Innovation in Pensions
There is broad consensus in Canada that innovation should be promoted. It can improve both our lives and our finances. Examples of this abound in information technology, health sciences, manufacturing, resource extraction, transportation, and many other sectors of the Canadian economy. There is, however, one sector that rarely makes the innovation list: the pensions sector. Given the material impact this sector has, and will have on both the lives and the finances of millions of Canadians, this is surely not a good thing. The goal of this paper is to show how the Ontario Retirement Pension Plan (ORPP) initiative has created an opportunity to inject fresh ‘value-for-money’ thinking into Canadian workplace pension design and delivery. At the same time, it is a unique opportunity for the financial sector, working in collaboration with government, to “connect the dots” – increasing public awareness of the vital role of financial services in allocating capital and risk. It is also an opportunity for Canada’s financial services industry to showcase its innovation capabilities, both nationally and internationally.2
Canada’s Workplace Pension Problem
We start with the ground-breaking 1994 study “Averting the Old Age Crisis” published by the World Bank. It suggested the ideal national retirement income system has three pillars: a universal pillar providing a basic pension to all3, a workplace-based pillar providing supplementary retirement income tailored to different sectors of the workforce, and an individualized pillar permitting people to create their own ‘add-on’ piece if they feel that the combined retirement income from the first two pillars is insufficient. How well does Canada’s retirement income system score by this ideal design standard?
The World Bank model flags a serious Canadian pension problem. Over three quarters of Canada’s private sector workforce does not have access to a well-designed, cost-effective workplace pension plan.4 This has two consequences:
- Some proportion of these millions of Canadians under-save, and thus will not achieve their retirement income aspirations.5
- Another proportion save inefficiently through high-cost investment vehicles. Likely, many of these savers will also not achieve their retirement income aspirations.6
Each of these consequences imposes significant costs on future generations. Two (not mutually exclusive) solutions have been proposed:
- Expand the CPP/QPP or some provincial version of it. Specifically, Ontario’s ORPP initiative was announced in 2014 and the ORPP Act was passed in 2015.
- Require employers to enrol their employees into a qualifying plan offered by an approved financial institution.7
The ORPP’s target launch date has been pushed back to January 1 2018. With the government change in Ottawa, discussions to expand the CPP/QPP have been launched, but it is uncertain at this point where they will lead. Meanwhile, Ontario has stated it will carry on developing the ORPP.
ORPP legislation will require Ontario employers to enrol their workers into the ORPP and contribute to it unless they offer a “comparable plan”. Current wording leaves room for debate as to what constitutes a “comparable plan”. Ontario has stated that plain-vanilla defined contribution plans must have at least an 8% contribution rate to be deemed ‘comparable’ to the ORPP with its proposed contribution rate of 3.8%.8 The important point is that the “comparable plan” concept is already embedded in ORPP legislation. This creates the private sector opportunity to compete with the ORPP, given the new requirement for Ontario employers to either enrol their employees in the ORPP, or in a “comparable plan”.
Seizing the Opportunity
Specifically, the ORPP Act offers an opportunity for Canadian financial institutions to offer Ontario employers a “comparable plan” with a contribution rate of at least 3.8%. Thinking nationally, such initiatives by Canadian financial institutions could also pre-empt the need for future CPP/QPP expansion by offering their “comparable plans” nationally.9
If properly executed, offering employers and their employees an alternative to the ORPP will foster healthy competition and innovation, and should therefore be seen to be in the public interest.10 Consequently, the federal and provincial governments should welcome such an initiative. With the launch date of the ORPP moved back to January 1, 2018, an ample window has opened to design ORPP-comparable workplace pension plans that reflect current best thinking about pension design. We show below that the ‘innovation’ we have in mind is by no means radical. Instead, it involves reassembling the basic pieces of retirement finance in ways which better suit 21st Century realities.
