With pension liabilities rising to record levels, many individuals are facing hard choices as a result. Should they delay retirement or lower their retirement standard of living? What about increasing investment risk? While an individual can make any one or combination of these choices to improve his or her situation, what about society? Can society improve its pension situation?

In order to answer this question, we need to look at both individual and collective retirement circumstances.
For purposes of illustration, we will assume that an individual does the following:

  • sets aside 10% of his or her annual earnings for retirement. A 10% savings rate seems reasonable, but the average household savings rate for Organisation for Economic Co-operation and Development countries is forecast at around 6%;
  • earns a real return on investments of 3.5% each year (on average). A 3.5% real return assumption is relatively conservative and, therefore, likely achievable;
  • achieves a “replacement ratio” of 50% or an annual income that is half of what the individual earned while working. This does not include any government programs; and
  • does not see real earnings grow pre- or post-retirement (i.e., real earnings grow at a 0% rate). This is a simplifying assumption.

The good news
There is some good news. If an individual starts saving 10% of earnings at age 20, and does this for 45 years, then that person can not only fund 15 years of retirement but (may) also leave a bequest amounting to roughly three years’ earnings. Alternatively, that person could live until 86 and leave no bequest but provide for six additional years of retirement. If the individual lives beyond age 86, then he or she will become dependent on alternative income sources, such as government or family.

But what if we change the assumptions? If an individual delays when he or she starts saving, the pension pot will be smaller. It will also be smaller if an individual saves less or secures a lower investment return. In order to still retire at 65 and fund 15 years of retirement (but leave no bequest) an individual could, one, delay saving until age 27; two, save 9% of earnings; or three, tolerate a real investment return as low as 2.2% per annum (p.a).

The bad news
What happens if all three of these shocks happen at once? In this case, save 9%, start saving at age 27 and get a real return of 2.2% p.a.—the replacement ratio falls from 50% to 34%. Not a pleasant situation.

Additionally, this simple example does not address the possibility of living longer than expected and if it is possible to save enough if an individual does.

Can society fund any additional pension requirements? Society needs to accumulate (and maintain) pension wealth equal to 4.7 times the total earnings in order to provide sufficient pension savings for its population.

Employee compensation accounts for approximately 50% of GDP, which would require the accumulation of pension wealth of around 235% of GDP. Currently, according to the Towers Watson Global Pension Assets Study 2012, the 11 largest pension markets in the world have pension assets amounting to 72% of GDP, and it has been around this level for the last 10 years. While this figure does not include non-pension savings that could be used in retirement, it does suggest a significant under-provision of resources available to support pensions for the broader society.

While many individuals may be able to save enough for retirement (typically 10 times their annual earnings), it is unclear whether society has saved enough for retirement. In order to offset individual pension shortfalls, is it possible for society to treble the amount of invested pension wealth without reducing the rate of return on those investments?

Government actions
Certainly the government is trying to deal with the savings shortfall through a number of initiatives including raising the retirement age to collect Old Age Security to 67 and promoting the creation of Pooled Registered Pension Plans (PRPPs). While the government has published regulations for the creation of PRPPs, much detail remains to be determined, as does the extent of the take-up by the working public and employers.

With regards to the impact on additional savings, it will depend on where the individual elects to invest his or her money. More money being invested in equity markets can be positive for returns, at least in the near term, though individual securities can become quite expensive versus their longer-term prospects. We have already seen the impact of large inflows of capital into the Canadian bond market, which has been positive for shorter-term returns as yields have fallen, but has impacted the level of bond yields that are now  at historical lows. Clearly 2% bond yields are not overly attractive longer term for those saving, and certainly not for those already retired.

Another question that has to be asked is would society be willing to defer consumption to give people the retirement they desire?

Canadians did tighten their belts in the late 1980s and early 1990s in order to reduce the deficit and potentially improve Canada’s fiscal position longer term. A positive result would have (and did have) the benefit of improving the position of a majority of the working population at the time, and in the future.

It would be hard to see a society engaging in the same level of sacrifice so that a portion of its members can improve their retirement. In fact, a disproportionate share of the burden would likely fall on today’s youth and young adults—a segment of society that is already finding it hard to obtain gainful employment and to afford the lifestyle of their parents.

It would appear that society will struggle to support a retired population in the style to which it aspires unless significant action is taken and unless there is buy-in by society in general.

Janet Rabovsky is a partner at Ellement. She has more than 25 years of experience in the industry. These are the views of the author and not necessarily those of Benefits Canada.
Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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