CAP members need to start focusing on contributions
Since 2006, changes in markets and interest rates have led to a drop in the average capital accumulation plan (CAP) member’s replacement income ratio—to 62%, down from 88%, according to Eckler’s CAP Income Tracker (CAPit). What’s interesting is that the 25-year investment strategy of plan members who retired in September 2013 had a very small impact on their final replacement income. In fact, CAPit figures reveal that investment strategies have less impact on replacement income than steady plan contributions. CAP sponsors definitely need to take this into account when considering both plan design and strategies for communicating with members.
Not surprisingly, CAPit data indicate that aggressive, equity-heavy investment strategies and balanced portfolios produced the greatest volatility during a plan member’s accumulation career as well as the sharpest declines, especially from 2008 to 2010. Falling interest rates since 1981 have caused conservative portfolios (70% bonds, 30% equities) to deliver the highest replacement income during almost all times—except for the strong bull markets of late 1999, early 2000, and the period from 2006 to 2008. However, interest rates are expected to climb in the future, so these trends will likely reverse, with equity-based strategies producing higher returns and more conservative ones lagging behind.
Contribution is King
Of course, CAP sponsors and members have no control over the economy—and no crystal ball to predict the long-term impact of different investment strategies. But they can control how much they contribute to their plans. CAPit data show that this is the most crucial factor in building replacement income over time.
Consider that CAPit’s benchmark member is assumed to contribute 10% of income annually to retirement. At a contribution level of 8%, the member’s replacement income ratio at 65 would be 56%. On the other hand, a contribution level of 12% would increase the replacement income ratio to 68%.
With conventional wisdom pegging the ideal replacement income ratio at about 70%, CAP members should be saving more than 12% of their income annually. Yet we’ve seen a discouraging drop in employee contributions to pension plans. Benefits Canada’s 2013 CAP Member Survey shows that employees contributed an average of 5.1% this year, down from 7.3% in 2007. Even when one factors in the matching company contributions enjoyed by some CAP members, there’s plenty of ground to make up if experts believe that members should save at least 12% of their income every year.
Act Now
So what can sponsors do? Making the plan mandatory, with immediate eligibility for new staff, is the best way to ensure that members save enough. Using a contribution formula that keeps the employer cost unchanged yet encourages higher member contributions can also help employees reach a certain contribution level.
Additionally, employers can encourage members to save more by communicating the significance of a contribution rate change of plus or minus 2% on replacement income.
Finally, sponsors offering plans that allow withdrawals should evaluate member behaviours and whether the plan meets its original goals. Too often, people in group RRSPs use them as another form of direct pay, withdrawing the employer’s contributions.
Longevity is increasing, yet investment returns are more volatile, and interest rate changes are not going to boost portfolios as they have in the past. For CAP members to retire comfortably, both sponsors and members should ensure that contributions are high enough.
Janice Holman is a principal and leader of the DC consulting group with Eckler Ltd. jholman@eckler.ca
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