Our goal for the Ideal Canadian Pension Plan (ICPP) is to at least double a career Member’s pension, as compared to the current market retirement solutions, given the same level of career contributions. This is obviously ambitious, but is it reasonable? Many of our potential stakeholders are sceptical when advised of our goal. They think that we are overstating the potential for the ICPP.
The extensive evidence we provide in this article helps potential stakeholders to understand that double the pension is not only is it reasonable, it is likely eminently attainable.
We established this goal based on our proprietary research. The results of our research indicated that we could easily double pensions for ICPP Members as compared to Members of traditional defined contribution pension plans in Canada or individuals using other typical retail retirement savings arrangements in Canada.
The graph presented at the end of this executive summary provides a fair comparison of the replacement ratios achieved under the ICPP and the other pension strategies offered in the Canadian pension marketplace. We have determined a replacement ratio for a 40-year career Member retiring at age 65 assuming this Member uses the various strategies throughout their career. We have made adjustments for typical expenses, investment strategies, and payout strategies employed under each scenario.
The purple line on the graph represents the ICPP using all of our recommended strategies, as applied over the Member’s 40-year career ending December 31 of each year from from 2003 to 2018. The other lines represent the investment strategies and payout strategies currently used in the Canadian pension marketplace.
The black line represents a Member using fixed income investments throughout their 40-year career and then purchasing an insured annuity at retirement. The red line represents the same Member who uses a balanced investment approach (60% equities and 40% fixed income). The blue line represents the same Member investing in Canadian equities. The green line represents a Member investing 50% in Canadian Equities and 50% in US Equities.
We present our results for each year since 2002. We did this because our ICPP Total Index is based on research using data beginning in 2003. The graph demonstrates that the ICPP would have provided a replacement ratio (an amount of pension) that is more than twice the replacement ratios provided under all other tested strategies at all end dates. In fact, the advantage is much more than twice under many of the scenarios.
The above replacement ratios were determined for a Member who had 10% of earnings contributed to a pension fund on their behalf during each year between age 25 and age 65. The contributions were then invested under the various strategies.
The pension available under the fixed income investment scenario for a Member retiring at December 31, 2018 with a pre-retirement income of $60,000 is $28,266. The pension available for the same Member under the balanced investment (60% equity and 40% fixed income) is $41,112. The pension available for the diversified equity investment (50% Canadian equity and 50% US equity) is $48,090.
The average pension available during retirement under the ICPP is $169,152. This is much more than twice the pension generated under any of the other strategies. The ICPP pension starts at $135,322 at age 65 but grows during the Member’s retirement based on post-retirement investment results. Even the pension that the Member starts with at age 65 is more than twice their pension under the other scenarios. The pensions under all other scenarios remain the same throughout a Member’s retirement.
We often make the statement in our presentations for the Ideal Canadian Pension Plan (ICPP) that it is our goal to at least double a career Member’s pension, as compared to the current market retirement solutions, given the same level of career contributions.
We established this goal based on our proprietary research. The numbers in our research indicated that we could easily double pensions for ICPP Members as compared to Members of traditional defined contribution pension plans in Canada or individuals using other typical retail retirement savings arrangements in Canada.
We expect to obtain this excellent result through three fundamental sources: 1. Expense savings, 2. purposeful collective investment strategies, and 3. the avoidance of inappropriate insured annuity purchases.
Expense savings come from reduced investment management expense and reduced administrative expense.
Better investment strategies come down to a couple of basic truths. First, well diversified equity portfolios produce excellent long-term investment returns. Second, some “rules based” investment strategies can increase long-term returns in an equity portfolio.
Avoidance of expensive insured annuity purchases in today’s environment is a must. Buying an annuity is tantamount to accepting higher expenses and poorer investment strategies during your retirement. Many individuals buy insured annuities because they believe they have no other choice. The ICPP will provide them with another, often better, choice.
The defined benefit pension industry in Canada emerged in the late 1950s and 1960s based on the savings that could be had from these same three sources. The underlying ideas for the ICPP are not new. They are old ideas, with a few modern improvements, applied as a new solution to the pension delivery problem that exists in Canada today. Using this solution, doubling a Member’s pension over a career is not just feasible, it is a likely outcome.
In order to demonstrate the increased value of the ICPP, we need a benchmark. How do we measure the delivery of pensions over a career? Careers typically last for periods of 35 to 40 years. Inflation happens and is variable. Wage increases happen and are variable. Investment returns vary by asset class and over time.
We decided that the best measure available for this exercise is the Replacement Ratio. For the purpose of this demonstration we defined the Replacement Ratio as the ratio of an individual’s earnings at retirement divided by the individual’s starting lifetime pension at retirement. A Replacement Ratio of 100% would mean that the individual replaced their before-retirement income with the same amount of post-retirement income.