A Functional, Understandable 21st Century Workplace Pension Plan
What does a functional, understandable 21st Century workplace pension plan look like? This raises another question. How much pre-retirement income should CPP/QPP/OAS and workplace pensions combine to replace if the goal is to maintain living standards in retirement? Research suggests that for many middle-income workers, 50% of pre-retirement income (rather than the commonly-used 70% target) will do the job.11 So if CPP/QPP/OAS provides 30% income replacement, the workplace plan should ideally provide the remaining 20-40%. With projections of a worker’s wage trajectory, career length, life expectancy, and the investment return on retirement savings, the contribution rate required to generate such a supplemental retirement income stream can be calculated.12
Ideally, return compounding over long investment periods rather than contributions will be the major source (60%-70%) of pension funding. This means workplace pension plans must have efficient long term return compounding engines to be successful (i.e., to be able to generate the target pension at an affordable contribution rate). The risk of compounding failure is minimized by a creating a stand-alone, open-ended, expertly-managed long term return-compounding investment program in which plan members own units.
Two further risks must be considered in designing a functional, understandable 21st Century workplace plan: draw-down risk, and longevity risk. Fortunately, both types of risks can be mitigated to a significant degree. Draw-down risk is the possibility of being forced to sell risk assets at an inopportune time. It can be mitigated by having members slowly sell their units in the long term return-compounding program and acquire units in a laddered fixed income program over an extended (e.g., between ages 50-70) period of time. Longevity risk is best mitigated through member access to a longevity insurance pool (i.e., insurance against living beyond one’s life expectancy). This workplace plan design has members automatically shifting exposure from the long term return-compounding program into a risk-mitigating strategy that provides lifetime payment assurance. It also allows members to override the default settings, to better reflect their own situations and preferences if they wish.13 This choice element is supported by strong communication and member support functions.
So far, very few countries have been able to offer their citizens access to the kind of workplace plan sketched out above. Why is that? Four barriers stand in the way.
Barrier #1: Lack of Innovation
We have already noted that there has been little innovation in the global retirement income provision space since the ground-breaking World Bank study in 1994. While economic forces have been leading to a steady displacement of workplace defined benefit arrangements with defined contribution arrangements, the non-productive defined benefit vs. defined contribution debate continues. Fortunately, glimmers of hope are appearing that we may be moving beyond this debate. For example, the Australians have begun to discuss bolting “income-for-life” back-ends on to their defined contribution plans. At the other end of the spectrum, the Dutch are having serious discussions on how to unscramble their collective hybrid defined benefit/defined contribution plans into arrangements that are simpler to understand and to manage, and that provide members with some choice.14
This is a good time for Canada to embrace functional innovation to modernize its retirement income system.
Barrier #2: Lack of Coverage/Inefficient Substitutes
We have already noted a second barrier – lack of workplace plan access. The Northern Europeans and the Australians were the first to break down this barrier by making workplace plan participation mandatory. Within the next few years, by law, all workers in the United Kingdom will be members of a workplace plan. And now there are stirrings in North America. Ontario is leading the way with its ORPP initiative. There are also a growing number of US states examining how to best address the lack-of-coverage problem.
The lack of workplace plan coverage has produced a nasty side-effect: forced use of Pillar 3 “add-on” products by workers lacking the information and education to make good retirement planning and investment decisions on their own. As a result, many have been, and continue to be advised to invest in high-fee implementation options by those who benefit financially from such decisions. This results in material reductions in retirement income relative to what could have been achieved by cost-effective workplace plan options.15
Barrier #3: Ineffective Implementation Infrastructure
Peter Drucker is considered by many to be the father of modern management theory and practice. He wrote his only book on pension design and management in 1976 (“The Unseen Revolution”). A key message was that organizations involved in the delivery of retirement income are not exempt from the ‘effectiveness’ dictums of mission clarity, good governance, and the execution of strategies to achieve the stated mission. Even today, many organizations in the global retirement income delivery space do not measure up well against Drucker’s effectiveness standards. Happily, Canada’s major pension organizations are leading the way towards wider adoption of the Drucker effectiveness model.
Nobel Prize winner George Akerlof identified another barrier to delivering ‘value-for-money’ retirement income services: asymmetric information between the sellers and buyers of these services. Research confirms what he predicted in markets with asymmetric information: buyers generally pay too much (e.g., too high fees) for too little value (e.g., below-market investment returns). How to level the informational playing field? Create expert buy-side retirement income services organizations with ‘fiduciary’ mandates (i.e., with a legal requirement to act in the best interest of the client/plan member). We need to create more such organizations. At the same time, we need to create incentives and legislative/regulatory structures that shift commercial financial services organizations away from exploiting their informational advantages, and towards pursuing measurable ‘value-for-money’ outcomes for their clients.
