Pensions are inextricably tied to the economy, said Malcolm Hamilton, an actuary with Mercer (Canada) Ltd., speaking recently in Toronto at the Association of Canadian Pension Management’s spring session, Checking the Pulse of Pension Reform.
“If the markets do well, any pension will work. If the economy is bad, any pension—no matter how good—will fail,” he said.
Hamilton illustrated his point with a look at two 20-year periods. Between 1960 and 1979, the median Canadian pension fund earned a 1.5% real rate of return, and between 1980 and 1999, the median fund earned an 8% real rate of return. “These are profound changes.”
In the last decade (2000 to 2009), the median pension fund earned a 3% real rate of return. But while it’s not the 1.5% return of the ’60s and ’70s, Hamilton said that there’s a sense that things are still bad now. “We’re looking at 50-year low interest rates,” he said. “The DB plan is no longer affordable and never again will be.”
What’s different this time?
- Population is aging and plans are at maturity — “Plans are never going to go back to being immature, and the population is not going back to be as young as it was in 1970s,” said Hamilton.
- Fiscal imbalance, sovereign debt — “That’s different than it was 20 years ago—not so much in Canada, but if you look to the U.S. (high deficits, high debt) and the rest of the world,” he added.
- Monetary policy — Federal Reserve chair Ben Bernanke is in a circumstance that no banker has been in, said Hamilton, adopting policies that no one has ever used. It’s too early to tell how these policies will play out, he continued. “We’ve gone to a place where we’ve not had much guidance from history.”
- Rise of emerging economies — This is positive in the long run, said Hamilton, but we don’t know how it will affect things over five to 10 years.
- Technology and innovation — While revolutionary products and mobile communications are positive, Hamilton said that we don’t know how they will play out.
“We are living in the shadow of a financial crisis and may be for some time,” he said. “This is not likely going to be business as usual.”
The pension affordability problem
As for making pensions affordable, Hamilton said longevity is only a small part of the problem. Between 1960 and today, the life expectancy for a 65-year-old Canadian increased by five years, or about one year per decade. But the impact on pension costs for unfunded plans adds 30% to the cost over 50 years. For fully funded plans, it’s 15% to the cost over 50 years.
Fertility rates, on the other hand, have a huge impact on unfunded plans with a 100% addition to the pension cost. For fully funded plans, it’s 0%. (Between 1960 and today, fertility rates have halved in Canada.)
Interest rates—which between the mid-1990s and today have declined from 4.5% to 1%—add 150% to the cost of fully funded plans, but add 0% to the cost of guaranteed fully indexed pensions.
Hamilton believes that longevity will continue to increase (but the pace will be uncertain) and that fertility rates may increase, but not to earlier levels. And as government, banks and individuals grow accustomed to low interest rates, he said, it will become harder for central banks to increase them.
Reform
So what can plan sponsors do? Hamilton made the following suggestions with regard to pensions and reform.
- Decide what role you want to play in the retirement plans of your employees.
- Quantify pension costs properly, in particular guarantees and legal exposures.
- Valuate the effectiveness of pension plans as compensation elements (Would the same amount, spent differently, do more?).
- Wait for the shape and timing of pension reform to become clear.
- Look for opportunities to use tax-free savings accounts, pooled registered pension plans, the Canada Supplementary Pension Plan and/or a “big CPP” to improve the design delivery or communication of your retirement plans.