Most people know Aesop’s fable The Grasshopper and the Ant, meant as a lesson on the virtues of planning ahead. While the carefree grasshopper spends the summer singing away, the industrious ant stores food for the winter. When the cold weather arrives, the grasshopper, dying of hunger, must ask the ant for food.
The tale is an apt analogy for retirement saving. But who is to say that the ant has saved enough? And if the grasshopper is Canadian, could he not avail himself of social programs to get him through the winter?
Amassing adequate retirement savings is a challenge for individuals trying to plan for retirement. Many employers provide a DC pension plan, which is supposed to help. However, since most people struggle with concepts such as life expectancy and the present value of money, DC plans have historically done a much better job of encouraging the accumulation of assets than they have of generating sufficient lifetime income. Such is the fundamental disconnect with DC, and plan sponsors are taking notice. More importantly, employees should pay attention, as retirement planning can never be fully done by the plan sponsor—it’s up to the individual.
But the math and knowledge required to build an effective retirement plan can be complicated, and the complexity increases when individuals need to combine prior and current pensions, including DB and DC entitlements. In fact, many employers today face the challenge of having employees with current or past DB schemes and others with pure DC entitlements working side by side. And the sad fact is, even those with DB pensions often don’t understand how they differ from DC plans.
While retirement planning is truly up to the individual, the employer can help by offering an ideal retirement planning model. The model should do the following:
- be engaging and informative;
- present complex results simply,without being misleading;
- encourage members to return, review and revise often; and
- mitigate employer risk.
This last point is crucial. Many industry experts are concerned about future court cases involving DC plans. The reason is easy to understand: the move from DB to DC plans was largely driven by companies looking to divest themselves of risk. But DC plans are no less risky than DB; if anything, they’re even more risky.
While the risks of a DB plan rest with the sponsor, the risks of a DC plan overwhelmingly lie with the plan member. If plan sponsors—with support from actuaries, lawyers and investment experts—feel that pension risks are unmanageable, how much more so are they when laid at the feet of members with limited financial knowledge?
It’s crucial, therefore, for plan sponsors to make sure they’re providing the best tools possible to their employees. Anything less increases the possibility that employees will blame employers for failing to meet their expectations, leading to the risk of possible litigation down the road.
An employer’s retirement planning tools should drive plan members to take action—typically, by increasing the level of future saving—based on three questions:
- What level of income do I want in retirement?
- What sources of income do I already have?
- What might happen in the future?
1. Required retirement income
One way of thinking about the retirement income goal is the neutral retirement income target (NRIT). NRIT is based on finding an equilibrium between a member’s standard of living before and after retirement. Imagine a member’s disposable income on a scale: on one side is the working years; on the other, the retirement years. The principle of the NRIT is that the disposable income should be roughly equal in the working and retirement years.
It would be irresponsible of a member to spend wildly in his or her working years and be destitute in retirement, but it would be equally illogical to starve during his or her working years in order to fund a lavish retirement. Thus, a balance is required. In fact, in Morneau Shepell’s 2009 60 Second Survey of more than 200 plan sponsors,only 1% said their employees should strive for a higher standard of living after retirement than during employment.
However, disposable income is not the same as income, and spending and consumption patterns often change at or around retirement. A number of key expenses tend to drop off or decline: taxes; mortgage payments (assuming the member pays off his or her house around retirement); employment expenses, including Canada Pension Plan (CPP) and EI contributions; retirement savings; and childcare expenses.On the other hand, many employees wind up supporting their kids after they retire or paying off their mortgage. Or there may be a whole slew of unforeseen expenses, such as caregiver costs for an elderly family member.
Pension experts have done extensive analysis based on some reasonable assumptions. For a typical couple with two independent children and a home that has been paid off by the time they retire, the NRIT ranges from 40% to 48%, depending on their income levels (ranging from $60,000 to $200,000). However, for a couple with fewer or no children, a mortgage-free home and plans to travel extensively during retirement, a higher goal would be a better target. Whatever the case, the retirement planning tool should provide guidance and assistance to determine the right goal for each individual.
2. Sources of income
When it comes to retirement education, most employees have a short attention span, especially younger ones. Combine that with generally low levels of financial literacy, and it’s obvious that most employees will not access multiple tools and projections—and they certainly can’t be expected to combine various types of pensions to see what the future holds. Thus, an effective retirement planning tool should combine all sources of income into a single projection. It could include DB pensions from the current or former employer (which may or may not be frozen), DC plans, RRSPs, tax-free savings accounts and non-registered assets, as well as CPP and Old Age Security. And don’t ignore the various tax treatments of these vehicles. Any tool that isn’t able to reflect all of these elements is providing only half the picture.
3. Unforeseen circumstances
Of all of the challenges facing DC plan members, the unknown is the most crucial—and the most ignored. DC plan members are subject to unpredictable market fluctuations, and the impact can be enormous, as has become painfully obvious to many in the last few years. For a 35-year-old, a 2% difference in the annual rate of return can have a 40% impact on his or her future level of retirement income.
Most retirement planning tools simply ask the member—a non-expert who typically has limited financial knowledge or resources—to provide a rate of return, allowing the tool to do the simple arithmetic of projecting the member’s fantasy income. This is not an acceptable solution, given the complexity and gravity of the question. We prefer a more holistic approach using what is actually known.
First, returns are linked to investment selection. Any projections of retirement income should reflect the types of investments actually being used by the member—a portfolio invested in money markets cannot be projected at identical rates to a balanced portfolio with an equity allocation. Ideally, the tool should not only reflect current asset allocations but also allow the member to model changes to those allocations to see what might happen if he or she invests more or less aggressively.
Second, the future is uncertain. Experts can determine expected distributions of returns based on statistical analysis, but predicting a single point is impossible. Retirement projections must show a range of possible results, reflecting both upside potential and downside risk—it’s just not good enough to show a single result.
Furthermore, once the link with investment selection has been established, a range of results allows for education about the impact of investment decisions, such as wanting to invest more aggressively. It will improve the upper end of the range of results, but are employees prepared to accept the risk on the downside?
Ultimately, plan sponsors should be encouraging active and frequent retirement planning by their employees. Good disclosure of unbiased and relevant results—and tools that do not mislead—will be the best defence in the event of any future complaints.
Plan sponsors, therefore, need to concern themselves with the details of the tools and projections being provided to their members; conveying risks and uncertainty; educating members on available options; and moving employees to take action.
As time management author Alan Lakein said,“Planning is bringing the future into the present, so you can do something about it now.” And that’s a model that will serve DC plan members well—now and in the future.
Idan Shlesinger is managing partner, DC pensions and savings plans, with Morneau Shepell. firstname.lastname@example.org
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