Pensions not only provide retirees with the financial support they need but also provide a benefit to the overall economy.I spent the last two days in Toronto and attended the HOOPP conference on the importance of DB pensions. I want to first thank Jim Keohane, Martin Biefer and Kate Lahey who along with others did a wonderful job putting this conference together.
DB pensioners spend approximately $27 billion in Ontario, said Michael Block, a principal with Boston Consulting Group, at an event hosted by the Healthcare of Ontario Pension Plan (HOOPP) in Toronto on Monday.
He noted that, in certain towns and cities, the impact and importance of both DB and retirement plans are more pronounced.
“Generally, the smaller the town the more important DB plans are and retirement plans in general,” Block explained.
For example, 38% of the total earnings in Elliott Lake, Ont., are made up of a combination of pension, Canada Pension Plan, old age security, Guaranteed Income Supplement (GIS) and RRSP payments. In Cobourg and Orillia, the total earnings from pensions are 28% and 25%, respectively.
“And that has a very big impact on those economies as well if you think about how much those individuals are spending in those towns,” he added.
Pensions can also help with retirement confidence, according to a survey from The Gandalf Group.
Ontarians who have a DB plan think they’re going to fall about 5% short of their working income, while those who don’t have any pension at all think they’re going to fall short by about 20%.
“What I can also tell you from looking at this data is that people with defined benefit plans don’t know how good they have it, and people who don’t have any pension at all don’t know how bad they have it,” explained David Herle, the company’s principal partner.
There are approximately four million Ontarians without a workplace pension plan, and Jim Keohane, president and CEO of HOOPP, said the survey results suggest that “Ontarians who do not have a workplace pension plan do not have pension envy, but rather they have pension anxiety.”
A large majority (86%) of Ontarians believe there is a retirement crisis brewing in the country, and they say that both employers and the government are responsible.
Seventy-three percent say employers don’t offer good pension plans, 69% say it’s because the government doesn’t make it mandatory to offer good pension plans, and 56% say the government doesn’t make it mandatory to participate in workplace pension plans.
“Implicit in all of those answers are two facts: one of which is that people think that employers should be providing pensions to their employees to access,” Herle explained. “Second of all, people clearly see a role for government here.”
Pensions also help reduce the number of Canadians who have to rely on government assistance programs such as GIS. According to Boston Consulting Group, 10% to 15% of retirees with a DB plan collect GIS, while 45% to 50% of non-DB retirees collect GIS.
With millions lacking adequate pension coverage, Keohane said the costs will fall on government and ultimately cost taxpayers. He added that they’ll also have to make decisions that they’re not equipped to make.
These individuals without coverage face the same investment challenges encountered by pension plans, challenges such as increased longevity, low interest rates and a climate of economic uncertainty.”
In attendance, I saw Susan Eng, VP Advocacy at CARP, who along with Jim Keohane is part of the technical advisory group on Ontario's new pension plan. John Crocker, HOOPP's former president and CEO, was also there to support the case for boosting DB pensions.
I also saw Ron Mock, president and CEO of Ontario Teachers' Pension Plan. Ron and I had a chance to briefly catch up right before the conference. He looks great for a man working seven days a week. He told me Teachers' results will soon be out and he'll spend some time with me to discuss them after he does the media circuit. He also gave me some good advice for my blog which I'll try to adhere to (no promises as I sometimes relish in being a real pension prick, especially with former employers who continue to underestimate my perseverance and intelligence).
There were many people missing from the conference. Interestingly, I didn't see any other president and CEO from Canada's top ten pensions. I was also disappointed that the Premier of Ontario and Minister of Finance didn't show up. The pension crisis is the most important public policy topic and this conference didn't get the media attention it deserves (what else is new?). I find it interesting that the CEOs of the two best pension plans in the world were sitting at the same table but other pension leaders and Ontario's top politicians didn't bother attending.
Everyone is busy but when HOOPP does a conference on the benefits of DB pensions, you make the time to attend and show your support (I did and this trip cost me over $700 from my pocket, which I was glad to pay). Susan Eng hit the nail on the head when she stood up and said: "I think you guys are preaching to the choir. We need to get the message out and truly influence public policy."
HOOPP is quickly asserting itself as the leader in DB advocacy. They're also leading the world in terms of long-term performance and their 2013 results demonstrate once again why they're among the best at managing assets and liabilities.