Barrier #4: Outmoded Legislative and Regulatory Structures
Requiring fiduciary behavior by institutions delivering retirement income provision services is a still-elusive goal in many countries, including Canada. Activist approaches will be required to materially move the yardsticks on this front. A related problem is that retirement income-related legislation and regulation tends to lag rather than lead current best-practices. For example, there seem to be barriers in Canada to offering cost-effective longevity risk pooling mechanisms. As another example, Canada continues to struggle to align federal and provincial laws and regulations in retirement saving and investing. Strong leadership will be required to make progress on this front as well.
Saskatchewan’s SPP Initiative
The Province which led Canada in the conception and implementation of Medicare has also led it in the conception and implementation of the kind of workplace pension plan we propose in this paper. The Saskatchewan Pension Plan (SPP) was launched in 1986 as a voluntary workplace pension plan by the Government of the day. Its focus was to offer small and medium-sized employers and their employees in the Province a well-managed, low-cost workplace pension plan option.
Today, the SPP has 33K members with their assets split between a unitized $300M Contribution Fund (CF) (i.e., what we called the return-compounding engine above), and a $100M collective Annuity Fund (AF) (i.e., what we called the risk-mitigating income-for-life program above). The Management Expense Ratios (MERs) of the two funds are CF: 0.95% and AF: 0.40%. We note that, given the available scale economies in pension investing and administration, these expense ratios would be considerably lower if plan membership and assets were 10 times larger. This likely could have been achieved if SPP participation had been made mandatory in 1986, rather than voluntary.
Offering an ORPP-Comparable Plan with 21st Century Design Features
Ontario’s commitment to the ORPP initiative provides a unique opportunity to break through the historical barriers to full workplace pension plan coverage in Canada. Having sketched out the key features of an ORPP-comparable plan with 21st Century design features, and noting that such a plan design in the form of the SPP has already existed in Canada for 30 years, we now show the value of such plans competing with the ORPP. Specifically, given equal expected cost to them, how would employers choose between the ORPP and a commercially-offered “comparable plan”? To maintain the acronym, let’s call such a plan the Private Retirement Pension Plan (PRPP). Presumably, employers would choose based on comparing the respective design features of the ORPP16 and of a PRPP17 offering. Here is a possible listing of these features:
The target pension benefit: a PRPP would be comparable to the ORPP’s target benefit at the ORPP’s 3.8% contribution rate. However, with the PRPP, the employer would have the option of choosing a higher target benefit with a higher contribution rate. In other words, a single integrated solution for the employer, rather than a more complex one with multiple parts.
Degree of employer involvement: we noted above that with the PRPP option the employer could create a “one stop” workplace plan solution for its workers.18 A related issue here is assured delivery capability. We visualize the PRPP being offered by sophisticated large-scale institutions with proven delivery capabilities in investment, benefit administration, and client/member communications.19 The ORPP has yet to build these capabilities or scale.
Risk mitigation: the PRPP design outlined above recognizes that the major risk facing workers is lack-of-return compounding risk, and the major risk facing retirees is payment-for-life uncertainty. This leads logically to its two-instrument approach.20 Our understanding of the ORPP design is that it will not distinguish between the differing risk preferences of workers and retirees.
Wealth transfers: the PRPP design ensures no systematic wealth transfers take place between future workers, younger workers, older workers, and retirees. To date, it is unclear how the ORPP design will ensure that this does not happen.
Open architecture: the PRPP will be able to accept already-accumulated retirement savings and move them into the same return compounding-to-safety life-cycle process as will be used for new pension contributions. Our understanding is that the ORPP will not be able to accept already-accumulated retirement savings.
Transparency: the PRPP will regularly report (i) member account balances in the long term return-compounding fund and (ii) income-for-life payment projections in the payment safety pool. It will also regularly report its operating expenses in a ‘value-for-money’ benchmarking framework. The ORPP will presumably regularly report its funded status and whether there is a need to adjust the plan contribution rate and/or plan benefits. Presumably, it will also regularly report its operating expenses in a ‘value-for-money’ benchmarking framework.
