The subject of retirement is an emotional one. It involves decisions about how people will spend up to one-third of their life, how much money they will need to fund that period, and the best way of saving to enable them to do so in reasonable comfort. It’s also a relatively new experience for humanity. One of the most striking questions that experts on the subject pose in presentations is “what the average US life expectancy was when the US introduced social security for everyone over the age of 65 in 1936?”
What’s the answer? It was only 63! Therefore the guarantee of a pension for the rest of your life from the government was not an especially generous one. It’s only in the last couple of decades that substantial numbers of the inhabitants of the wealthy countries in North America, Western Europe, Japan, Australia, and New Zealand have retired and enjoyed a relatively active, healthy life. This is partially due to improvements in nutrition and lifestyle, and to the changes in the nature of work, with physically demanding and dangerous labour being replaced by office work, a work environment that was once confined to a small, wealthy minority.
The expectation on which most retirement schemes are based, whether provided by the state or by private companies was that retirees would only live for a decade or so after retirement, and would not expect to be in a condition to travel widely, partake in recreational physical activities or have large discretionary expenditures. The state system was always intended to be a backstop, providing a “barebones” level of income to ensure that there was a safety net available for those citizens who, either through misfortune or improvidence, had not made adequate provision for their future. The unstated assumption behind the social security system was that retirees’ families would continue to look after their parents, as had been the case for most of human history, and that there would continue to be many more people of working age than retirees, thus ensuring a healthy dependency ratio (the number of retirees receiving pensions divided by those in work and paying taxes).
Neither of these assumptions has proved to be correct. With the trend towards smaller families, as demonstrated by the fall in the birth rate over the last forty years in many wealthy countries to below the replacement level of 2.1 children per family, the fall in the percentage of the population getting married, and the increase in divorce and separations, both the willingness and ability of families to provide for their parents and grandparents and the dependency ratio have fallen sharply. Therefore, the ability of the state system to provide even the relatively meager pension it had promised is now at risk. Further, retirees face the prospect of outliving their own savings as their life expectancy has increased substantially over the same period while their families’ willingness and ability to support them has diminished.
Demographers’ assumptions for population growth in Canada and the US over the 25 years to 2026 are that both countries will see their populations grow by between 0.6% p.a. and 1% p.a. However, that portion of the population aged over 65 will grow 3 to 4 times as fast, by 3.5% p.a. in the US and over 4% p.a. in Canada. The same holds true for that portion of the population aged over 85, which consumes the majority of healthcare expenditures even though in absolute terms it represents less than 15% of the size of the over 65s, due to the much greater need for drugs and medical procedures, as well as more intensive care. As a result, governments across the western world are moving to address these issues by raising the retirement age and reducing the real cost of providing pensions by making them track the lowest version of inflation measures rather than earnings or a retail price index. Likewise, many employers have responded to the pension crisis by closing their defined benefit pension schemes to new members and replacing them with much less generous defined contribution plans.
Many of the myths of retirement are associated with the previous era, when employers and the state were willing to make promises that were relatively cheap to provide, due to shorter life-spans and a high ratio of workers to pensioners. Firstly, there were a number of “rules of thumb” that became established wisdom based on the experience of the period from 1950-2000. In no particular order these myths include:
1)Retirees needed their pensions to generate between 65-75% of their employment income to maintain their lifestyles;
2)As retirees got closer to retirement, the percentage of their pension fund that should be invested in less volatile income-producing investments such as government bonds should increase and the percentage in more volatile, “riskier” equities should decrease. The basic rule of thumb was to subtract one’s age from 100; the amount left was the amount that should be in stocks and shares, hence it reduced automatically as you became older;
3)When you retire, you should buy an annuity from a life insurance company, which would give you a guaranteed income for the rest of your life, however long that might be;
4)Finally, you shouldn’t change jobs too often, as most private-sector pension plans were what were known as defined benefit plans, which paid you close to three-quarters of the average of your last five years salary. Those employees who left the plan early effectively subsidized those members who stayed in.
None of these myths are entirely correct, and while a few may still have some validity, the rest are no longer valid. Firstly, expecting your pension plan to generate 65-75% of your employment income was always a figure that seemed to have been plucked from thin air. Individual circumstances vary so widely that having even a “ballpark” figure for an expected level of retirement income was always more driven by the desire to encourage higher savings than any empirical evidence. With lower expenses for travel and clothing, with the mortgage paid off and children educated, and with no pension and employment insurance contributions and a much lower tax rate, retirees’ expenditures are much lower than when they were in full or even part-time employment. Then there is the likelihood of a possible move to cheaper accommodation, either by downsizing within the same community or moving to somewhere cheaper (and if Canadian, probably warmer as well).
