Lessons from Canada
Gail Moss assesses the challenges Canada is facing in the area of workplace pensions
On 13 and 14 June 2010, federal, provincial and territorial finance ministers met in Prince Edward Island, one of Canada’s ten provinces, to discuss reform of the country’s pensions system.
The meeting’s high profile had already been reflected by an open letter from a dozen pension fund heads and fund managers to Jim Flaherty, the federal finance minister.
The so-called ‘Flaherty Letter’ highlighted the lack of access to low-cost pension arrangements in the private sector. It called for an impartial federal-provincial task force to be set up with a mandate to identify the best solution to the problems of pensions coverage and cost-effectiveness.
Like many countries, Canada is subject to a disparity between the public and private sectors when it comes to pensions. While 85% of public sector employees participate in pension plans (almost all DB), only 25% of private sector employees participate in employer-sponsored retirement programmes.
However, some industry experts say the trend towards DC is not as pronounced as in other countries. While new company plans tend to be DC schemes, Canadian companies tend to grandfather their DB plans for current members, while introducing DC plans for new hires.
“In places such as the UK, many DB plans had more aggressive investment policies, with an equity content as high as 70% rather than the 50 to 60% we see in Canada,” says Scott Clausen, partner, Mercer in Toronto. “However, the international accounting standards that will soon apply in Canada will still make the volatility in pension investing more visible in the future. The impact of these new accounting standards is yet to be felt.”
In Canada, state benefits are relatively generous compared with other countries. The basic pension - the old age security (OAS) and guaranteed income supplement (GIS) - together provide a basic minimum income guarantee.
On top of these, there is the state earnings-related scheme, the Canada Pension Plan (CPP), applying everywhere except Quebec, which has its own Quebec Pension Plan (QPP). The CPP and QPP provide a defined benefit replacing a maximum of 25% of earnings, up to a certain limit.
In the workplace, 90% of Canadian organisations now offer some sort of DC plan, with only 40% still offering an open DB arrangement, according to Hewitt.
For workplace schemes, both employees’ and employers’ contributions are tax-deductible when made, up to a limit. Investment income grows on a tax-deferred basis, while the pension is taxed once it is withdrawn.
For DC plans, there is a contribution limit of 18% of income (including both employee’s and employer’s payments), subject to dollar limits for higher-paid employees. Canadian employment laws make automatic enrolment or escalation difficult.
Across the board, Hewitt estimates that on average, employers’ contributions are around 7% of annual salary, while employees might put in 5-6% themselves.
Once their individual pension pot has been established, retirees must start to withdraw funds by the age of 71; some types of account have minimum withdrawal requirements. In terms of products, Canada has a well-developed individual annuity market.
Of course, lack of pensions coverage in the private sector is not unique to Canada. But, says Mercer, the problem is not helped by the country’s legislative structure. Pensions are regulated at provincial level, which means ten different sets of rules, with a similar situation for employment law.
“That creates a high administrative obstacle for companies wanting to offer plans, especially on the DB side,” says Clausen. “If you have employees around the country, you have to meet the requirements of numerous sets of legislation.”
Another departure from other countries, he says, is that the pensions system is very strong at lower income levels.
“The greatest need for saving is for people in the C$30,000-100,000 (€24,000-79,000) income bracket,” says Clausen. “There is still a gap at higher income levels because state benefits are clawed back but, in theory at least, people on C$100,000-plus should have enough income to save for their needs. However, politicians find it difficult to strengthen plans for only middle income individuals because it is not politically palatable to exclude lower income earners, even if they do not need additional savings.”
Given the relatively generous state pensions, he says that any new pensions system introduced to close the savings gap should be voluntary.
“We need to avoid forcing low income individuals to save for retirement, when it is a long way away, when they need money for current expenditure,” he says.
However, in terms of investment strategy, Canada has followed its geographical neighbour, at least in one respect - although 10 years later. More and more employers are starting to introduce target date funds, according to Mazen Shakeel, principal and senior retirement consultant, Hewitt.