I had a chance to meet up with Jim Keohane for a one on one meeting on Tuesday morning. We spoke about HOOPP's approach and why it's the best way to secure the long-term sustainability of pensions. Typically, 66% of asset growth in a DB pension comes from investment gains, which is excellent. At HOOPP, 80% of asset growth comes from investment gains and at a fraction of the cost of most other large public pensions (0.3% or 30 basis points). HOOPP's members contribute 9% and the government contributes 11%.
As I've remarked previously, Harvard's Business School should do a thorough case study on HOOPP and Ontario Teachers. They have a lot in common but there are important differences too. HOOPP does all of their public market and absolute return strategies internally and in private markets they are more focused on small and mid market funds than the big brand name funds (they are also managing less than half the assets of Ontario Teachers).
Interestingly, Jim told me that the average age of the members of Ontario Teachers is much higher than that of HOOPP. "With the baby boomers generation entering retirement, healthcare spending is continuing to rise. This means the government is hiring more nurses and healthcare professionals to keep up with demand, which means we still have net positive cash flows. The truth is Ontario Teachers should be taking less risk than us because of the demographics of their plan."
As far as their 2013 results, Jim told me flat out: "We are happy because we maintained our fully funded status and even added to the surplus. We don't care if the Caisse returned 13% in 2013 because they took more equity risk like most other pensions in the RBC Dexia universe. In an environment like 2013, we will underperform our peers who are more exposed to public equities but if another crisis hits, we will handily outperform them. We focus on matching assets to liabilities and mitigating downside risk."
I reemphasize that looking at headline numbers is stupid. When comparing the performance of pensions, you have to understand the risks they are taking. Also, look at the value-added over their benchmark and whether those benchmarks reflect the risks of the underlying investments. HOOPP added 209 basis points over its benchmark in 2013 after adding 289 basis points in 2012, which is unbelievable.
More importantly, HOOPP is not only fully funded, it's overfunded, which means they are in an enviable position of not having to take as much risk to reach their target rate of return and their members will enjoy increases in their benefits while the plan sponsor (Ontario gvt) will not have to contribute more to the plan.
As far as external managers, Jim laughs when he hears you have to go with brand name funds in private markets. "You can say the same in public markets. Stick to the top decile performers but good luck finding them." He added: "We scrutinize our costs and that includes conferences, traveling expenses and due diligence. It's not our money, it's our members' money."
In terms of HOOPP's winning approach, Jim emphasized it took a solid five years to implement it. They got off their old system and implemented SimCorp as their investment and accounting system. Others like AIMCo also did the same thing. "To manage assets and liabilities, you need the best investment systems and you need to have the right people to implement the new approach."
Jim told me they use a discounted cash flow model to gauge the valuations of 100 large companies and it has served them well in terms of market timing and understanding when markets are way over and under valued. "In 2008, when we sold those long-term put options on the S&P, we were collecting 800 basis points of premium off the bat with virtually no downside risk. It's the type of asymmetric payoff we pounce on when it's available."
Jim also scoffed at critics who claim all that HOOPP does is sell volatility. "That's pure nonsense. We don't do variance swaps. We specifically sold ten year put options on the S&P because the 10-year vol contracts are too volatile. Lots of players sold ten-year vol going into 2008, making great returns, but they gave it all away and got their heads handed to them in the crisis. We focus on asymmetric payoffs and mitigating downside risk."
We ended our conversation with a discussion on the current state of pension plans and how many underfunded pensions are screwed. "They will not be able to earn their way out of their underfunded status. Contributions will have to rise and benefits will decline." An ominous warning akin to the one the Oracle of Omaha recently made.
In fact, when we discussed the hope and pray strategy most pension funds are taking, Jim referred to Einstein's definition of insanity: "Doing the same thing over and over again and expecting different results." (I referred to this myself when discussing hiring practices at pensions in my comment, reversion to mediocrity).
I thank Jim Keohane for taking the time to meet me and explain their approach. I leave you with Jim's excellent speech which Kate Lahey was so kind to provide me:
Funding the retirement of our fellow Canadians is expensive and is going to get more expensive as the Baby Boom demographic bulge enters retirement. In a society like Canada where we value social welfare, we as taxpayers will end up paying for this one way or another. What I will show you today is that in the long run, it is much more cost effective to deal with the problem today by improving pension coverage and adequacy than to wait and deal with it later via the social welfare system. It is a case of “you can pay me now or you can pay me later”, but the cost of dealing with it later will be much higher.Below, an explanation of how HOOPP designs their public equities portfolio. I thank everyone involved in putting this conference together and hope to see more pension leaders get involved in the fight to save and bolster DB pensions.
