Put up your hand if you read the prospectus for the pooled/mutual funds or individual stocks in which you invest your retirement savings. That is what I thought.
I have had an interesting seat in my career in the world of pensions. I started in 1986 at the Government of Ontario as Bill 170 was being considered and even was able to attend public hearings where pensioner groups spoke about the importance of indexing pensions and employers like GM argued that indexing pensions was completely unaffordable. That Bill ultimately became the revised Ontario Pension Benefits Act of 1988 and while the new statute required pensions to be indexed going forward, the actual regulations on how the indexing would be calculated were never proclaimed. In 1990 the Income Tax Act was overhauled and since those legislative changes it has been a steady migration in the private sector from defined benefit plans to defined contribution plans.
The 1990s and much of the 2000s has been spent setting up private-sector DC plans – both registered pension plans and RRSPs – intended to help workers accumulate savings for retirement. Early retirees had small balances and if they were lucky most of their retirement income came from a legacy DB promise. As the decades roll on, we are seeing larger and larger DC balances and for many workers these funds are their entire retirement nest egg (outside of home equity and government pensions). In the last decade, decumulation has become the buzzword – and with good reason – we help workers save but the industry doesn’t do a good job of converting those savings into retirement income.
Many industry professionals will use the term pension and annuity interchangeably. I tend to think of a pension as a fixed monthly payment from an employer sponsored pension plan whereas I think of an annuity as a fixed monthly payment from an insurance company. Because the words are more interchangeable than I first realized, I now use the term ‘insured annuity’ to describe a pension being paid by an insurance company. Insured annuities are the gold standard of retirement income – guaranteed in amount, guaranteed to last a lifetime, and backed by the capital of the insurance company as well as the industry backstop Assuris. There is no other tool that provides the predictability of an insured annuity. I have written about annuities here (amazingly this was almost 10 years ago) and here.
Unfortunately, annuities are not as popular as they should be. After lots of discussions, the aversion to annuities comes down to two key themes. First, people wonder if they will die too soon after they start their annuity and ‘lose’ while ignoring how valuable an annuity would be if they live a long life and ‘win’. Second, when people look at the income that an annuity would provide, it is less than they, or their financial advisor, thinks they can earn by continuing to invest wisely in diversified funds. I won’t get into what the psychologists call ‘loss aversion’, I will simply observe that the beauty of DB pension plans was the fact that the starting point was monthly income, and no one thought about the plan as their pot of money to draw down – there was no winning or losing since the monthly income lasted for life – exactly for how long it was needed.
As for the second issue – the fact remains that guarantees have costs. It is unfortunate that retirement calculators allow workers to imagine a retirement where they earn equity returns right up until the day they die even though any capable investment advisor would not let a 90 year old client dependent on their dwindling nest egg invest 50% of their remaining savings in equities. We are setting up workers to not want annuities because we tell them to plan for more income than an annuity will provide. When workers are confronted with the fact that annuities will not generate the income they were targeting, we tell them the solution is to invest in equities.
Over the past 20+ years, sponsors that have not wound up their DB pension plans have substantially increased contributions to these plans. This has been necessary as the regular reviews by actuaries has continuously reminded sponsors that pensions are getting more and more expensive. On the DC side of the game, most sponsors have the same contribution rates they set in the 90s or 00s, which are inadequate to produce anything like the DB promises of an earlier era. The implicit understanding by CFOs is that employees should increase their savings to make up the difference – sadly that understanding is not so clear to workers.
One final problem with the decumulation dilemma, is that for the prudent saver, in order to avoid falling short you must, by definition, over-save. This is not the most effective use of capital and for families with children it means depressing the lifestyle of the kids when they are young so you can send them a windfall gain when they are older.
Searching for Solutions
The DC industry is scrambling for solutions. The Federal Government has introduced Variable Payment Life Annuities as a way to blend the benefits of mortality pooling and equity investing (Jason has written about VPLAs here). VPLAs are a good compromise between annuities that fully pool mortality and investment risks and individual DIY decumulation plans where it is every retiree for themselves.