We obtained data representing annual rates of return for Canadian equities, US equities measured in Canadian dollars, median Canadian bond portfolios, inflation rates, and general wage increases since 1950 in Canada. We then calculated the amount of assets that would accumulate if the Member saves 10% (e.g. 5% employer and 5% employee contributions) of his income each year and invests in the various strategies over a 40 year period. The first period runs from January 1, 1950 to December 31, 1989, the second runs from January 1, 1951 to December 31, 1990, and the last runs from January 1, 1979 to December 31, 2018. We then converted that lump sum amount into a pension payable to the individual with 60% continuing to the individual’s spouse at retirement. Our base results are shown below:
The black line represents a continuous investment in a fixed income (i.e. bond) portfolio over the 40 years. The blue line represents a continuous investment in Canadian equities over the 40 years. The green line represents a diversified investment half in Canadian equities and half in US equities rebalanced to the same mix at the end of each year over the 40 years. The red line represents a balanced investment of 60% of the assets in the 50/50 mix of equities and 40% of the assets in the bond portfolio with rebalancing at the end of each year over the 40 years.
We have not adjusted the results for expenses and we assumed that the lump sum amounts would be converted to a lifetime income at age 65 using the uninsured variable annuity and using the same assumptions for each period. This is our baseline.
Note that the diversified 50/50 equity strategy produces the best results in every year except 2008 where it is slightly below the balanced 60/40 approach. Canadian equities come next. The bond (fixed income) portfolio is generally the laggard.
There are some important observations to be made. The Canadian equity results are surprisingly poor. The Canadian equity market is not well diversified, does not represent the entire Canadian economy well, and has not produced excellent results over the long term. The 50/50 equity portfolio is better diversified and has consistently produced excellent results over the long term.
The bond results appears nice and smooth; seemingly less volatile. The range of bond results is huge, exhibiting replacement ratios from a low of about 33% in the early 1990s to a high of about 70% in the early years of this millennium. Bonds obviously do not provide guarantees. The early 1990s were generally not a good time to retire from a defined contribution arrangement in Canada.
The balanced 60/40 portfolio produces good results in many years, but rarely better than the 50/50 well diversified equity portfolio. In the few years that the results were better, they were only slightly better. In many years, the equity results were materially better than those produced by a balanced portfolio.
The results indicate that investment approaches matter. Well diversified equity portfolios are demonstrably better than bond portfolios over the long term.
The excess volatility in the equity markets can produce quite variable results over short-term periods. That is why transitioning into a more balanced approach is recommended under the ICPP as a Member approaches retirement.
Given the obvious volatility of the results, continuous management of a retirement process should be promoted. A Member could vary contribution levels to mitigate the volatile investment results.
We also prepared similar results for a 35 year career as shown below:
We obtained results from December 31, 1984 through December 31, 2018. This graph shows the influence of the substantial bond sell off in the early 1980s. The bond result in the early 1980s was close to 20%. Think the current environment is bad for new pensioners? The 1980s and early 1990s were much worse.
We will use the 40 year career as representative in the balance of this discussion.
The remainder of this article will take the reader through an in-depth analysis of the ICPP advantage. The analysis is quite technical and provides the background for our claim that the ICPP should provide excellent results for a career Member. We would be happy to provide further explanations or illustrations upon request.
We begin by preparing a graph that includes the effects of the ICPP Total Index since December 31, 2002. We do not have actual data for the ICPP Total Index prior to that date. The results are shown below:
The purple line represents the effect of using the ICPP Total Index rather than the 50/50 equity strategy for years after 2002. The ICPP Total Index invests approximately 50% in Canadian equities and 50% in large multinational equities traded in US dollars. All results are in Canadian dollars.
The results are quite dramatic as shown by the purple line. The replacement ratio for the ICPP Total Index is more than double the replacement ratio for the best other investment strategy after approximately ten years of adopting the ICPP Total Index as the strategy. We will review what the possibilities are of using the ICPP Total Index over an entire career later in this discussion.
We will focus on the period beginning December 31, 2003 in the balance of this discussion as we only have data from then on for the ICPP Total Index. A graph showing the recent results follows:
The Expense Issue
Up until this point, we have made no adjustments for expenses.
Individual Canadians typically pay 200 basis points or more in Investment Management Fees (IMF) to obtain retail investment solutions for their retirement savings. We adjusted the Replacement Ratios by assuming IMFs equal to 200 basis points (i.e. 2%) of assets under management will be paid each year.
