The provincial government’s consultation paper on the Ontario Retirement Pension Plan, released at the end of 2014, proposed members of comparable pension plans will be exempt from having to enrol in the ORPP. However, the definition of comparable was limited to defined benefit plans and target benefit multi-employer plans. Defined contribution plans were excluded, since they lack inflation adjustments and expose individuals to longevity and investment risks. In short, DC plan sponsors and members would also have to contribute to the ORPP, to limit the danger of undersaving for retirement.
Are DC plans incapable of providing an adequate level of retirement income that will last for the rest of the retiree’s life — and perhaps beyond, as a residual death benefit? The answer depends, in part, on the decumulation vehicles members choose.
Today’s decumulation market
Options are currently somewhat limited. But as Canadian DC plans and their members mature, sponsors, members and providers are all starting to pay more attention to decumulation, hopefully leading to more innovation.
Decumulation solutions range from self-administered vehicles — life income funds, registered retirement income funds and annuities — to insurer-provided products, to customized solutions developed by plan sponsors.
Read: Employers’ decumulation duties remain unclear
For illustration purposes, we’ve consolidated these choices into three different options:
- 50/50 annuity/LIF. Since there’s no opportunity to provide a residual death benefit in an annuity and the risk of outliving savings with a LIF or RRIF is high, these options are combined here;
- Insurance company product. A generic version based on the two most widely available options; and
- 50/50 sponsor/LIF. Offered under the University of British Columbia Faculty Pension Plan.
Some plan sponsors may not be familiar with the type of customized solution UBC offers. It’s really an option only for large plans with sponsors willing to make an ongoing commitment to retired members.
UBC is in it for the long term when it comes to its pension plan members, according to Lorraine Heseltine, member services specialist for the university’s faculty pension plan. “The plan’s mission statement says it all: ‘The main purpose of the plan is to provide a well-managed, cost-effective retirement plan, designed to assist members in meeting their financial responsibilities, both leading up to retirement and, if members choose, through retirement.’”
Read: How to help plan members with decumulation
The UBC plan offers two decumulation options — a custom LIF/RRIF and a variable annuity — and the number of retirees in the plan has more than doubled since the LIF/RRIF was introduced in 2004. “Staying in the UBC plan appeals to members, and they like the flexibility we offer,” says Heseltine. “Some members start with the LIF/RRIF option and then switch to the annuity later.”
Heseltine is quick to emphasize a do-it-yourself strategy requires dedication on the plan sponsor’s part. “We want our members to really understand all of the options available to them and make an informed decision based on their particular circumstances,” she explains. “We offer regular retirement income options seminars throughout the year.”
Heseltine also acknowledges a continuing relationship with retired plan members requires a certain mindset. “In order to offer this option successfully, you really have to care about your members as much during the decumulation phase as you do during the accumulation period.”
But it’s not an option everywhere in Canada. Currently, pension regulators in B.C., Alberta, Saskatchewan and Manitoba allow pension payments from DC pension plans.
Measuring results: a hypothetical scenario
Of the decumulation options available, which one provides the best outcomes for the plan member? Consider the following hypothetical (but not uncommon) scenario.
Background: A 60-year-old DC plan member has a balance of $500,000. She would like to target a starting annual retirement income of between $20,000 and $30,000 per year, with some investment of her retirement income and a residual death benefit.
Read: Defined contribution communication: Decumulation dilemma
The member has three options:
- use half of her balance to purchase an annuity, with the remainder invested in a LIF;
- direct her entire balance to an insurer’s product; or
- direct half of her balance to the sponsor’s customized solution (assuming a 4% interest rate) with the remainder invested in a LIF.
Assumptions:
- The 50/50 sponsor/LIF option has lower fees than the 50/50 annuity/LIF option, assuming better pooled fees for plan sponsors compared with the retail market.
- For the 50/50 annuity/LIF option and the 50/50 sponsor/LIF option, the member selects a joint and 100% survivor form of pension (since insurance products typically provide surviving spouse income benefits).
- The member withdraws as much as needed from her LIF (subject to legislated minimums and maximums) to achieve a level of overall income comparable to her initial goal.
- All LIFs, as well as the sponsor fund and the insurance product (i.e., any products that are invested and exposed to market risk), have a standard investment mix of 50% equities and 50% bonds for the decumulation phase.
Outcomes: Residual death benefits and income levels for ages 60 to 90 were tracked using a stochastic model (1,000 simulations), looking at the median level of market performance (mid-range), the 90th percentile (optimistic) and the 10th percentile (pessimistic) (see Figure 3, below). The findings under each scenario use a simple ranking system (3 = best; 1 = worst).
Read: Pension column: Focusing on decumulation
Conclusion: The 50/50 sponsor/LIF option provides the best blend of residual income and annual pension income (see Figures 1 and 2, below). The pension amount provided under each economic scenario is the highest without sacrificing residual value.
The insurance product provides high residual value as well — particularly in the early years — but at the cost of downside protection in the annual pension amount. The 50/50 annuity/ LIF self-managed results are fair to poor, on average, depending on the scenario.
Time to innovate
Based on this analysis, basic retail offerings (i.e., annuities, LIFs/ RRIFs) are indeed challenged to provide a reasonable lifetime income with residual death benefits. Concerned about the potential lack of death benefits, most members allocate a very small portion, if any, to purchase an annuity, which exposes them to even greater risk of outliving their savings.
There has been some innovation from the insurance industry, but these products could be improved. In particular, solutions to date sacrifice too much retirement income in exchange for high residual balances in members’ early years. (To put this in context: based on standard actuarial mortality assumptions, there is only a 30% chance that a member retiring at age 60 will die before age 80.)
Read: Reflections on decumulation
For larger plan sponsors, creating their own decumulation solutions can help members during their retirement years, and the cost to the sponsor is fairly small. However, this strategy does involve taking on some risk. And whether or not it’s appropriate for a particular plan sponsor will depend on the company’s workforce objectives and its openness to having a connection with employees once they leave.
Although DC decumulation in Canada is still in its infancy, plan sponsors should consider the options available to members and decide how much support, if any, they’re prepared to offer. Sponsors will need to push for more innovation from providers if DC plans are to truly provide a lifetime retirement income.
Nigel Branker is a partner and leads the Ontario pension consulting practice, and Mary Mong is a pension consultant with Morneau Shepell.
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