This formula will yield an answer in dollar terms which can be compared to the intended result. But there is a fourth—and hidden—factor: “E”, which represents member expectations. While the sponsor who designed the plan might look at the numbers believing the CAP is on track to deliver what it promised, the plan’s members may have different expectations. Member expectations can arise from various sources, including the often-repeated target of a 70% income replacement ratio to achieve a comfortable retirement.
While sponsors usually examine whether a CAP is delivering on its promise through the formula above, if the CAP members are expecting a 70% replacement ratio, there is now a new benchmark for the compliance comparison. Of course, the 70% replacement ratio includes all sources of retirement income—public plans and personal assets—as well as the CAP. Because income from government plans is determined by an individual’s income level, it makes sense to segment the plan’s membership by income when testing the CAP’s compliance with its purpose—and member expectations.
THE NEW EQUATION
The magnitude of the risk to the sponsor is driven by the size of the gap between member expectations and the actual payout. The larger the gaps, the bigger the risk to be managed. Some may view it in terms of the likelihood of a successful lawsuit and the size of the settlement. Once the risk measurements have been done and the gaps identified, it is time to consider what remedial action the sponsor can take to manage the four factors that form the risk equation (E = C(1+R)t). The sponsor may not have 100% control over these four elements, but they can exercise their influence to reduce the plan’s risks.
• Managing expectations is an ongoing process. It starts with explaining the purpose of the plan and promoting member use of projection tools and understanding of how contributions accumulate and convert into retirement income. Sponsors might also consider twoway communication such as surveys and informal focus groups. Pension planning can be complicated for the average employee, so it’s not enough to simply tell them what they should expect. It’s also important to find out the messages they are receiving, the impressions they have formed and any misunderstandings they may have.
• It is obvious that raising contributions will help close a gap between the expectation and the eventual payout. But, the increase does not have to come entirely out of the sponsor’s pocket. Creating new opportunities for voluntary member contributions can also lower the risk of not meeting expectations. For example, if there is an annual bonus program, employees can be encouraged to roll their money, pre-tax, into the savings plan.
• No one directly controls the “R” factor, but the sponsor can encourage good investment habits, minimizing the number of employees who default into short-term funds, promoting asset allocation strategies, and avoiding market-timing practices. All of these initiatives will help optimize the long-term rate of return.
• The time element is controlled by encouraging early participation and minimizing withdrawals.
None of these measures can be considered rocket science. Together they form the foundation of a practical, common sense risk management process any CAP sponsor can follow. With a maximum of four factors, the formula for success is simple.
Roger Renaud is senior vice-president, group savings and retirement at Standard Life in Montreal. roger.renaud@standardlife.ca
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