While decumulation is a critical aspect of retirement, in my opinion, it doesn’t attract enough attention.
Decumulation is the process of drawing down a capital accumulation plan’s pension assets to generate income, which many employees who are part of a CAP may not fully understand. CAP and defined benefit accounts have similar objectives: accumulation of sufficient assets for a pension. A CAP is often an employee’s only retirement plan. Effectively, it’s a personal DB plan. Unlike a DB plan, however, CAP members are responsible for managing the account and bear all the risks.
Decumulation: the challenge
Managing any pension program is a challenge and this is particularly so for the average employee when markets are volatile.
If employees retire or leave an organization, a CAP account may be transferred to a financial institution without their knowledge. The fees in such a plan can be higher even if clients can often expect to receive only minimal levels of attention.
Information and tools
Guidelines from the Canadian Association of Pension Supervisory Authorities recommend CAP sponsors provide members with relevant tools and investment information, including: federal and provincial pension legislation and regulations relating to CAPs; how to fund their pension; a retirement planning tool; details about the investments; investment performance and benchmark indicators; and life expectancy information.
Familiarity with the CAP plan and the responsibilities of each party is important. Members should also know about communication and education provided to a spouse. Government programs, such as the Canadian Pension Plan, Old Age Security and Guaranteed Income Supplement, and similar sources offer useful information for estate and tax planning for employees.
Funding is a key issue
The adequate funding of CAP accounts varies widely. Retirement requires a long-term perspective and CAP members, therefore, need to keep abreast of their funded status, managing contributions, adjusting expectations, or deciding whether to take on more or less risk. Yet, even as monitoring the funded status is crucial, plan members are often not given the tools to do this effectively.
CAP members can’t make tax-deductible contributions to offset losses or beef up funding and I believe this a major shortcoming of a CAP when compared to a DB plan.
DB plans use public and private investments such as pooled funds, equities, partnerships, real estate, infrastructure, hedge funds and bonds. This diversification increases returns and reduces risk. Unlike in a CAP plan, longevity and inflation risks can also be spread over long periods in a DB.
CAP’s often have limited investments. When selecting these, the plan sponsor must consider both accumulation and decumulation phases. Plan members usually select from eight to 15 types of investments. These options, I believe, often fail to meet the best in class standards. While increasing the number of investments is possible, such an approach may end up confusing members and this approach complicates the tasks of communication and education for plan sponsors.
Ten, 20 and 30-year bonds are used in DBs to match their funding liability, but few CAP members understand the role of duration matching. This is a key feature of DB plans, however; CAP investments seldom include a long-term bond.
Equities play a key role over the long term (20 years and beyond). Long-term equity and benchmark return and volatility (risk) indicators are useful, but are seldom provided. And having to rely on just one-to-10-year performance indicators encourages a short-term versus long term investment approach.
The lack of long-term performance information and a long bond option in CAPs is a major shortcoming, in my opinion.
Assisted investments for less involved CAP members
Passive funds are common in CAPs and attempt to mirror the performance of a fund’s benchmark. Passive funds generally outperform actively managed funds and have lower fees. Passive funds can benefit sponsors and CAP members by minimizing investment risk in what’s sometimes known as a deviation from the benchmark.
Balanced funds are also common in CAPs and are easy to understand and they often serve as the default funds. These balanced funds often feature a mix of equities and bonds that tends to remain stable.
Target date funds are also common in CAP, but in my opinon these too are often used as the default fund. The objective of TDFs is to minimize investor involvement in investment decisions in accumulation and decumulation phases. Target-date investments are usually based on age: fixed income instruments, such as bonds, can be added over time to reduce an excessive exposure to equities.
Plan sponsors should be cautious about TDFs, or any investment options, which don’t include adequate historical information about their performance in periods of market volatility.
Life expectancy increases for plan members and spouses impacts the amount of retirement savings needed. Thus, life expectancy information based on age, gender and other parameters should be available to CAP members.
As unique as a fingerprint
The decumulation phase is complex: every case is unique. Understanding that a CAP account is a type of DB plan is important.
Pension plan sponsors must always act in the best interest of their members. A sponsor can’t transfer its fiduciary responsibilities to another party or waive its liability.
Financial institutions offer solutions such as annuities, balanced funds, or TDfs, which may not be a good fit for every case. For example, balanced and target date funds make assumptions based on common financial profiles and objectives, thus they fail to consider the individual circumstances. Moreover, investors may incorrectly assume that TDFs guarantee a pension income.
CAP communications should target active members, retirees, terminated employees still in the plan and spouses. And information about long-term investments, benchmark returns, volatility performance and funding should always be provided.
The fees should be reviewed regularly and highlighted; particularly, in such cases as when there’s a conversion from a DB plan to a defined contribution plan or when a CAP account is transferred to a recordkeeper.
Gerry Wahl is the managing director of The Pension Advisor. These views are those of the author and not necessarily those of the Canadian Investment Review.