Defined benefit pensions must balance adequacy (producing enough retirement income) with sustainability (lasting until all retirees die). As a priority, sustainability always wins. When a pension is inadequately funded, it will cut the benefits it distributes to members before it will shut down (think Nortel and Sears).
The same principles of adequacy and sustainability apply for RRSPs and defined contribution pensions. Today’s low interest rates, higher job turnover and limited workplace pension access puts pressure on this balancing act.
Four accepted ways to improve retirement income prospects are:
- save more before retirement (spend less after);
- start saving earlier;
- work longer; and
- take more investment risk.
There are few good substitutes for saving more and starting earlier, but education, family and careers get in the way. Working longer is an option, barring health issues, but eventually only one choice remains: taking more risk. Unfortunately, by the time other options are exhausted, taking more risk may not be a great idea.
For an Ontario teacher earning a $100,000 salary, the annual combined employee and employer contributions of about 24.4% currently replaces 70% of income after 35 years of service (2% per year of service). This pension, considered quite adequate, comes with a high cost to teachers and taxpayers: lower take-home pay today for the teacher and a substantial matching commitment by Ontario taxpayers.
To put the adequacy of that public-sector pension in perspective, the same benefit from a 60% stock, 40% bond portfolio would require a person to contribute about 27.6% of salary annually, before costs. My colleague Ioulia Tretiakova and I derived this figure from our paper in the Rotman International Journal of Pension Management (2011). Even if an employer contributes half (13.8%), it’s a big bite from current consumption.
Nonetheless, employees tend to bargain for adequacy (higher pensions), while employers fight for sustainability (lower costs and lower matching contributions). Public-sector pension plans are examples of politicians funding pension adequacy with future taxpayer commitments that may not be sustainable with an aging population.
When there’s no time to save
For DC pensions and RRSPs, both adequacy and sustainability can suffer, since many people find it difficult to sacrifice consumption now for secure retirements later without an employer’s mandate, forcing retirees to take more risk later.
Despite these constraints, RRSP and DC plan investors also expect consistent income replacement in retirement. As such, the investment industry must develop new approaches to harvesting returns when there is no time to save more.
This is a goals-based problem requiring a liability-driven investment solution (LDI) rather than the return maximization one (modern portfolio theory, or MPT) that most investors and advisors use.
The tools for each approach are different. Under return-focused MPT, investors choose the most aggressive asset mix that will allow them to sleep at night. For goals-focused LDI, the risk of not achieving the targeted income in retirement is more important. The viability of LDI is supported by a September 2017 study from Allianz that showed 63% of Americans surveyed are more afraid of running out of money in retirement than dying.
If your clients are at risk of running out of money and it’s too late for them to save more, taking more risk is the only option. This strategy comes with the added hazard of being forced to withdraw funds when the market is down. This sequencing risk can be partly addressed by minimizing portfolio volatility. When designing retirement portfolios and adding risk, I include a minimum-volatility ETF for Canada (see Table 1), BMO Low Volatility (ZLB). Other low-volatility products exist for other regions, but maintaining a constant level of volatility (standard deviation) would be best. The U.S.- NYSE Arca-traded DeltaShares S&P 500 Managed Risk ETF (DMRL) is included because it follows this disciplined risk management approach. Ideally, a Canadian ETF sponsor will launch a series based on the S&P Managed Risk Series that would allow investors and their advisors more sophisticated tools with which to construct goals-based and retirement portfolios.
Since this is not yet the case, keeping volatility low will give the portfolio the opportunity to grow from exposure to asset classes with better return prospects than bonds.
Table 1: Low-volatility products
|Canadian equity||BMO Low Volatility||ZLB||0.39%|
|U.S. equities||DeltaShares S&P 500 Managed Risk||DMRL||0.35%|
Mark Yamada is president of PÜR Investing Inc., a software development firm. Disclosure: PÜR Investing Inc. provides risk-based model portfolios to Horizons ETFs.