The increasing number of retiring Baby Boomers has put the focus on the capital accumulation plan (CAP) decumulation cycle and the mistaken assumption that it starts upon retirement. In actuality, the cycle begins 10-15 years in advance of retirement when there is still an opportunity to make changes.
Part of the problem is that CAPs are often incorrectly referred to as pension plans – a defined contribution pension plan is not a pension plan. Which is defined by one popular money website as “a retirement account that an employer maintains to give you a fixed payout when you retire.” While CAP sponsors do try to make it clear that a DC is only intended to assist in saving for retirement, the average member is simply not financially savvy nor sufficiently engaged enough to appreciate this difference.
Because it is often an individual’s only source of non-government pension benefits, a DC plan should be managed as if it was a personal DB plan – like an Individual Pension Plan (IPP).
In that context, the decumulation cycle should be based on an individual’s need for sufficient assets to cover the underlying personal pension “liability”.
At the same time, plan sponsors must look closely at the decumulation cycle and their responsibilities as fiduciaries under the CAP guidelines. Here are some key areas of concern:
Retirement products
The payout phase is a critical part of the decumulation cycle that starts as soon as members draw funds out of their DC accounts. At that point members must transfer their accounts to a retirement product offered by the fund holder (record keeper) or another financial institution.
It is important to inform (and remind) members of their role and responsibilities and to tell them about the termination options and what happens to their account in the payout phase. A quarter – 24% – of respondents to Benefits Canada’s 2015 CAP Member survey indicated they had a poor understanding of their plan. A further 41% believe the employer is responsible for providing them with adequate funds for retirement
As a fiduciary, the administrator must act in the members’ best interests. Only 10% of plan members surveyed by Benefits Canada understood the options available in the payout phase — even fewer understood how much they needed to contribute to achieve their retirement income goals.
Understanding how to draw down retirement savings in the payout phase is also a challenge for members.
Disclosure regarding retirement products is a grey area. What kind information, if any, should be provided regarding the retirement products of other financial institutions? Should the pros and cons of annuities be clearly explained to members? If the sponsor delegates these tasks to the record keeper, disclosure expectations should be laid out and monitored because of the potential for conflicts of interest.
Remember: unlike a DB plan, retirement products and DC plans do not allow members to ‘replenish’ their account in the case of loses and any resulting “underfunding”.
Education and communication
Education and communication encourage engagement and are a critical aspects of CAPs — they are also likely areas for litigation. Appropriate information and education in the decumulation phase may mitigate the risk of future litigation, but what should this include?
CAP members must understand that, once they leave the organization or are in the payout phase, they are no longer plan members: the sponsor is not responsible for communication and education (unless it is a Variable Benefit Plan). A member should be told not to expect the same level of attention, education or communication from a financial institution as they get from the employer.
This may also encourage members to become more engaged. Up to-date information about the differences between DC plans, RRSPs and TFSAs during the payout phase is important and should be brought to the member’s attention well in advance of retirement.
A bigger fiduciary issue to consider is understanding where information becomes advice — e.g. Target Date Funds.
Fees
Fees reduce asset accumulation, therefore members need to be aware of them at all stages of retirement saving.
Fees differ for each investment option. In most cases only gross return data (before fees) is provided. Members need to see the gross returns net of fees for each investment option to assist them in selecting investments particularly in the decumulation cycle.
The issue of higher fees for retirement products is often overlooked by CAP sponsors and, by members when developing a financial plan.
The CAP Guidelines recommend that CAP members consider using a financial advisor. While 79% of the CAP Member survey sponsor respondents agree that providing an advisor would be beneficial, this seldom happens because of potential legal concerns.
An advisor would benefit most members with respect to developing a financial plan and setting realist saving, return and retirement income goals however it also results in additional fees.
Since the members pay the cost of the record keeper, fund manager and advisor from their CAP accounts they should see the rate paid to each party as part of the Investment Management Fee (IMF) and, at least annually, the total fees paid during the year. This information assists in assessing alternative retirement providers and products in the payout phase.
Longevity, time, and timing
CAP members are encouraged to view their retirement savings with the long term in mind. For example, members are often told they are “in it for the long term”. This can be misleading in the decumulation cycle – for example, it depends how long say a 50-year-old member is likely to live versus a 25-year-old member. The CAP Guidelines recommend that sponsors offer a range of investment options that take into consideration the purpose of the plan and the diversity and demographics of the members.
CAPs often do not address these basic requirements in the payout phase.
People are living longer than ever before — CAP members should be reminded that they need to take into account both their own and spouse’s expected life spans and retirement income needs. The impact of a spouse outliving the member is often overlooked as well as potential tax and estate implications when a member dies.
From a fiduciary perspective current actuarial mortality estimates, by location and industry when appropriate, should also be available to members regardless of whether or few members use this information.
Longer duration investments such as long bond funds that better match members’ funding (liability) requirements are common in DB plan investments but seldom available in CAPs. It has been argued that duration matching is a concept that is too complex and confusing for members.
Confusing or not, longer duration investments should be part of the investment options to ensure they are providing appropriate investment opportunities for all members.
Time and timing risk are critical in the decumulation cycle particularly in the draw down phase.
Investments
CAP members often have unrealistic return expectations. For example, in the CAP Member survey the average respondent expected annual returns of 15% or higher. The Economist recently reported that the median professsionally managed pension fund return over the last 25 years was 8.5%. A recent article in the Globe and Mail suggested that the expectation for future equity returns should be in the 8% range.
With 10-year Canadian government bonds trading around 1.5% and with a 60% fixed income and 40% equity asset mix, future balanced fund type returns of 4-5% are likely.This is before fees, taxes and inflation. A reality check is obviously needed: one would assume it is the sponsor’s responsibility to ensure that current future return expections would be provided rather than leaving it to a member’s “best guess”.
The impact of volatility and timing is a critical aspect of investing in the decumulation cycle, particularly in the payout phase. While volatility has a high profile in DB plans because of solvency funding requirements, it is generally overlooked in CAPs.
Only 31% responding to the CAP Member survey indicated they understood investment risk. Do these members have anything more a superficial understanding of risk given it is a challenging topic for professional investment managers?
Importantly, members must understand how very difficult it is to recover from loses, particularly in the payout stage as funds are being drawn out of an account. From a fiduciary perspective, risk information i.e. standard deviations, tracking error and information ratios, should be available to CAP members.
The short- versus long-term focus in CAP plans is demonstrated by the fact record keepers provide performance data for ten or less years – a mid-term view at best. To avoid market short-termism longer-term risk and return information is appropriate for longer term retirement saving objectives. It is often not provided.
Communication and education are particularly critical in the decumulation cycle and payout phase. Two questions also need to be considered: “are CAP members getting sufficient performance information and appropriate investment options?”
Stay tuned for the second post on this topic which will include strategies for dealing with these issues.