You have heard from the polling results from the Gandalf group shared earlier that a very high percentage of Ontarians think there is an emerging retirement income crisis in Canada – and they are right. Indeed, there is a pension problem in Canada, but it is not one that anyone seems to be focusing on.
The real pension problem in Canada is the large number of private sector employees not covered by a workplace pension plan and the increasing trend of workplace pension plans being shifted from defined benefit plans to defined contribution plans. If this trend continues, it will cost all Canadians dearly.
This problem is most acute in the middle income group – those with incomes between $40K and $125K. Most of this group has not accumulated sufficient savings in their working careers to be able to afford to retire, and a large percentage of these workers will end up on social welfare in retirement.
OAS and GIS are already among the largest expenditures of the Federal Government, and when you look at the demographic trends it is quite frightening. Retirees are the fastest growing segment of the population and longevity continues to improve as people are living longer. You can see that this expense is about to grow rapidly.
Right now, most of the rhetoric around pensions that appears in the media seems to centre on “pension envy” - the unfairness of public sector employees having “gold plated” DB plans when a high percentage of private sector employees have been shifted to defined contribution plans, or have no workplace pension plans. And it is not a healthy discussion.
The critics of public sector pension plans would have you believe that the public view is not “I want what you have.” It is more about “I don’t want you to have what I don’t have.” But facts don’t back this pension envy view at all.
First, it would be hard to describe a HOOPP pension as “gold plated”. The average HOOPP pension is $23,000 per year. When combined with CPP benefits and their personal savings, it provides HOOPP retirees with a decent income but certainly doesn’t provide them with a lavish lifestyle.
Secondly, HOOPP plan members have put aside a significant portion of their income over their working careers to save for their retirement – typically between 7% to 10% of their gross income each year. They have saved enough to properly fund their retirement and will not be a burden on the social welfare system. They aren’t the problem.
The polling of Ontario residents that the Gandalf group has done on our behalf would suggest that Ontarians who do not have a workplace pension plan, do not have pension envy, but rather they have pension anxiety. They are very concerned that they don’t have access to an adequate workplace pension plan and they would like to have one.
We need to shift the public policy discussion to coming up with solutions that create retirement savings vehicles which can provide adequate and secure retirements for all workers.
In order to think about a solution we need to understand some of the positives and negatives of different pension plan arrangements.
It is important to understand the factors that have influenced private sector employers to move away from offering defined benefit plans to offering defined contribution plans. It is not about cost savings, it is about accounting rules and risk transference.
The Sarbanes-Oxley legislation which was enacted in response to the Enron and Worldcom accounting frauds, imposed accounting rules which effectively killed corporate defined benefit plans. In an effort to create greater transparency of off balance sheet corporate activities, this legislation required that all of these activities, including the companies defined benefit plans, be consolidated into financial reporting.
This creates significant volatility in financial results. Shareholders, not liking this volatility have put increasing pressure on the management of corporations to exit the pension business.
As a result, most corporations have closed their defined benefit plans and converted their employees to defined contribution plans.
This is not about affordability. If contribution rates stay the same there are no current savings to the employer from the shift to DB from DC. The main benefit to employers is future cost certainty.
Their obligation ends once the initial contribution is made. The burden of investing the money and obligation to make up any shortfalls is shifted to the employee and ultimately to the social welfare system.
The problem with this shift is that the vast majority of people are much better off being in a more structured plan such as a defined benefit plan.
Shifting individuals to defined contribution plans puts them in a position where they have to make decisions about their retirement savings which they are simply not equipped to make.
Unless people are in a forced savings plan, they don’t save.
They underestimate the amount they need to save.
And they don’t have the training or the temperament to successfully navigate the complex, volatile financial markets that we have to deal with every day.
Due to the fragmented nature of the defined contribution market, the cost of implementation is very high.
And DC plans are just savings plans. There is no mechanism to convert the accumulated savings into an income stream, so the individuals have to figure that out as well.