With the fall in long-term interest rates over the last thirty years, combined with increased life expectancy, the automatic reduction of equities in favour of fixed income has become much less advisable. With average life expectancy now over 80 for men and over 85 for women in North America, retirees have at least 20 years on average of retirement to fund. Conventional fixed income with 10-year bond yields below 3% before tax and inflation will not be able to maintain whatever income level the retiree needs. This also applies to the purchase of annuities to fund retirement. Long term interest rates, which dictate annuity payments, have fallen to a level that will not be adequate for many, if not most retirees.
Lastly, the closure of many private and some public sector defined benefit pension plans means there is no longer a significant benefit to remaining with one employer for the majority of one’s career. The success of a defined contribution plan is entirely dependent upon the performance of the underlying investments, although an employer may make matching contributions, thus boosting the initial amount invested.
Fortunately, governments have responded to the looming pension crisis by providing tax-exempt or tax-deferred savings schemes such as Registered Retirement Savings Plans (RRSPs) in Canada or Individual Retirement Accounts (IRAs) in the US to encourage their citizens to save in order to complement the state system and private sector pension plans. While these have many advantages for the prospective retiree, they are not particularly flexible and have several levels of fees associated with them, which can make a substantial difference to the final amount saved. In Canada, Individual Pension Plans (IPPs) and Personal Pension Plans (PPPs) offer a better alternative for incorporated individuals. The PPP, in particular, offers more flexibility and incorporates the required features of actuarial and administrative services in compliance with applicable legislation, making it an attractive retirement solution for clients who have the necessary level of income and are already incorporated or able to become incorporated.
Governments around the world have recognized the importance of providing appropriate pensions for their citizens, and have been aware of the changing needs, which have made the retirement myths no longer relevant. In the last thirty years, tax-advantaged individual retirement savings plans such as Registered Retirement Pensions Plans (RSPPs) in Canada, 401 (k) plans in the US, and Self Invested Pension Plans (SIPPs) in the UK have allowed individuals to save for their retirement without being dependent upon workplace pension plans. It has made the workforce more mobile, as their pensions are no longer tied to the length of their employment with one employer, a necessary reflection of the end of lifetime employment. However, all of these individual plans are defined contribution schemes; in other words, the size of the individual retirement income is dependent upon the performance of the investments in the plan, rather than being a percentage of final salary.
Ironically, the only substantial group of workers who still enjoy the advantages of the traditionally defined benefit pension schemes is government employees, as many private-sector employers have now closed their own defined benefit schemes to new hires and are even attempting to reduce benefits to employees within their defined benefit plans. Only the public sector employers are able to still offer generous defined benefit plans, and even here, some cash strapped municipalities in the US are now reducing benefits. The recent decision by the courts at the end of 2013 that bankrupt Detroit could reduce pensions to retirees is a precursor of further reductions as government finances come under pressure from deteriorating demographics.
Therefore, for the individual looking for the private sector equivalent of the traditional defined benefit pension, there are not many alternatives. One possibility in Canada is the Personal Pension Plan (PPP) for incorporated entities, which apart from its many attractive features such as creditor protection and deduction of fees from gross income, offers the individual the choice of making pension contributions either on a defined contribution or defined benefit basis. This allows contributions to be adjusted to reflect a business’ cash-flow needs, and contributions on a defined benefit basis are actuarially calculated, meaning they increase annually as retirement approaches. While the performance of the investments in the fund will still dictate the size of the final pension, these investments can mirror those of large public sector funds and, unlike RRSPs, including private equity, venture capital, franchisees, and other non-correlated assets. Furthermore, in the event that returns are below the 7.5% p.a. hurdle that the Canada Revenue Agency has established as the benchmark for such plans, a lump sum payment can be made to bring the plan back into line and is a further tax deduction to the corporation. Thus a PPP offers incorporated individuals the closest approach to belonging to one of the major public sector defined benefit plans without actually being a teacher or municipal employee.
In light of the new tax rules that penalize passive investments within CCPCs, advisors must understand how pension legislation can become a powerful tool to deal with wealth succession, business succession, and tax optimization within a corporate environment.Learn more about the ppp101 course