest expected long-term rate of return and have never lost purchasing power over the long-term, what makes equities risky over the long term?”
Finally, Members are typically provided with retirement savings plan statements, usually quarterly but sometimes monthly or just annually. The Member statements focus on the Member’s account balances, recent investment returns and account transactions since the previous statement. This is key information, but there is often nothing about how the Member’s investment accounts relate to their retirement goals. Their risk is that they will not achieve their retirement goals. Knowing they are on track with their savings is important.
Many Members do not pay much attention to the statements. If the investment statements show poor results, for example, a recent loss in the Member’s equity account balances, the Member’s sometimes take action—they sell and move to a “less risky” investment. In fact, the bigger the recent loss, the more likely individual Members are to sell equities and replace them with a “less risky” fixed income investment. This was especially true during 2008. Many Members reacted to the recent news and sold their equity holdings when they were cheap. They panicked. They succumbed to “short termism”. This was and is the wrong thing for a long-term investor to do.
Advantages of the ICPP
1. Lower, Fair Fees and Expenses
The ICPP has established a goal to provide its long-term investment services to its Members for less than 20 basis points per year (one basis point equals one-hundredth of one percent). Half of the expense load goal represents investment management fees and the other half represents fund expenses (e.g. trading costs and custodial costs). To put this into perspective, the goal is to provide investment services for no more than $200 per year for each $100,000 invested. Typical Canadian industry fees are much higher. They can be expected to be $1,000 per year or more for each $100,000 invested.
This matters because a lower fee will result in larger account balances at retirement. A 100 basis point (i.e. 1%) per year reduction in investment service costs over a long-term career will result in a 20% to 25% increase in account values at retirement, all else being equal. A 100 basis point reduction is entirely possible under the circumstances. A 25% increase in assets at retirement results in a 25% increase in pension in a defined contribution plan, all else being equal.
In addition, administrative expenses are also reduced because the ICPP is one plan for everyone. We will not be establishing and maintaining new plans for every Participating Employer. We will report once to regulators and have one governance program. This will allow us to provide the ICPP at substantially reduced administrative expenses.
Even better, administrative expenses will only be paid by Members who benefit from the service. Active Members will pay for active Member communications. Pensioners will pay for pension payroll services. While these expenses will not be large, it is also important that we make sure that they are fair. A Member pays fairly for the services provided to the Member.
We expect the fee/expense advantage to be more than 25% for a typical career Member prior to retirement. In other words, the typical career member should expect at least a 25% higher retirement income at retirement because of the fees and expenses established for the ICPP compared with current solutions offered in the Canadian marketplace.
2. Better Long-term Investment Process
The ICPP has established a long-term investment process for all of its Members. The investment process is the same for each Member, although the amounts held in each Member’s accounts will not be the same. The amounts held in each Member’s accounts reflect their individual retirement goals and the remaining time to their expected retirement date.
For a younger Member who has more than ten years to go before retirement, all of their contributions are invested in the equity-based ICPP Accumulation Fund. Once they get to within ten years of expected retirement, their investments are automatically transferred to other investments specifically designed to support their chosen retirement payout option(s) in accordance with the ICPP rules.
In essence, each targeted benefit option has a dedicated investment process that operates much like a target date investment fund, except that the underlying investments are selected to provide the best theoretical investment support for that particular payout option. The target benefit (i.e. payout) option, as well as the target payout commencement date, determines the particular Member’s investment solution. A Member, in essence, has a number of separately managed target date (target benefit) funds that are specific their goals.
The Member doesn’t manage this investment process; the Plan Administrator manages the process on their behalf. The Member makes contributions and the Plan Administrator looks after the investments.
The ICPP Accumulation Fund is specifically designed to support an investor with a long-term investment horizon. This long-term investment fund is invested entirely in equities selected for a Canadian retirement. As noted earlier, equities have historically had a 3% per year long-term return advantage over any other potential asset class. A 3% advantage will more than double your investment over a 25 year investment period.
In addition, the ICPP Accumulation Fund is designed to provide additional advantages to a Canadian investing to support their retirement in Canada. The ICPP Accumulation Fund only invests in large publicly traded Canadian companies or very large publicly traded multinational companies with a significant Canadian presence that are traded in U.S. dollars. The companies represent the Canadian economy, provide appropriate global exposure and have a blended Canadian and U.S. dollar exposure.
The Fund invests in these companies in a way that precludes a significant weighting in any one company or industry and is rebalanced quarterly using established rules thereby promoting diversification and controlling portfolio risk. The fund invests in leading companies in industries with positive long-term expectations.
3. Better Member Communication
The ICPP Administrator provides all Members with ongoing information about their retirement savings. Confirmation of contributions, investment earnings and account balances are all provided at least quarterly. Frequently asked questions, and their answers, are published. Member data is available for confirmation. All of the information that Canadian Members have come to expect will be available.
Unlike many retirement savings plans in Canada, however, the Member Communication commitment from the ICPP Administrator will not stop there.
The ICPP will also provide Members with information about how well they are doing with respect to meeting their retirement goals. A Member will receive information each year through standard member statements or, on demand, through an on-line dedicated Member information portal. Members will know whether they are ahead, on track, or behind in their retirement savings.
Members will be able to compare this year’s reports to last year’s to help them with their planning.
To illustrate how important this can be, let us play a little thought experiment. Think back to the Member statements that would have been provided after 2008. This was the year of the most recent stock market correction worldwide.
The younger Members of the ICPP, those 30 years of age or under, would have received a report that showed their account balances had dropped materially since they were in invested entirely in equities. At the same time, their ability to meet their long-term retirement goals had not changed much, primarily because most of their scheduled contributions were still in the future. In fact, the decline in equity markets was actually an advantage with respect to current contributions as compared to the previous year because purchasing equities was so cheap.
Most younger Members would have done nothing. A few would have increased their personal contributions. Either would have been acceptable in the circumstances.
The older Members of the ICPP, those within ten years of retirement, would have received a report that showed their account balances had dropped materially, but not necessarily as dramatically as for younger members since some of their investments would not have been invested in equities.
For these older Members, however, the large decline in equities values may have changed their ability to meet their long-term retirement goals because most of their scheduled contributions were already invested. This would have been communicated to them.
These Members would therefore have the information to take action. Some would decide to delay their retirement to make up the difference. Some would decide to increase their contributions to make up the difference. Some would have just heightened their future monitoring of their retirement goals and, in the end, done nothing. What they would not have done is sell their equity investment because that election was not available to them under the ICPP. They are not allowed to try to time the market, which is a common mistake.
Older Members could have taken actions to protect their retirement, but could not have taken the wrong action of selling equities at precisely, or as it turns out within months of exactly, the wrong time. If anything, they would have been buying more equities by increasing contributions.
Some older Members would have done nothing, but most would have taken action by planning to delay retirement or by increasing personal contributions or both. All would have been acceptable and Member communications from the ICPP are designed to support this activity. It is likely that special communications would have been prepared at that time to help older Members with their planning.
Of course, there are many other Members who are not young and not old—the middle group. The communications for this group will necessarily be very dependent on their personal retirement goals. A 45-year-old who plans to retire at age 55 has very different needs than a 45-year-old who plans to retire at age 70. The ICPP will provide communications that are specific to the Member based on their stated retirement goals. This is an advantage for the middle group, but not the only advantage under the ICPP.
In the next post, we will review why the ICPP will be of value to someone who is in the middle years of their career.