Closing the pension gap

Statistics Canada has published a number of surveys/reports indicating that somewhere between one-third and 40% of Canadian workers are covered by workplace pensions, which means that somewhere between 60% and two-thirds are not. Moreover, while workplace pension coverage is very high in the public sector – more than 80% in 2008, it is that much lower in the private sector (approximately 25%). Regardless of the specifics, it seems clear that far too few employees in Canada participate in a workplace retirement savings plan, and there are no signs of improvement.

Is the problem worse for small and medium-sized businesses? There doesn’t appear to be a lot of hard data in this area, but there is compelling evidence to suggest it is a more significant problem for SME’s. While businesses employing less than 100 workers make up nearly half (48%) of the country’s private sector labour force, small private sector pension plans (those with less than 100 members) represent only 7% of the sector’s pension membership. So it seems pretty safe to suggest that the problem is worse for SMEs.

Here is how I framed the problem, and the solutions I suggested.

1. The Consumption-Savings Puzzle

Whether we are talking about employees of large or small firms, an individual’s decision to participate in a work place retirement savings program is about the age-old decision by an individual to consume more now, or, save/invest more now and consume more later. This decision applies to more than just the decision to save for retirement. A theory of rational consumer behaviour would involve each individual analyzing the trade-off between the two and making an appropriate decision. In real life, people need help to make good decisions and a good decision in this context involves balancing a large number of variables.

2. More Financial Advice and Knowledge

To make good spending/savings/investment decisions, the individual needs knowledge, both about the potential consequences of making various decisions, and, just as important, about how to implement the decision(s) that are made around consumption/saving/investment. A good decision about how much to save for retirement becomes less so if the same person runs up unmanageable debt in order to finance current consumption, or consumes much less than they need to.

I reminded the audience that several suggestions have been made for improving the retirement system by limiting the number of investment choices and making enrolment mandatory with the option of opting out of an employer’s plan. These are good suggestions, but implementing them across the third pillar of Canada’s retirement system would not reduce or eliminate the need for financial advice. I also pointed out that in all of Fidelity’s research, people who get financial advice are better off and are more confident about their financial situation than those who don’t.

To this end, I acknowledged the broader dissemination of financial advice in Canada – one of the goals of the federal government’s task force on financial literacy – is to be encouraged. But to effectively enhance retirement planning at small and medium-sized enterprises, it will need to be focused on the individual’s specific situation, come from or be associated with the plan sponsor, and involve some prodding of the plan members to actually get financial advice. It may be necessary to make advice an essential part of enrolling in a work place retirement savings plan and should be mandatory before an employee can exercise the right of opting out of the plan.

Better savings vehicles and more of them

However good a consumption/saving/investment decision may be, the individual needs the appropriate vehicles to implement the decision. The ready availability of effective retirement savings vehicles is crucial. And, whatever side of the argument you may be on regarding the ideal solution, the gap needs to be filled. There are three important requirements these vehicles must meet:

• Returns Balanced with Risks: Whatever the ultimate retirement savings solutions that are introduced or modified, those solutions are going to have to deal sufficiently with financial market risk. Risk exists, it always has and it always will. However, risk can be dealt with – by assessing it, pricing it and making carefully considered decisions about how much risk to take. Surely we have learned this from the global financial crisis of 2007-08. Education about risk and reward will be essential. An effective approach to this is to do market projection scenarios with at least two sets of probabilities, approximating both average (or “normal”) and extended-bear market conditions. Fidelity’s retirement income planning research makes extensive use of both Monte Carlo simulations and a wide range of historical market analyses.
• Reasonable Costs: Clearly, costs need to be reasonable and in line with services provided. And clearly, competitive costs of managing and administering retirement savings are helpful in ensuring the best possible net investment returns. But there will be costs – for investment management, for record-keeping, for providing financial advice and tailoring retirement savings plans to individual needs.
• Administrative Simplicity: Expanded coverage will need to be sufficiently administratively simple and cost-effective that SME owners will be prepared to embrace them.

I concluded my presentation by first identifying my favourite of three broad policy options I mentioned at the outset, i.e., #1 initiating a second-level public pension plan, #2 making substantial changes to defined benefit plans to make them more applicable to SME’s and #3 taking a number of smaller steps upon the well established base that already exists. I chose the third option.

Acknowledging that many of my suggestions were in support of recent recommendations put forward in papers prepared for Advocis and by the C.D. Howe Institute, I also included suggestions based on the U.S. Pension Protection Act and proposed that getting financial advice be made a mandatory part of work place retirement plan participation. I divided these recommendations into four broad groups:

• Group #1 is about increasing enrolment and participation in work place retirement savings plans. It would include suggestions such as auto-enrolment with opt out; limited investment choices; target date funds as default investment options; auto escalation of contributions, somewhat longer vesting period than current; and increased contribution room.
• Group #2 is about making work place savings plans more available, including enabling the provision of work place savings plans by a provider other than an employer; enabling self-employed workers to enroll in such plans; lightening up on some of the costs associated with group RRSP’s by allowing the deduction of some administrative expenses and removing federal payroll taxes from employer contributions.
• Group #3 is about improving retirement income, including the implementation of a lifetime contribution limit, raising the age limit for contributions, allowing defined contribution plans to self-annuitize, eliminating minimum annual withdrawals from RRIF’s and LIF’s; allowing all retirement income recipients to claim the pension credit; and allowing income-splitting by all retirement income recipients.
• Group #4 is just one item, but an important one: harmonize all federal-provincial rules around work place retirement savings vehicles and retirement income.

My final word to the audience: there will not ever likely be a perfect solution to the challenge of ensuring Canadians have adequate retirement savings and incomes. There are however, some pretty good solutions. We should set our sights on achieving some of those pretty good solutions.