The Third Rail

Canada’s pension system is in trouble and we need to do something about it. This is the main message of the book The Third Rail, written by Jim Leech, CEO of the Ontario Teachers’ Pension Plan, and Jacquie McNish, senior writer with the Globe and Mail. The book is a fairly easy read and is worth a look.

The authors take a detailed look at pension crises in New Brunswick, Rhode Island, and The Netherlands, and describe how the problems were solved. A common theme is that the pension plans were changed to make benefit levels conditional on the returns on pension assets. On one hand this makes a lot of sense. We can’t expect pension backers (taxpayers or companies) to grow benefits faster than they can grow the savings set aside to pay those benefits. On the other hand, if we make cost-of-living increases conditional on pension asset returns, this automatically takes the pressure off pension administrators to manage the funds well. They can award themselves excessive fees or allow companies and governments to take pension contribution holidays, and the automatic reductions in cost-of-living increases will cover up the abuses. If pension benefits are going to be conditional, we need plan administrators to have strong financial incentives to run the plans efficiently and effectively.

Turning to the pension situation in Canada, the authors tell a parable about a farmer whose most productive cow dies. A chance encounter with a magic fish grants the farmer a wish. Does he wish to have his cow back? No, he says “I want my neighbour’s cow to die!” The authors claim that this is “the social dynamic of the pension debate” in Canada. Those who have no pension want to take away others’ pensions. The authors think we should instead try to build a strong pension system for all Canadians.

So the authors accuse Canadians of spitefulness, but I have practical concerns. If we take federal public servant pensions as a model, can we afford to extend such a plan to all Canadians? I think not. According to Statistics Canada, the average federal public servant retires at age 58, and only about 55% of the Canadian population is between 20 and 58 years old. If we eliminate the unemployed and those who cannot work, less than half of Canadians would be working, and this fraction will continue to decline over time. Do we really think we could run our economy including distributing food and other goods and keeping golf courses manicured if less than half of Canadians are working?

The only logical conclusion is that if we are going to design a pension system covering all or almost all Canadians, it cannot be as generous as federal public service pensions. We need a system that encourages Canadians to work later in life.

The authors describe a “longevity pension” being considered in Quebec where benefits begin at age 75. This would be in addition to QPP which generally begins around age 65. This kind of proposal makes sense to me. It says, we’ll take care of you after age 75, but if you want to retire earlier, you need to save some money.

Instead of expanding the existing CPP, I like the idea of creating another system that only pays benefits after age 75 and is entirely pre-funded. The idea is that you only get benefits in proportion to the amount you pay in. Young Canadians today could look forward to knowing that they’ll be taken care of after age 75. Until then, they have to work or save enough to live on until they reach 75.

In a discussion of expanding CPP, the authors suggest that “Ottawa could consider speeding up the delivery of enhanced pensions by temporarily bridging the gap to fully fund the new benefits.” Put another way, Ottawa could take some of the increased CPP payroll deductions of young people and give it to current retirees. I’m opposed.

The authors argue that the current system of voluntary pension savings in RRSPs fails in a number of ways. One of their main arguments is that too many people just don’t save. This is very true. And even if you don’t care about the welfare of non-savers, you end up paying for it anyway in the form of more GIS payments. Another strong argument is that “Canadian investors pay average annual management and trailer fees equal to 3.43 per cent of invested assets.” This may not sound like much, but over 40 years, this yearly fee compounds to consume 75% of assets!  (I've now investigated the references that led to the 3.43% figure and it appears to be incorrect. The origin of this figure seems to be from Table 1 of The Ambachtsheer Letter (April 2013), which indicates that the average MER in Canada is 1.93% and Trailer Fees are 1.50% (which sum to 3.43%).  These figures came from "CSA Discussion Paper and Request for Comment 81-407 Mutual Fund Fees," December 13, 2012.  Page 11249 says "At the end of 2011, the asset-weighted average MER of all Canadian mutual funds was 1.93%."  Footnote 10 says "Canadian no-load funds may pay trailing commissions of up to 1.50%."  While 1.50% may be a maximum for trailing commissions, it is far from typical.  Further, trailing commissions are a component of MERs, so it makes no sense to add in the trailing commissions again.  So, the 3.43% figure used by Leech and McNish makes no sense.  Further, it ignores other fees such as front loads and deferred sales charges.  In the end, the conclusion that total fees are very high still holds, but the 3.43% figure should be ignored.)

In contrast, “the typical defined benefit pension fund management expense ratio of 0.4 per cent” consumes only 15% of assets after 40 years. This is obviously far better, but still seems high when we see that Vanguard manages to run funds with much lower expenses. Perhaps pension plan administrators face costs that Vanguard does not.

In summary, I think the authors are right that we need to face our pension problems. They are right when they say that existing defined benefit pensions have sustainability issues. They are also right when they say there is a problem with so few younger Canadians covered by pensions. However, if we are going to have mandatory pension systems (like CPP), the focus should be on large enough benefit amounts to provide a decent standard of living but starting late in life (at least age 75). Attempts to shift money around to give us all great pensions in our late 50s or early 60s are doomed to failure.