Last week, Purpose Investment Inc. announced “The Launch of the Longevity Pension Fund (“Longevity” or the “Fund”), the first income-for-life mutual fund designed for Canadians in retirement”. Of course, words like longevity and pension caught my attention. I wondered how they did it? Do they somehow embed annuities inside a mutual fund so that there is a guarantee that the money will never run out?
Working for you my readers, I went down the rabbit hole and actually found the 47-page prospectus to help me understand the math. I have never read past the third page of a prospectus because to me they are written by lawyers for lawyers to make sure when you come to realize you didn’t understand your investment their defense before the courts was pre-built. Who has the time? Lucky for me, the second paragraph of the prospectus gives half the answers for which I was looking:
“The Fund is not an annuity or other type of insurance contract. The Fund is not an insurance company. The Fund’s units are not insurance contracts or annuity contracts. Unitholders of the Fund (the “unitholders”) will not have the protections of insurance laws. Any distributions provided by the Fund are not guaranteed or backed by an insurance company or any third party.”
So, we are just left with how does it work? There is a long answer to this question in the 47-pages. As far as I can tell the short answer is that it is a form of a tontine where when you die or withdraw from the fund you get your contributions back, less any payments already received. All the investment income rolls forward to survivors. A great deal for those that live long lives and not so good for those that die ten years after they buy their units. This isn’t just my opinion; they say it themselves in the third paragraph on page 1:
“In respect of the Decumulation Classes, a unitholder’s payment stream is tied to the life of the unitholder and, accordingly, people with serious or life-threatening health issues should not invest in the Fund.”
It is too early for me to tell where this product belongs in the retirement tool kit – maybe there is a place and maybe there is not. Perhaps a discussion for another day.
The Right Stuff
Having thought about this decumulation problem for years, I have come upon my preferred answers. Maybe a surprise and maybe not, it is insured annuities. So how am I going to reconcile the aversion savers have towards making a big decision to turn over their nest egg to an insurer when they retire? The simple answer is we need to break that one big decision into smaller decisions. My proposal is to pair recordkeepers that are accumulating assets with insurers that are providing the ideal decumulation vehicle. How do I visualize this working? Using technology, savers will have daily (or at least monthly) access to annuity prices and at any time can consider moving part of their nest egg from the mutual/pooled fund side of the ledger to the deferred/immediate annuity side of the ledger. This approach will have five advantages over the single ‘purchase – don’t purchase’ decision.
First, it makes the decision smaller and the consequences of getting it ‘wrong’ will be lessened. Second, it will allow workers to systematically take risk off the table by locking in true income for life – which is really the goal in the end. Third, workers will be better apprised of the value of their savings and their readiness to retire or the need to increase savings. Fourth, it will let savers incrementally take risk off the table, which means your retirement income won’t be entirely dictated by the markets in the short period of time leading up to your retirement. Finally, it will reduce the ‘at risk’ nest egg workers have to manage and worry about as they approach retirement.
My nest egg now generates greater investment returns than the annual amount I contribute. I have gone from thinking about my savings from once a decade, to once a year, to once a quarter, to this year almost weekly. It takes time to manage your savings when they become worth 5 or 10 times what you will earn working this year. Employers should not want their employees this distracted, and workers should not want the stress that comes with managing an amount of money that often is worth more than their house.
So why aren’t we doing this? Well a year ago I would have told you that the technology and administrative effort to pull this off would be enormous and sometimes we imagine solutions that just aren’t practical. But that isn’t my answer today. My friend Trevor has built for the US market the technology to connect recordkeepers and insurers that I dream of (and for full disclosure I have invested a few dollars to help him get there). Trevor started with the US where the problem is much bigger because they have many more recordkeepers and insurers and its DC industry is more mature. In the meantime, my friend Paul who runs an insurance company in Canada has partnered with an RRSP company to do exactly what I am describing.
I believe that if we give savers a real chance to build real retirement income incrementally, they will happily take it and it will result in better retirement planning and more appropriate levels of risk taking. Isn’t this what we want for everyone that doesn’t have the ever-rare luxury of having a DB pension plan where all of this is managed behind the scenes?