CAP member risks
For most plan members, the main purpose of a CAP is to accumulate assets. Very rarely are plans designed—or are members equipped—with support or strategies to help them understand how the assets should be managed during the actual retirement period.
As they seek to ensure adequate ongoing income each year, retirees face significant risks, including investment risk, inflation risk and longevity risk. In addition to the challenge of managing their income level each year, retirees also face a variety of possible unforeseen financial risks: unexpected healthcare needs and costs; loss of the ability to live independently; sreliance on caregivers; changes in housing needs; changes in marital status; and the needs of family members.
Investment risk – During the period leading up to retirement, different investment approaches—and the results, depending on timing and the particular funds chosen—will have a significant impact on the CAP member’s income at retirement. In a recent Towers Watson study for one CAP sponsor with 4,500 employees, the projected replacement ratios at retirement ranged from 4% to more than 40%. While this range is partly attributable to differences in length of service, a major source of the variation is investment returns.
Except for those CAP members who buy fixed or indexed annuities, members continue to be exposed to investment risks after retirement. Retirees face the challenge of balancing competing objectives to:
• ensure the security of their accumulated savings while enhancing returns and protecting their purchasing power;
• enhance the security of their income stream while maximizing the liquidity and flexibility of their assets; and
• make long-term investment choices appropriate to a time horizon that can extend for several decades while considering the negative impact if long-term investments produce poor returns in the early years following retirement.
The difficulty of balancing these competing objectives is further heightened if the retired CAP member also wants to bequeath a portion of his or her accumulated assets to family members or a charity upon death.
Inflation risk – Inflation has become much less volatile in recent years; however, healthcare costs are increasing dramatically. While coverage for many drugs is provided by governments after age 65, employees may not plan for the rising costs of other healthcare expenses, such as vision care, dentistry, medications that aren’t included in provincial formularies and the costs of assisted living during the later retirement years. With costs shifting from governments to employers—and from employers to employees—more of the inflation risk is being borne by retirees. The challenge that retirees face is heightened by unexpected sources of inflation that can arise.
What level of inflation protection is needed? The answer will vary by individual but is typically less than the full Consumer Price Index. According to 2005 data from Statistics Canada, as individuals age, their average spending drops—yet they continue, on average, to allocate a portion of their spending toward savings and gifts. This suggests that overall declines in spending are not simply attributable to fewer financial resources but may also relate to voluntarily reduced discretionary consumption.
Longevity risk – The amount of time that each of us has left is uncertain. Unfortunately, many individuals underestimate their remaining lifespan, or their need for caregivers or other unexpected family demands. Consequently, they run a significant risk of outliving their retirement savings.
Based on recent Society of Actuaries mortality tables for the active working population, an individual retiring at age 60 today has a good chance of living well into his or her 80s and a significant probability of surviving beyond age 90. Will that person’s retirement savings last 30-plus years?
As a simple illustration, suppose that a CAP member has an account balance of $100,000 at retirement, invests it to earn a 6% annual return and picks a desired level of annual spending (with withdrawals increasing by 3% each year). How many years will it be before the money runs out?
• If $5,000 is withdrawn in the first year, the assets will last for 29 years.
• At a $10,000 initial withdrawal rate, the savings will run out in 12 years.
• With a $15,000 initial withdrawal rate, the savings will be exhausted in only seven years.
Yet without adequate planning tools and information, few CAP members would think that a $10,000 initial withdrawal level could ultimately result in financial ruin.
Risk mitigation tools
In a 2009 Towers Watson study, 40% of the business leaders surveyed reported that their employees were requesting more financial education or retirement planning assistance. With a maturing CAP membership and increasing exposure to the potential liabilities associated with not assisting and educating plan members, good communication and modelling tools are vital for both plan members and sponsors.
The next generation of tools being implemented by progressive employers today includes stochastic modelling (showing a range of possible outcomes, not just a single scenario) and incorporates income from other sources, reinforcing the role the CAP is intended to play as one of a variety of retirement income vehicles. On the surface, these tools appear to be more complex. However, they are actually easier for plan members to use, since they eliminate the need to make judgment calls about future assumed investment returns. Moreover, with the use of multimedia techniques, these more dynamic modelling tools can be more engaging to work with than traditional tools.
CAP sponsors also need strategies to manage their plans more effectively, including tools to provide dashboard information on plan member participation levels, investment patterns and distribution elections, as well as CAP valuation tools to provide insights into how members are tracking toward retirement income targets that were set when the CAP design was initially developed and communicated.
Implications for employers
Empowering plan members to take ownership of their retirement security is a fundamental premise of CAPs, but a significant degree of employee risk can accompany this opportunity. And employee risks can potentially turn into employer risks.
For employers that provide retirement coverage through a CAP, there is a strong business rationale to help plan members understand, manage and mitigate these risks—not just during the accumulation phase but also as members begin to shift from building wealth to preserving wealth as they approach retirement. For plan sponsors, the solution lies not only in revisiting CAP design but also in shifting the focus—and improving the quality—of member education. BC
Ian Genno and Nigel Branker are consultants based in Towers Watson’s Toronto office.
ian.genno@towerswatson.com
nigel.brankertowersw@atson.com
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© Copyright 2010 Rogers Publishing Ltd. This article first appeared in the March 2010 edition of BENEFITS CANADA magazine.