Decumulation poses many challenges and risks for Capital Accumulation Plan (CAPs)
sponsors and members.
Fuelled by the increasing number of retiring ‘boomers’, more attention is now being focussed on the CAP decumulation cycle. The assumption that the decumulation cycle starts upon retirement is a mistake – it begins 10-15 years in advance of retirement when there is still an opportunity to make changes. The recent equity market collapse heighten the issues of drawing down retirement savings accounts i.e. decumulation phase.
(Statistics quoted in this article refer to the 2015 Benefits Canada CAP Member Survey -BC Survey)
CAPs are often referred to as pension plans. A Defined Contribution Pension Plan (DC) is not an employer pension plan it is a personal savings plan: “A pension plan is a retirement account that an employer maintains to give you a fixed payout when you retire i.e. a Defined Benefit type of plan.” DC or RRSP programs in fact are personal DB (Defined Benefit) pension plans. All the risk lies with the members! CAP sponsors usually emphasize that a DC is only intended to assist in saving for retirement however, the average member is not financially savvy or sufficiently engaged to appreciate this difference.
A DC (RRSP) plan should be managed as if it was a personal Defined Benefit plan or, an Individual Pension Plan (IPP). The decumulation cycle, or payout phase, is also the critical aspect of all pension plans i.e. asset accumulation sufficient to cover your underlying personal pension funding “liability”.
CAP Guideline # 8 highlights the key issues in the decumulation cycle:
· the payout phase and retirement products;
· the diminished role of the administrator in the ‘payout phase’;
· the investments in the payout phase; and,
· the need for retirement product information that facilitates informed decision making.
The payout phase begins when DC members draw funds out of their DC accounts. At that point members must transfer their accounts to a retirement product offered by the fund holder (record keeper) or another financial institution. It is important to inform (and remind) members of their role and responsibilities, about the termination options and what happens to their account in the payout phase. Recently, 24% of the BC Survey respondents indicated they had a poor understanding of their plan. 41% of the respondents also believed the employer is responsible for providing them with adequate funds for retirement
Only 10% of respondents in the BC Survey understood the options available in the payout phase and even fewer understood how much they needed to contribute to achieve their retirement income goals. Drawing down savings in the payout phase is also a challenge for members.
Disclosure regarding retirement products is a grey area. What kind information, if any, should be provided regarding the retirement products of other financial institutions? Should the pros and cons of annuities be clearly explained to members? If the sponsor delegates these tasks to the record keeper, disclosure expectations should be laid out and monitored because of the potential for conflicts of interest. As a fiduciary, the administrator must always act in the plan members’ best interests.
Education and Communication Education, communication and member engagement are critical. They are also the most likely areas for legal disputes. Information and education in the decumulation phase is neccessary to mitigate the risk of litigation but what should this include? CAP members must understand that once they leave their employment organization or are in the payout phase they are no longer plan members and, the sponsor is not responsible for communication and education (unless it is a Variable benefit Plan). A member will not get the same level of attention, education or communication from a financial institution as provided by an employer.
Up to-date information about the differences between DC plans, RRSPs (and TFSAs if provided) in the payout phase, should be highlighted well in advance of retirement.
Fees reduce asset accumulation. Members need to be aware of fees in all stages of retirement saving. Fees differ for each investment option. In most cases memebers only see gross return data (before fees). They need to see the gross returns net fees for each investment option in order to effectively select investments, particularly in the pay out phase. The issue of higher fees for retirement products is often conveniently ignored by CAP sponsors or, by members when developing a financial plan.
The CAP Guidelines recommend that CAP members consider using a financial advisor. While 79% of the BC Survey sponsor respondents agree that providing an advisor would be beneficial it is uncommon because of legal concerns. Having an advisor would benefit most members to develop a financial plan and to set realist saving, return and retirement income goals however, it also results in additional fees.
Since the members pay the cost of the record keeper, fund manager and advisor from their CAP accounts they should see what was actually taken out of their account and paid to each party in Investment Management Fee (IMF). Since members do not see the monthly or annual IMF paid it tends to be overlooked. Members should insist that the totally amount taken out of their accounts for fees be disclosed, at least annually.
Longevity, Time and Timing
CAP members are encouraged to view their retirement savings with the long term in mind. For example, members are often told they are “in it for the long term”. This is misleading in the pay out phase since it depends how long you live. The CAP Guidelines recommend that sponsors offer a range of investment option that take into consideration the purpose of the plan and the diversity and demographics of the members. Sponsor investment options often do not address these basic requirements in the payout phase.
Longevity risk is increasing: 65 year old males are now expected to live another 21 years and females 24 years. CAP members need to consider their spouse’s expected life spans and retirement income needs. The impact of a spouse out living the member is often overlooked as well as potential tax and estate implications when a member dies. From a fiduciary perspective current actuarial mortality estimates, by location and industry when appropriate, should also be available to members regardless of whether or few members use this information.
Longer duration investments such as a long bond funds that better match members’ funding (liability) requirements are common in DB plan investments but seldom available in CAPs. Service providers argue that the concept of a personal pension “liability” that must matched by investments and funded, is too complex and confusing for members. Confusing or not, longer duration investments should be part of the investment options to ensure they are providing appropriate investment opportunities for all members.
CAP members often have unrealistic return expectations. For example in the BC Survey the average CAP member expected annual returns of 15% or higher. The Economist recently reported that the median professsionally managed pension fund return over the last 25 years was 8.5%. A recent article in the Globe and Mail suggested that the expectation for future equity returns should be in the 8% range. With 10 year Canadian government bonds trading around 1.5% and with a 60% fixed income and 40% equity asset mix future balanced fund type returns of 4-5% are likely.This is before fees, taxes and inflation. A reality check is obviously needed: one would assume it is the sponsors responsibility to ensure that current future return expections would be provided rather than leaving it to a member’s “best guess”.
The impact of volatility and timing is a critical aspect of investing in the decumulation cycle, particularly in the payout phase. While volatility has a high profile in DB plans because of solvency funding requirements it is generally overlooked in CAPs. Only 31% responding to the BC Survey indicated they understood investment risk. At best most members have a superficial understanding of risk which is understandable given it is a challenging topic for professional investment managers. Members need to understand how difficult it is to recover from loses, particularly in the payout stage. From a fiduciary perspective risk information i.e. standard deviations, tracking error and information ratios, should be available to CAP members.
The short vs. long term focus in CAPs is demonstrated by the fact record keepers provide performance data for ten or less years – a mid-term view at best. Longer term risk and return information is appropriate for longer term retirement saving objectives however it is often not provided.
Communication and education are particularly critical in the decumulation cycle and payout phase. Two critical questions to consider in the decumaltion cycle: “Is sufficient performance information, and are appropriate investment options being provided to CAP members?”
Gerry Wahl, Managing Director, The Pensionadvisor