Surely employers and their employees would benefit from being able to choose between the ORPP and a PRPP with the features sketched out above. Creating this choice would foster the kind of practical innovation in pension design and management that Canada needs.
Three Challenges Remain
We see three challenges that will need to be addressed in moving forward with this proposal for competition in workplace pensions:
- The ‘comparability’ issue: There continues to be a perception that the collective ‘one-size-fits-all’ approach embedded in the proposed ORPP design will shelter participants from future investment return uncertainty, and hence, from contribution rate and pension benefit uncertainty. New research from the Netherlands, as well as practical Dutch experience with the kind of plan design the ORPP planners seem to have in mind, indicates that this is not the case.21 On the other hand, where the current “plain vanilla” defined contribution model does fall down is in its failure to provide “income-for-life” longevity insurance. The PRPP model we propose addresses this shortcoming.
- The ‘high-cost’ issue: Because the PRPP is a commercial offering, it will be assumed to be high-cost. The PRPP Acts have been written to guard against this possibility. In addition, the PRPP should have a public interest-minded, technically-competent, independent oversight board, as well as disclose on a regular basis ‘value-for-money’ evaluations of PRPP’s investment and member services functions by an independent benchmarking organization.22
- The ‘anti-selection’ risk issue: Because the ORPP is a government-sponsored offering, it will be assumed by many to carry a guarantee. This, of course, is incorrect and opposite to the policy objective. It will be incumbent upon the ORPP Board and government to ensure that employers and employees are not misinformed in choosing options.
Stepping back from the immediate public policy challenge, one can see a broader opportunity. There is a pressing need to re-assert and promote public awareness of the ability of the financial sector to promote social well-being. We show in this paper that there are in fact extraordinary opportunities for the sector to develop (and better explain) products, services and markets that address a pressing social (and economic) need.
Leadership by policy-makers and financial institutions can help demonstrate that financial regulation and services are about more than protecting consumers from deceptive products and practices. Rather, it should be to ensure that society is well served and that consumers get “value for money” – a fair deal. This should encourage increased financial innovation (as a substitute for government intervention in markets) and a better articulation of public stewardship responsibilities throughout the financial services supply chain.
About the Authors
Keith Ambachtsheer is Director Emeritus of the International Centre for Pension Management at the Rotman School of Management, University of Toronto. He is also President of KPA Advisory Services, and a co-owner of CEM Benchmarking Inc. His new book “The Future of Pension Management: Integrating Design, Governance, and Investing” (Wiley) has just been released.
Edward Waitzer holds the Jarislowsky Dimma Mooney Chair in Corporate Governance, and is Director of the Hennick Centre for Business Law at Osgoode Hall Law School and the Schulich School of Business, York University. He a former Chair of the law firm Stikeman Elliott LLP and remains a senior partner there. He is also a former Chair of the Ontario Securities Commission.
- We wish to thank Dominic Barton, Andrea Boctor, David Denison, David Dodge, Don Ezra, Malcolm Hamilton, David Marshall, Jean-Claude Menard, Gordon Thiessen, Fred Vettese, and Susan Wolburgh-Jenah for commenting on earlier drafts of this paper. However, the authors take sole responsibility for the ideas and recommendations expressed here.
- It is noteworthy that the federal government has just created an Advisory Council on Economic Growth to be led by McKinsey & Co’s Managing Director Dominic Barton. Arguably, the opportunity we set out in this paper fits well with that initiative.
- For simplicity’s sake, we treat the OAS, GIS, and CPP/QPP as all part of Canada’s Pillar 1 in this paper, although the CPP/QPP have some workplace plan-related features.
- Source: Statistics Canada.
- A number of studies have pointed out that the majority of Canadians retiring today are in fact able to maintain their standard of living. Arguably, the current generation of retiring Canadians has benefitted from a fortunate combination of long-term historical factors, including long careers with single employers, significant Pillar 2 plan membership, high interest rates, and strong real estate and equity markets. Future generations of retirees are not likely to be so lucky.
- A large proportion of these savings (e.g., in the forms of RRSPs, TSFAs, and RRIFs) are invested in retail mutual funds with MERs of 2%/yr. or higher. A rule of thumb is that an additional 1%/yr. in fees reduces the ultimate pension by 20%.