On the other hand, there are significant benefits derived from incorporating pooling in the design of a pension scheme – those being risk sharing and reduced cost.
There is significant risk sharing imbedded in the design of DB plans which benefits all stakeholders. That risk sharing is not available in individual plans.
The first of these is intergenerational risk sharing. If you were a HOOPP member and you retired in 2008, it made no difference to you pension. You got what you were expecting, because the risk was shared across multiple generations. In contrast, if you were in a DC plan and were planning to retire in 2008, the market conditions may have forced you to completely alter your retirement plans.
The second risk sharing benefit is the diversification of longevity risk. In a large scale plan like HOOPP, some of our members pass away early in their retirement years, and some live to be over 100 years old – in fact HOOPP is paying pensions to 52 members over 100, but the average mortality is quite predictable being in the mid 80’s so we can plan and set our contribution rates based on that outcome.
But if you are in defined contribution plan, you have to assume that you might live to be 100. So you have to either save a lot more, or spend a lot less in retirement to ensure that you don’t outlive your money.
This risk sharing which is part of the plan design in Defined Benefit plans provide significant savings to all stakeholders because it enables you to reduce the contribution rate yet maintain the same benefit. It also provides certainty to plan members because they know they are not going to outlive their money.
There is a broad based misconception out there that defined benefit plans are high cost. When you look into the facts you find that this is definitely not the case. The reality is that defined benefit plans provide the lowest cost of delivery of pension benefits and provide the highest amount of pension income for the dollars contributed.
A recent study published in the UK confirms this. The study compared the pension income of the average British citizen covered by a defined contribution scheme with the average Dutch citizen who is part of a defined benefit plan.
What the study found was that the implementation cost of defined contribution schemes was on average 1.5% per year higher than the cost of managing defined benefit schemes.
When this difference is compounded over the life of the plan, it results in a much reduced pension income. The study found that a British citizen who made the same contributions and earned the same investment returns ended up receiving a pension payment which was 50% lower than his Dutch counterpart.
The HOOPP fund costs bear this out. Last year, our total cost of operating the fund was 30 basis points. By comparison, most mutual funds, which is the investment vehicle used by most individual retirement accounts, have management expense ratios between 1.5% and 3% - 5 to 10 times higher!
Another interesting fact about HOOPP is that of each pension dollar paid out, only about 10 to 12 cents of that dollar comes from employer contributions. About 10 cents comes from the employee’s contribution and about 75 to 80 cents comes from investment returns accumulated over the life of the plan. So the taxpayers only contribute about 10 cents of cost of benefits.
Defined Benefit plans are by far the cheapest and most efficient scheme for converting savings to pension payments. But another import aspect of DB plans that gets overlooked is that they are also very positive contributors to the economy as you have just heard from the BCG study.
And the findings from the study were quite clear. Benefits paid to Ontario’s DB plan members play a significant role in the province’s economy, both at a provincial and local community level. Ontario’s approximately 1.3 million DB pensioners channel an estimated $27 billion back into the economy annually in the form of consumer spending. This generated $6 billion in tax revenue back to the government through HST, income tax and other tax sources.
Overall, payments to DB plan members have an especially important impact in some of the smaller municipalities in Ontario.
In some of the well known retirement communities such as Elliott Lake(37%) and Collingwood (25%), the significant portion of the community income coming from retirement benefits is perhaps not surprising. But in it is also quite a material part of the economies of many other Ontario municipalities such as St. Catherine’s at 22%, Kingston at 21%, and Thunder Bay at 20%.
One interesting learning that came out of the study was a snapshot of the difference in spending patterns between those with Defind Benefit plans such as HOOPP and the group who are not part of defined benefit plans.
The study found that retirees who were members of defined benefit plans, because they had predicable income and knew that another cheque was coming next month, and they knew that they would not outlive their money, they actually spent the income they received.
On the other hand, a very different spending pattern was exhibited by retirees who were not part of Defined Benefit plans. They found that this group became savers in retirement because did not save enough during their working careers. Due to income uncertainty and concern over outliving their savings, they did not spend and deferred purchasing and discretionary items.
This implies that if the trend of employers moving from DB to DC plans continues it could have a long term dampening effect on economic activity.
