This past summer, the employer members of OMERS proposed cutting the basic pension formula from 2% of final average pay (on earnings over the year’s maximum pensionable earnings) down to 1.85%. This seems like a fairly modest reduction in percentage terms, but it would have been represented as one of the most significant events in many years within the pension industry. While OMERS ultimately dropped the idea, for now anyway, the idea may be far from dead.
Even though more and more DB pension plans have been paring back their pension promises in this new low-interest era, the cutbacks have been restricted to ancillary benefits such as post-retirement indexing and early retirement incentives. The basic pension formula in most DB plans has been left untouched. In particular, the 2% accrual rate remains the standard in public sector plans. If plan sponsors are trying to find ways to make their pension plans more sustainable, why not put the basic pension formula on the table, too?
Could it be that the 2% accrual rate is necessary to ensure an adequate level of retirement income? If we accept this notion for the moment, let’s see where it leads us. Based on 35 years of pension plan membership, the 2% accrual rate—integrated with Canada/Quebec Pension Plan (C/QPP)—produces retirement income equal to 70% of final average pay. But is 70% the right target? And, if it is, then shouldn’t it include Old Age Security (OAS) as well?
For purposes of exploring these questions, let’s consider a typical DB plan member who earns $75,000 a year (which, by the way, is very close to the average pay of all DB members in our pension plan database; DB members in general are better paid than the average Canadian worker).
In our book, The Real Retirement, Bill Morneau and I define the neutral retirement target as the income target that allows a person or household to continue the same level of regular consumption after retirement. We showed that the neutral target for middle-income earners is significantly less than 70%. During our working years, so much of our gross income is dedicated to mortgage payments, child-raising costs, employment-related expenses, income taxes and retirement saving that we are lucky to have 50% of our gross income left over for regular consumption. In fact, financial planners have shown me examples of couples in mid-career who have just 35% of their income for regular consumption.
If 50% of income (or less) suffices for regular consumption before age 65, why do we suddenly need 70% after 65? (I recognize that low-income Canadians need a higher income replacement ratio, and they get it, but here we are focusing on middle-income earners.)
For the sake of argument, let’s postulate that our true retirement target is 57% rather than 50%. This extra 7% is based on conservatism rather than science, and it also has the virtue of simplifying the math to follow. We will lengthen the pension accrual period from 35 years to 36 years since every Big Six bank survey confirms that Canadians will work longer, either through need or desire. And let’s take OAS into account. OAS constitutes about 9% of final average pay for someone whose final pay is $75,000, so why would we not recognize it when calculating our retirement income needs?
Taking into account these adjustments leads to an annual pension accrual rate of just 1.33%, inclusive of C/QPP. Over 36 years, a 1.33% formula produces a pension of 48% of final average pay to which we add another 9% from OAS to get to 57%. Yes, 1.33% is a lot less than 2%.
Let’s run through the possible objections to this rather surprising result. The first is that those pesky mortgage payments and child-raising costs might not go away by retirement. In the vast majority of cases, they do disappear by then, and if they don’t in your case, then maybe you are not ready to retire.
The second objection is that it is unrealistic to expect an employee to accrue pension with one employer for 36 years. Most workers will change jobs several times during a career. No one said that your final employer is responsible for topping up for the pension you should have accrued during your early working years. As for the 36-year period, it’s hard to assert it’s too long. After all, the C/QPP accrual period is 39 or 47 years, depending on whether you include the dropout period.
Third objection: OAS is a flat benefit, so it represents less than 9% for those earning more than $75,000. True, but our calculations show that neutral replacement ratios drop with higher incomes. Also, OAS is more than 9% for those earning less than $75,000.
A fourth objection is that public sector pensions are really not that high. In the federal government Public Service Pension Plan (PSPP), the average pension for male retirees is about $28,000, which doesn’t sound excessive. Remember, though, that this is an average of all retirees over the last 40 years or so, many of whom retired with significantly less than 30 years of service. If we focus just on male retirees ages 60 to 64, the average PSPP pension is more than $40,000 (including Retirement Compensation Arrangements pension).
Finally, some will claim that we increase our consumption in retirement and hence need more income. Academic studies do not bear this out. Our regular consumption remains about the same in our early retirement years and then tends to keep pace with inflation until age 70 or so. After that, consumption starts to fall with advancing age. By the time we reach our 80s, most of us are spending much less, and do so out of choice. Malcolm Hamilton’s research showed that the average 85-year-old Canadian saves or gives away an average of 18% of his or her income. And not all of those octogenarians had good pensions.
In spite of these arguments, a 1.33% accrual rate will be hard for some industry observers to accept as being sufficient. Indeed, I’m the first to concede it’s not the right number in every situation, but if we are going to challenge it, we should do so using fact-based arguments rather than rhetoric. In this period of general restraint when plan sponsors are looking for ways to make pensions more sustainable, we should not restrict ourselves to adjusting ancillary benefits. The level of basic pension benefits should also come under scrutiny.