My wife is the Ontario Teachers Pension Plan’s worst nightmare.
She started working as a teacher full-time at age 24, and under the current pension formula, she’s due to retire at the ripe old age of 53. Sure, that’s early, but what makes her the OTPP’s worst nightmare is another number: her life expectancy. Her grandmother passed away a few years ago, aged 100 years and 6 months.
If my wife lives as long as her grandmother did, she’ll have worked for 29 years and been retired for more than 47—and collect 1.6 years of pension income for every one year of contributions.
Longevity risks, combined with a shrinking working population, are causing enormous shockwaves in the pension system: bankruptcies in the U.S., reform in many countries and, recently, protests in Montreal. How did we get here?
The Bismarckian Trap
The first modern public pension was established by German chancellor Otto von Bismarck in 1889. An 1881 letter from Germany’s emperor, William the First, to parliament, reveals the pension was designed to provide guaranteed income to “those who are disabled from work by age and invalidity have a well-grounded claim to care from the state. ”
That pension was not meant to let someone sail off into the sunset and play golf. Quite the opposite: it was meant to take care of people who were unable to work due to the physical stresses of age, which the Germans figured would likely happen after age 70. (The pension age was changed to 65
The German model is often cited as the template for other state and private pensions that caught on around the world. But the model contained one fatal flaw: it pegged retirement age at 65.
According to researcher Patrick Liedtke, in 1881, a German man could expect to live 35.6 years and a German woman, 38.4. Even discounting for high infant mortality, few people ever collected on Otto’s promise. But today, the World Bank puts German life expectancy at 81 for someone born in 2012.
By making retirement age fixed, instead of flexible based on gains in life expectancy, pensions are being squeezed at both ends—they have to collect more money while members are working in order to pay out benefits longer.
If Otto had the foresight to make the retirement age flexible, Liedtke asked, when would people be retiring now? Try age 95! But since most people prefer certainty to ambiguity, politicians and pensions sponsors have been reluctant to move the retirement age from 65. As such, the number is sacred.
When people take risks they’re insured against, it’s called moral hazard. Driving is a perfect example. Would we drive as fast or as inattentively if we didn’t have insurance, guard rails, air bags and snow tires? Likely not. Economists say we are consuming safety improvements by taking new risks—to the extent that our total risk level returns to where we were previously comfortable.
In the case of improving life expectancy and pensions, society has certainly consumed the improvements. Until recently, most nations had mandatory retirement ages, forcing productive members of society out of the workforce and eliminating their contributions to pension regimes. Modern Western society, thereby, created the concept of modern retirement with its world travel, golf and recreation. The ability to retire at age 65 has become a confirmation of success.
To make matters worse, we further consumed improvements by supporting the vision of early retirement, of which the cultural standard is 55—10 years earlier than the ever less-meaningful target of 65. And for the lucky ones, like my wife, some pensions permit even earlier retirement.
I place the blame for this in two places: first, with pensions for offering this benefit; and second, with our industry for encouraging the dream of retirement at 55. The end result: what was sustainable for Otto is highly unsustainable for the modern world.
Unseating the sacred number
How does this impact advisors?
1. We need to remind clients that retirement is changing.
When asked when they want to retire, most clients will either pick the date their pension starts, or default to 65. Even financial planning software defaults to this age. But, as clients approach 65, many are becoming less willing to retire, even if they’re on sound financial footing. They enjoy working because they like contributing to society, and their careers form part of their identities.
As age 65 approaches, ask clients whether they truly want to retire. Many may opt to consume more in their working years, pushing back retirement age by choice. And we may start to answer questions about how much less our clients can save in later years, not more. If clients choose to work beyond 65, that increases their savings years and, more importantly, reduces their number of retirement years. This results in a decreased need for annual savings and a smaller required nest egg. This leaves the client with a few choices: keep saving at the same rate and leave a bigger legacy, increase retirement consumption, or increase consumption both now and in retirement. I’m guessing most people would favour the last choice.’
2. We’ll have to tell clients not to count on their pensions.
That’s because pensions schemes are already changing. OAS is pushing its start date back to age 67. OTPP has gone from 100% indexed, to two-thirds indexed, to indexing as a best effort. Unlike before, teachers in Ontario can’t expect their pension to maintain their lifestyles. Indexing as a best effort could mean no indexing at all. To illustrate the impact, if one assumes a 3% rate of inflation, a retiree would see her real purchasing power decline almost 50% after 20 years if indexing doesn’t come to fruition. Advisors are going to have to help these people realize that their guaranteed retirement isn’t safe, so they’ll have to start saving more personally.
Quebec public pension members are being asked to increase contributions from 30% of the annual amount to 50%, and settle for a best-effort indexation benefit. So, advisors will have to consider only contractually vested benefits as likely to occur, and realize that most clients will have to work longer than expected.
If younger clients hold 55 or 65 sacred, they’ll have to increase prior savings in order to account for changes to the pension system’s retirement age, benefit level, benefit basis (best five years versus average five years) and indexation (which will likely disappear).
While eliminating pensions from your assumptions is extreme, you’ll need to encourage clients to build a larger nest egg. Clients should plan on retiring on not just what they need, but also a fair amount more than they need. How much more? Assuming a 3% rate of inflation, no indexing, a 5% after-tax rate of return and 20 to 30 years in retirement, an investor would have to save four to seven times what their annual pension benefit would be.
So, if someone retires with a $60,000 annual pension benefit, the present value of an indexation benefit is $240,000 to $420,000. While that isn’t the biggest mountain to climb in a lifetime, a person would have to save that on top of pension contributions.