On average, the replacement ratios obtained are reduced by approximately 60% through the payment of a 200 basis point investment management fee. This is true under all of the end dates and under all of the investment strategies.
This means that every $1,000 dollars of monthly pension that an individual would have received without having to pay investment management fees, the Member will only receive $625 dollars of monthly pension.
This result is shocking. Most people do not appreciate just how important investment management fees can be over a long period of time. Of course, an individual could avoid most of these investment fees by investing personally. Some current exchange traded funds provide investment solutions at substantially reduced fee levels for retail investors.
Our results are shown on the following graph:
In fairness, many single employer defined contribution pension plans have negotiated lower investment management fees on behalf of their Members. The best fees are approximately 50 basis points (i.e. 0.5%) each year. A defined contribution pension plan for small to mid-size private employers typically pays in the range of 100 basis points (i.e. 1%) each year.
Our target for the ICPP Accumulation Fund is ten basis points (i.e. 0.1%) each year, once the fund becomes large enough. This fee will be applied equally to all Members of the ICPP. The ICPP Accumulation Fund uses an investment strategy based on the ICPP Total Index. There are also additional fund expenses that could add an additional 10 basis points each year. This is also true of any other investment fund.
For comparison purposes, we decided to measure the results assuming an individual (e.g. a self-employed individual) pays 200 basis points in IMF, while we could offer the ICPP Accumulation Fund using a 20 basis point IMF.
The advantage of the ICPP Accumulation Fund is approximately 50% on this basis. In other words, a pension of $1,000 would increase to a pension of $1,500 because of the difference in investment fees in this comparison.
Our results are presented below:
We also compared the results assuming an individual is a Member of a typical defined contribution pension plan and pays 100 basis points in IMF while we could offer the ICPP Accumulation Fund using a 20 basis point IMF. The purple ICPP line in the graph is labelled “ICPP Adj” to reflect this difference in expenses.
The advantage of the ICPP Accumulation Fund is approximately 30% on this basis. In other words, a pension of $1,000 would increase to a pension of $1,300 because of the difference in investment fees in this comparison.
In summary, we expect at least a 60% advantage over the typical individual using retail investment management services and at least a 30% advantage over a Member of a traditional defined contribution pension plan. This analysis is in respect of investment expenses only.
We do not have enough information to analyze administrative expense. The ICPP advantage in this area would be to share resources through one plan. This can reduce expense or allow the ICPP to provide better support to its Members for the same dollars. While we believe this “shared resources under one plan” to be an advantage, we do not include it in any further analysis in this discussion. Had we included administrative expenses, we expect the ICPP advantage would be higher.
The Investment Mandate Issue
We have included the investment results of the ICPP Total Index for the period since December 31, 2002 in all of the results we have presented to this point. We would, of course, expect to use the ICPP Accumulation Fund for a Member’s entire career and they would benefit from that investment strategy for their entire career.
We estimated the effect of applying the ICPP Total Index strategy to an entire career by adjusting the 50/50 equity strategy returns by the average additional increase in the ICPP Total Index against the 50/50 returns during the period from January 1, 2010 to December 31, 2018. This average additional increase was 2.6% per annum during the period from January 1, 2010 to December 31, 2018. We selected this period because we have been maintaining the ICPP Total Index on a prospective basis for this period.
The ICPP Total Index returns, and therefore the additional returns, for the periods prior to December 31, 2009 are based on back tested data. You should note that the annual additional returns for the period from January 1, 2003 to December 31, 2009 were somewhat higher than the annual additional returns for the period from January 1, 2010 to December 31, 2018. Future additional returns may be higher or lower than those obtained during either period.
We continue to show the effect of investment fees assuming the individual is a Member of a typical defined contribution pension plan. The comparison against an individual acting alone are not shown but would demonstrate more of an advantage.
Our results follow:
The results are as expected. The ICPP Total Index strategy in combination with the investment fee advantage has resulted in replacement ratios that are at least double the replacement ratios for the other strategies at all end points.
Our goal is to double pensions and on this basis we expect to achieve our goal. In other words, we have converted a pension of $1,000 a month to a pension of at least $2,000 a month, all else being equal.
In fairness, we do not recommend that a Member of the ICPP invest using a strategy based on the ICPP Total Index for the Member’s entire career. In fact, we transition any Member’s investments out of the ICPP Accumulation Fund into the ICPP Payout Fund over the ten years prior to the Member’s expected retirement. The ICPP Payout Fund invests approximately 50% of its assets in the ICPP Accumulation Fund and 50% of its assets in a Canadian universe bond fund. As a result, we expect that some of the potential upside of the ICPP Accumulation Fund will be lost to provide a more predictable retirement result.