He also says most employers have revisited default strategies for DC plans.
“Money market funds are now less favoured than balanced or asset allocation funds, because the inflation risk with money market funds is seen as worse than market risks for balanced or asset allocation funds,” he says. “We are also starting to see the introduction of decumulation products into the Canadian marketplace.”
Shakeel says that many providers have been reviewing their investment options and the number available has gone from three or four to well over a dozen: “But people are starting to question whether the investment structure is still too complex for the average employee.”
However, one of the biggest issues for the industry is management fees; Canada has some of the highest fees in the world for retail savings products.
“Members of individual retail plans pay 200-300 bps in fees,” says Shakeel. “Also, members of small employer-sponsored DC plans can pay high fees because the plans do not have economies of scale.”
There are now calls to permit these types of schemes to be aggregated (perhaps on a multi-employer basis) or run by large providers or government.
“These employers might have less flexibility, but the priority is getting more employers to offer workplace plans and getting more employees to participate,” says Shakeel.
“In terms of coverage, it seems very clear that it will be a private sector solution that comes into play,” says Warren Laing, chairman of Open Access, a fiduciary manager for DC plans.
Open Access offers pension savers a range of model portfolios using third-party funds. It does not accept commissions or trail fees from providers, but charges plan members a fee, which is lower than average retail fees as the company effectively sticks to the providers’ institutional fee scale.
Furthermore, the company enters into a discretionary money management agreements with each employee to provide ongoing investment management at the employee portfolio level.
The idea of outsourcing the management of individual DC plans or small group schemes is echoed by James Leech, president and chief executive, Ontario Teachers’ Pension Plan (OTPP) and a signatory of the Flaherty letter.
And he says that other possible solutions include expanding the CPP and QPP, or enrolling non-covered workers in a low-cost, well-managed personal account-based plan, which could be provided by the private sector, by pension plans themselves, or through a national structure directly supplementary to the CPP/QPP.
From a pension fund’s point of view, however, funding is the key issue. And some funds are already coming up with innovative solutions.
Recently, OTPP adopted conditional inflation protection, creating a kind of DB-DC hybrid. Inflation protection is guaranteed at 50% of the inflation rate, but above 50% it is conditional on the fund’s financial resources.
The fund has also established a sustainability working group, with representatives from the Ontario Teachers’ Federation and the Ontario government - the fund’s sponsors - and its own management team.
“Our sponsors are committed to dealing with the issue of recurring shortfalls because what these shortfalls are telling us is that we need a small course correction today that will translate into a large difference 70 years from now,” says Leech.
He also says that saving in a DB plan can deliver the same level of retirement income at almost half the cost of a DC scheme. One reason is that members of individual schemes cannot pool longevity risk, so are forced to accumulate more in a DC plan than in a DB plan, which is based on actuarial averages.
Another reason is that DB plans can adopt an optimally balanced investment portfolio in perpetuity, whereas individuals must de-risk sharply as they age - and transaction costs for rebalancing are very high.
The outcome of the Prince Edward Island meeting gave some indication of how Canada will tackle its pensions problems.
Flaherty said that a new, government-sponsored CPP had been ruled out, but that what would be considered was a modest, phased-in and fully-funded enhancement to defined benefits under the CPP, in order to increase coverage and adequacy.
“There is a minority of middle-income and lower middle-income Canadians who are not saving adequately for their retirement,” said Flaherty. “We need to take steps now to deal with it, bearing in mind the intergenerational equity.”
He said any changes would not be enacted before mid-2011 at the earliest.
Flaherty also announced plans for ministers to work together on pension innovation involving the private sector, and making available arrangements for multiple employers of employees and the self-employed.
“This is a voluntary scheme with private sector insurance companies that could be used by jurisdictions and would be incentivised by government through government policy, but not sponsored by government,” he said.
“Recent announcements by the Federal and Ontario governments are a fundamental step towards facilitating the retirement dreams of the average Canadian,” says Laing. “This announcement builds upon the strength of both government and private sector retirement income systems, while seeking to reach more working Canadians.”