CAP sponsors and retiring plan members face the downside of economic and market cycles—but there is hope.
Imagine that you are about to retire under the capital accumulation plan (CAP) where you work, and that the conditions for your retirement are ideal. For most plan members, this scenario would include good health, a paid-off mortgage and a comfortable nest egg generating a secure personal income. And, since this is an imaginary scenario, add in strong government pensions, minimal taxes, and a sunny outlook for the markets and the economy in general (i.e., low inflation). In short, you are feeling healthy, wealthy and wise—and fully in control of your destiny. Remember, this is the dream you’ve been working toward for your entire life.
Not everyone expects this dream to come true, but it is reasonable to expect that plan members are most likely to retire when they feel their nest eggs have hit their target levels and they are confident that they will be able to sustain positive market returns. On the contrary, they are less likely to rush into retirement when their portfolios are being hammered by negative results and the market outlook is less than rosy.
None of this is terribly startling or illogical, but there seems to be an ironic symmetry in the way CAPs work over time. The irony comes into focus when looking at the perspective of the other partner in the CAP deal: the sponsoring employer.
For the plan sponsor, a benefits program serves to attract and retain the talent needed for the organization to succeed. This means hanging on to valued staffers when the demand for the product or service they produce is strong and growing. By definition, for most enterprises, this occurs when the economy is in its growth phase. Conversely, an employer will be looking to cut payroll when business demand is sluggish or declining (i.e., when the economy is slowing down).
Notice how the two perspectives line up: CAP members want to retire when conditions are rosy, yet that’s when employers want them to stay on the job. Given the choice, members will want to postpone retirement at the same time as their employer is contemplating a downsizing.
If this theory is correct, a real-life demonstration of its effects could well be on its way as the current economic cycle progresses. The pieces are starting to fall into place.
In a CAP, the amount of retirement income depends on the size of the plan member’s accumulated nest egg. This is based on just three factors: the member’s contributions, the average net rate of return on investments, and the length of time that the contributions remain invested.
Plan members have some direct control over how much is contributed and how long it stays there, as well as indirect control of their investment earnings through the level of risk they are willing to assume. As the decision to stay or go draws near, it’s rather late to make up contribution shortfalls, so the only real factor at play is timing.
When the retirement is voluntary, the timing will have much to do with the individual’s outlook for the future. The decision to retire calls for careful consideration of many factors. How much money is on hand to convert to income? How much income will the current assets generate? What other sources of income are available? How much will be needed for a decent retirement? But in the end, it comes down to one simple question: Do I have enough?
No one can guarantee the future, so each individual has to answer that question by making guesses about longevity, lifestyle, inflation and market performance. In short, the individual needs to paint a picture of what the future might look like. When the outlook is right, then the time to retire has arrived.
Wealth Effect
Another factor that can affect the right time to retire is the so-called “wealth effect,” which has been observed to drive consumer spending. As people feel wealthier, they spend with greater confidence. This can occur, for instance, when rising house prices create the illusion of instant affluence. Without having to make any savvy investment decisions, average homeowners can suddenly discover that they are richer than they think—at least, on paper.
Of course, what goes up must come down. Overheated real estate values have a habit of cycling back down again, as we have seen in the subprime credit crunch in the U.S. housing market. As more and more buyers qualified for home ownership, the rise in demand pushed prices higher, confirming the inevitable increase in home values and adding impetus to the trend. As overextended buyers realized that they could not really afford the houses they had purchased, the trend reversed and a wave of defaults created a sudden increase in the supply of houses, triggering the inevitable decline in prices.
The wealth effect, then, works in both directions. When people feel wealthier, they are full of confidence and keen to spend. When they feel less wealthy, they think twice before spending extravagantly or voluntarily saying goodbye to a steady paycheque.
So where do future retirees find themselves today? Are they making realistic guesses about the future? News headlines conjure up images of decline, not growth; turbulence, not stability; rising costs and falling market returns. It’s tempting to reach for the old “perfect storm” cliché and apply it to the outlook for our CAP members: low interest rates (which make insuring the annuity income stream expensive and/or unattractive); the rising cost of living (which makes future income needs uncertain); turbulent capital markets (which make future rates of return doubtful); and an economic slowdown that may lead to job cuts and forced retirement.
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