We prepared a graph to demonstrate this effect as provided below:
The results are more stable with the transition included, but are generally lower (except in a down market where they are higher. At the end of the recent bull market the loss is most pronounced and is approximately 20%.
The transition strategy is recommended to reduce risk (volatility of final result); to provide a more stable retirement result. This is probably better illustrated by using a 35 year career against our data because that will allow us to include end dates from 1998 to 2018. This encompasses two equity market downturns. One in 2001-2002 and then the market meltdown in 2007-2008.
Note that the 2001-2002 market downturn was more worrying from a retirement perspective than the 2007-2008 downturn. In either case, the transition strategy works.
Our results are shown below:
The Annuity Purchase Issue
Typical defined contribution pension plans provide lifetime incomes through the purchase of insured annuities.
We prepared estimates of the Replacement Ratios that would be obtained under each investment strategy should an insured annuity be purchased for the Member at each end date using annuity purchase prices at that time. (We used the annuity proxy rates recommended by the Canadian Institute of Actuaries for pension solvency testing for this purpose). We also presented the ICPP Total Index result using the uninsured variable annuity approach that we have used for all purposes in this discussion up until now.
The results indicate that annuity purchases provided higher initial pensions than the uninsured variable annuity (both using the ICPP Total Index investment strategy) until recently.
Our results are shown below:
In the graph above, the dark purple line represents the ICPP result under the assumption that the ICPP payout strategy used is to purchase a level income insured annuity (i.e. the same as for the other investment strategies). The light purple line represents the ICPP using the variable annuity payout strategy.
The ICPP does not intend to purchase level income insured annuities as its core strategy.
We also need to adjust the ICPP Total Index returns to have them cover a Member’s entire career to provide a realistic comparison between the ICPP and the other strategies.
The adjusted results place us a little below our “double the pension” goal for some end dates, as can be seen in the table below. If you observe the results at end dates from 2003 to about 2005, some of the replacement ratios using other investment strategies are just below a doubling as compared to the ICPP variable annuity with adjustments on an historical basis.
These results are presented below:
We expect a replacement ratio for this 40 year career Member who contributes 10% of salary to be at least 150% of final earnings at all end dates.
There is one final adjustment to make. The ICPP variable annuity is expected to provide regular increases to the pensions in pay during retirement. The insured annuities that we have illustrated do not. We know that the cost of providing inflation protection is approximately 25% for funding purposes. That is, funding at retirement must be 25% higher if we want to provide past-retirement increases. The funding target is 25% higher because we expect to pay pensions that are, on average, 25% higher over a Member’s retirement.
The above table shows our results at retirement but the ICPP Variable Annuity schedules increases each year that the other strategies represented on the above graph do not.
We made a final adjustment to our numbers by increasing the ICPP Variable Annuity payout by 25%. This is our final graph and was presented earlier in this article:
The ICPP results are more than twice the results for all other strategies at all end dates. In fact, the advantage is much more than twice under many scenarios.
We summarize these results in tabular form below for a Member earning $60,000 at retirement:
The final graph speaks for itself. The ICPP advantage is substantial. It is therefore reasonable to establish a goal to provide career pensions that are at least double those available in the current marketplace for the ICPP. While we may not achieve that goal for all of the ICPP career Members under all circumstances, we think it is very possible we will achieve this goal for most of the ICPP career Members.
The pension available under the fixed income scenario for a Member retiring at December 31, 2018 with a pre-retirement income of $60,000 is $28,266. The pension available for the same Member under the balanced investment (60% equity and 40% fixed income) is $41,112. The pension available for the diversified equity (50% Canadian equity and 50% US equity) is $48,090.
The average pension available during retirement under the ICPP is $169,152, obviously much more than twice any of the other strategies. The ICPP pension starts at $135,322 at age 65 but grows during the Member’s retirement based on post-retirement investment results. Even the pension that the Member starts with at age 65 is more than twice their pension under any other scenarios. The pensions under all other scenarios remain the same throughout a Member’s retirement. These pensions are very high for a Member earning $60,000 at retirement. A 40-year career employee retiring December 31, 2018 would not have had to contribute 10% of earnings throughout the Member’s career to obtain a good result. This Member may have decided to retire much earlier, because their pension savings would have justified that action.
The ICPP Variable Annuity solution is substantially better than all other strategies over the end points we tested. This is our core strategy. It is the main reason that we have been promoting the ICPP.
The advantage is expected to be lower for a Member with a shorter career in the ICPP. Expense savings may not be as great as presented for some shorter career individuals, however, the advantage should still remain substantial for all ICPP Members.
We are available to provide additional explanations about any of the ideas or results presented in this discussion.