- See, for example, Ambachtsheer and Waitzer (2011), “Saving PRPPs: It’s up to the Provinces”, CD Howe Institute. While the context was Pooled Retirement Pension Plans in the 2011, we show here the concept is equally relevant in the ORPP context. Ontario’s 2015 PRPP Act has created the necessary legal connection for our proposal to proceed.
- Actually, as the intent is to exempt the first $3,500 of income from ORPP contributions, the effective contribution rate is more like 3.5% of pay. A number of knowledgeable observers have noted that the 8% contribution rate requirement to make a DC plan ‘comparable’ seems high.
- For this to occur, other provinces to would have to join Ontario in requiring employers to enrol their employees in a qualifying workplace pension plan. Quebec has already gone some way in that direction with its VRSP Act. We also note that new, innovative workplace pension designs would be welcomed beyond Canada’s borders, arming Canadian financial institutions with an international comparative advantage.
- The former CEO of UK’s NEST initiative expressed this view to one of the authors despite the fact it meant NEST would lose its monopoly position in the UK pensions market. NEST is an initiative to increase workplace pension plan participation in the UK by requiring all employers to offer a qualifying workplace pension plan. Legislation permits private sector competition with NEST.
- For example, see Vettese (2016) “The Essential Retirement Guide: A Contrarian Perspective”, Wiley.
- Approximately an 8% of salary contribution rate over a 40-year period would be required to achieve the 30% income replacement target using ‘reasonable’ projections. These pension finance realities raise important questions. For example, should plan members not have some say in what income replacement target they would like to achieve? As another example, is history likely to be a good guide in making the necessary ‘reasonable’ projections about investment returns and longevity?
- See Ambachtsheer (2016), “The Future of Pension Management: Integrating Design, Governance, and investing”, Wiley. See also Ezra (2016), “Most People Need Longevity Insurance Rather than an Immediate Annuity”, Financial Analysts Journal, March/April, and Sexauer, Peskin, and Cassidy (2015), “Making Retirement Income Last a Lifetime”, Financial Analysts Journal, January/February.
- It is ironic that the ORPP designers appear to favour the pension design the Dutch now want to abandon.
- A recent paper published by the University of Calgary’s School of Public Policy defends this practice. In “A Major Setback for Retirement Savings: Changing How Financial Advisors are Compensated Could Hurt Less-Than-Wealthy Investors Most”, Pierre Lortie argues that less-than-wealthy workers benefit from the mutual fund trailer fees they pay because the resulting financial advice leads them to save more for retirement. This paper offers a far more cost-effective strategy to that end.
- The ORPP’s design features have not been fully disclosed at this point. We encourage their full disclosure as soon as possible.
- The federal PRPP Act was passed in 2012, and its Ontario clone version in 2015. The Acts require that a PRPP sponsor submits a 5-year business plan to OSFI (or FSCO in Ontario) for approval. The business plan must demonstrate good plan design, strong operational capabilities, and low operating costs. Ontario’s August 11, 2015 Statement on ORPP design included the language “The government, in consultation with pension experts, intends to develop an appropriate comparability threshold for PRPPs…”.
- The ORPP target income replacement rate is set at 15%. If a higher income replacement rate is desired (e.g., the 30% in the example above), the employer and its employees would have to look somewhere else for a solution, unless a PRPP with the design features we set out is on offer.
- However, a commentator on an earlier draft of this paper pointed out that there is considerable room for improvement in private sector delivery quality.
- Jan Tinbergen was awarded the first Nobel Prize in Economics for establishing this ‘two goals – two instruments’ principle.
- Recent Dutch research on the limitations of intergenerational risk-sharing will be helpful to this end. See, for example, Bonenkamp, Broer, Westerhout (2014), “The Value of Collective Pension Contracts”, Netspar.
- Supra note 7, for discussion of key elements of a governance framework. A related issue here is employer liability: we would expect that enrolling employees in either the ORPP or the proposed PRPP would relieve employers of any fiduciary obligations regarding their management and operations. Finally, in the interest of full disclosure, one of the authors has a financial interest in such a benchmarking organization.