As unlikely as it may have seemed just a few years ago, over the past 18 months, retirement financial preparedness has become headline news in Canada. But even before the onset of the recent economic turmoil, many members of capital accumulation plans (CAPs) were likely in danger of reaching retirement with insufficient levels of income to maintain their standard of living. The following are some of the challenges that CAP members and plan sponsors face, both during asset accumulation and in the transition to retirement.
Retirement income replacement
There are as many answers to the question How much income is required in retirement? as there are individual retirees. And even if a specific target income amount is defined, the savings required to reach that target can vary widely.
Figure 1 calculates, over a series of scenarios, the cost to buy an annuity providing an income of $20,000 per year. For an individual with a final salary of $50,000, this would represent a 40% income replacement ratio, excluding all other sources. Including government benefits—which, at age 65, would replace just under 35% of pre-retirement income for someone at this pay level—the retiree could expect a total replacement income of about 70% of pre-retirement income.
Figure 1: Cost to buy a pension of $20,000 per year
| Cost | Conditions |
| $247,000 | Retirement at age 65 |
| $280,000 | 60% survivor pension |
| $343,000 | Pension is indexed at 2% |
| $390,000 | Retirement at age 60 |
| $401,000 | Person is female |
| $428,000 | Annuity rate is 0.5% lower |
Assumptions: 4.5% per annum annuity discount rate, UP94 mortality table projected to 2020, spouse is the same age as the member.
Figure 2: Yearly contribution required as a percentage of salary for a target balance of $343,000
| Cost | Conditions |
| 7.4% | Hired at age 25, retired at age 65, 7% fund return |
| 12.9% | 4.5% fund return |
| 17.4% | Retirement at age 60 |
| 26.3% | Hired at age 35, retired at age 60 |
Assumptions: $50,000 salary at retirement, 3% per annum salary growth, male, annuity purchase assumptions as per Figure 1 with a 60% survivor pension and 2% indexing.
Assuming that the pensioner is male, retires at age 65 and has a spouse of the same age who will benefit from a 60% survivor pension indexed at 2%, the pension would cost $343,000, as shown in Figure 1. But how much salary would the employee need to save each year to reach this target?
In Canada, the median employer contribution rate to a defined contribution (DC) pension plan is 5.2% of covered payroll. Considering DC pension plans and savings plans together, the figure rises to 5.5%. However, as Figure 2 shows, the median employer contribution level likely wouldn’t provide sufficient savings to buy the target pension. And it’s unlikely that plan members will make the necessary additional contributions to cover the risk of low returns, early retirement or a late start to savings.
Although this is a simple example, many employees and their employers might find these results surprising. Do you think your employees understand what level of assets will be needed to generate an adequate retirement income? Do they understand how to set a realistic retirement income goal? Do they have the right tools to enable them to make prudent and rational decisions to effectively manage their financial future?
For employers that provide retirement coverage through a CAP, these questions can have important implications, such as:
• an impact on workforce planning and employee retirement patterns, which may be affected by longer-term issues such as the adequacy of CAP contribution rates as well as shorter-term issues such as market downturns;
• potential litigation risk arising from employees misunderstanding how much to save, how to invest and how much to expect at retirement; and
• an impact on employee satisfaction, depending on the level of assets accumulated in the CAP as retirement draws nearer.
To mitigate these risks, employers need to articulate clearly the role the CAP is expected to fulfill within the larger context of personal savings and government programs. Education is also necessary to ensure that employees understand their financial options as they transition into retirement, including self-management of their investments, annuity purchases and other strategies.