What level of ‘pensions’ do Canadians really want?

NationalPost.com – FP/Opinion
Published: Friday, March 19, 2010 .   David A. Dodge, Alexandre Laurin And Colin Busby,  Financial Post

Canadians who desire to replace a high fraction of pre-retirement earnings with an inflation-adjusted income stream, from retirement until the time they die, must save a high fraction of their earnings each year. However, for a range of reasons, the amounts needed to do so far exceed what most individuals actually save or what employers contribute to defined-contribution plans. In many cases, they also exceed what employers consistently contribute to defined-benefit or hybrid pension plans. And they sometimes far exceed what the Income Tax Act allows.

What are the annual rates of retirement savings — beyond mandatory CPP/QPP premiums — that people of different incomes must save to enjoy what most consider to be a comfortable retirement? We have estimated the fraction of pre-tax earnings that must be saved each year, to provide lifetime inflation-adjusted pre-tax income after retirement equivalent to a target fraction of final earnings based on plausible assumptions about important economic factors. Key issues are savers’ return on investments, income levels, the age of retirement or number of contribution years, target post-retirement income as fraction of pre-retirement earnings and annuity factors.

With reasonable assumptions for an individual who begins saving at age 30, we find, for example:

– With the exception of the working poor, a high fraction of gross earnings — e.g., from 10 to 21% for retirement at 65 — must be saved every year to provide for a 70% replacement of earnings after retirement (see table). This fraction is likely higher than many Canadians believe and higher than is set aside in most employer-based group RSPs or defined-contribution plans. It is also higher than the effective contribution over time to many employer-sponsored defined-benefits plans, and for high-income earners exceeds the annual limits placed on RRSP contributions.

– Delaying saving until later in life implies extraordinarily large fractions of income — more than 20% for a significant number of above-average earners — must be saved during the last decade of working life.

– Reducing the target replacement ratio of pre-retirement income from 70% to 60%, would appreciably reduce the fraction of earnings to be saved. However, above-average earners must still save remarkably large fractions.

– Taking into account the approximate amounts of current CPP/QPP premiums charged for provision of regular retirement benefits, the fraction of gross cash payroll that must be saved to provide a target replacement income of 70% of pre-retirement earnings approaches 20% for all average and higher wage earners.

These indicative calculations suggest that Canadians (either individually or through employer plans) are currently saving far less than they need to save to provide for pensions approaching 70% — or even 60% — of pre-retirement earnings. For instance, average combined RPP/RRSP savings rates are roughly 7% of earnings for working Canadians under age 60. And this raises important policy questions.

First, are Canadians willing to give up enough current consumption during their working lives to enjoy the level of consumption after retirement that is provided by a 60% or 70% pension? Their actions suggest they are not. This may be simply because they thought they were saving enough to meet this goal. Or it may be that conventional assumptions about the desired trade-off between consumption during working years and post-retirement consumption are wrong for many, or most, Canadians.

Second, are Canadians willing to work more years and retire later in order to reduce the fraction of earnings they must save during their working years? It may be that many would prefer to work longer and save less while working in order to enjoy a high target income in retirement. Others may, of course, choose to retire earlier and enjoy lower income and consumption in retirement.

Our suspicion is that there is no consensus about the appropriate trade-offs on these two issues. Different Canadians will legitimately make different choices. But to make smart choices, Canadians — employers, employees and the self-employed — need both adequate information and, most importantly, appropriate vehicles to provide efficient risk-adjusted management of their savings both during working years and in retirement.

This gives rise to the third key question: do current public policies provide the right incentives for the development of appropriate vehicles for managing retirement savings? Much of the current public debate focuses on this question but tends to assume that we know the answers to the first two questions. The outcome of this investigation simply indicates that the level of saving necessary to provide high and secure post-retirement incomes, so that the debate on how to “improve” our Canadian pension system is well grounded.

Changes in public policy can certainly improve incentives for, and the efficient management of, retirement savings. But in the end, if Canadians want high incomes and consumption in their retirement years, they will have to save more of their incomes and forgo more consumption during their earning years.

-David A. Dodge is senior advisor, Bennett Jones LLP, Alexandre Laurin is a senior policy analyst at the C.D. Howe Institute and Colin Busby is a policy analyst at the C.D. Howe Institute.

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