Recent research from Towers Watson found that the typical DC plan in Canada only replaces about 15% of retiree’s pre-retirement income. Contrast that with a typical DB plan like HOOPP which replaces 60% of pre-retirement income. From that you could imply that if all DB participants were shifted to DC, economic activity from that source over time could decline by up to75%.
Defined benefit pension dollars, directed towards consumer goods and services, are instrumental in supporting local businesses in smaller communities across the province. Given the economic importance of Defined Benefit plans in these centers as indicated in the BCG research, removing pension income derived from these plans from the economy would have a material negative impact on local businesses across the province.
Additionally, the study showed that DB pensions reduced the need for government assistance programs such as the Guaranteed Income Supplement (GIS). According to the study, an estimated 10 – 15 % of DB pensioners in Canada access GIS as opposed to approximately 45 – 50% of non-DB pensioners, significantly reducing the cost of this national program.
I mentioned earlier that the primary motivation for employers to shift from DB to DC plans was about risk transference.
You could say that private sector employers are acting perfectly rational in making the shift from DB to DC.
If they are able to shift this risk off of their books and onto the books of individuals and the social welfare system, and if the government lets them do it, then that is exactly what they should do.
But if you are a government employer, this is not such an obvious choice. The risk does not go away.
As a government, you are simply shifting the risk from you the government as an employer, to you the government as the administrator of the social welfare system.
For governments, particularly in a country like Canada where social welfare is a highly prized value of our society, a shift from defined benefit plans to defined contribution plans simply makes no sense.
It increases the cost of delivery which ultimately decreases the funds available to pay pensions which in turn will create an increased burden on the social welfare system.
This is simply kicking the can down the road, but down the road it creates a much bigger problem because there is less money available to pay pensions.
So what is the solution? What can we do to create broader pension coverage so that more Canadians can adequately save for their retirement?
The conclusion that the facts draw you to is that defined benefit plans, rather than being thought of as part of the problem should be thought of as a key part of the solution.
Ideally, what we would like to create is a plan structure with some of the attributes of a defined benefit plan which works for most employees, yet also meets the employers need for cost certainty and doesn’t become a burden on taxpayers down the road.
HOOPP has been a successful organization for a long period of time. We have been meeting the needs of employers and employees in the healthcare sector in Ontario for over 50 years.
HOOPP has one of the top track records of any pension plan globally over the past ten years, with a 10 year compounded return of just under 10%. That stability has enabled us to maintain our contribution rates and benefits throughout the financial crisis, so the cost to Ontario Taxpayers has not gone up, and we have the lowest contribution rates of all the major pension plans. We are also fully funded, with a funded ratio of 114%, meaning we have more than enough assets on hand to meet current and future pension obligations.
Under the current terms of reference, HOOPP would be labeled as a shared risk target benefit plan. We think that the structure of the HOOPP plan has many of the features which go a long way towards meeting the needs of both employers and employees.
The HOOPP structure is a good model to be used as a starting point for the design of a supplemental pension plan to be combined with CPP benefits.
Some of the design features of the HOOPP Plan which should be incorporated in the design of a new plan include:All of these features could be applied to constructing a pension scheme that works.
- Have an income replacement target of 50 to60% of employees working income when combined with CPP benefits.
- Have contingent benefits which can be paid when they can be afforded but may need to be altered when there is insufficient funding.
- Shared longevity risk which makes the plan more affordable and assures retirees that they won’t outlive their money.
- Seamless conversion of savings to retirement income
- Have an organizational structure which is independent of both employers and government and be operated as a business with the sole objective of meeting the intended benefits
- Have very tight risk controls
- Have limits on future funding risk for employers and taxpayers
- Have sufficient scale to keep costs low
- Have portability across employers.
Supporting our fellow citizens in their retirement will not be cheap, but we are going to pay for it one way or another. If we fail to create schemes where people can accumulate sufficient savings to pay for their retirement then they will end up on social assistance. It is a case of you can pay me now or you can pay me later, but the cost of paying me later is much higher.
Globally, Toronto is considered a centre of pension excellence. The large scale Ontario based Pension Plans are considered to be among the best managed pension plans in the world. We have a significant amount of expertise here in Ontario which can be brought to bear on the retirement challenges we face.
But to do this, we need to shift the debate. We need to move away from talking about breaking what is fixed to moving towards fixing what is broken.
Retirement income adequacy is one of the most important social issues we will face over the next couple of decades, so it is critical to get it right.