Ontario’s ORPP is meant to address the looming retirement savings problem facing many middle-income, private sector workers like the Janets and Johns in this paper. The paper argues that the current version of the Plan is problematical in its benefit design, and in how it is targeted. It also argues that enlarging the CPP would not be the panacea many seem to think. Instead, fixing the specific ORPP problems identified in this paper would offer the targeted group of middle income, private sector workers the best hope of achieving the post-work financial security they aspire to.2
What is the Pension Problem to be Solved?
If the proposed Ontario Retirement Pension Plan (ORPP) is the solution, what is the problem the Plan is meant to solve?
There are in fact two problems:
- Millions of middle-income private sector workers in Ontario are not members of an employment-based pension plan. As a likely result, many of these workers will not save enough to finance the retirement they aspire to3, and
- As another result, many of those who think they are saving enough for retirement on their own, are being advised to pay uneconomically high fees for retirement investment services, which will result in materially lower pensions than they aspire to. 4
Ideally then, a well-designed ORPP does two things. First, it gives Ontario’s workers saving insufficiently for retirement easy access to an arrangement that (a) facilitates a simple, systematic approach to accumulating retirement savings, and (b) does so in a highly professional, cost-effective manner. Second, it gives Ontario’s workers who think they are saving sufficiently for retirement access to an effective, much lower-cost retirement savings option currently not available to them.
This paper assesses how effectively the ORPP, in its currently proposed form, is likely to achieve these two goals. The currently proposed form is likely to fall short in two important ways: in plan design, and in how it is targeted. The paper suggests four measures that would make the ORPP a better-designed, better-targeted vehicle.
It’s all about Janet and John
A lot of the commentary we are reading on the ORPP proposal is not about the people it is meant to serve. Federal and provincial politicians are divining the vote-getting potential of pro- and con-ORPP stances. Organized labour keeps beating the single ‘expand the CPP’ drum. The financial services industry is gauging the various options from their own profit potential perspectives. Employer groups worry about mandated increases in their labour costs. The media don’t really understand the issues. Economists call all these perspectives ‘agency issues’.
This paper assesses the ORPP proposal from the perspectives of Janet and John, two middle-income Ontario workers who are not members of an employment-based pension plan. They are the ‘principals’ in this ORPP conversation. Here is a simplified description of their situation:
- Janet and John work for 40 years at a pay of $60K/yr, live 20 years after retirement, and need $40K/yr to maintain their post-work standard of living.
- Assume the first $20K/yr comes from a combination of OAS/CPP payments to Janet and John and their spouses.
- In this (again, simplified) example, it is the second $20K/yr for 20 years that they need in some way to generate themselves.
Where is this second $20K/yr for 20 years going to come from?
Financing Janet and John’s Supplementary Pension
The simple answer is that it comes from saving part of the $60K/yr earnings. How much needs to be saved to finance 20 years of retirement? That depends on whether or not the retirement savings are invested, and what return they earn. Consider two cases: 0% and 4%:
- Assuming a 0% return, Janet or John will need to have accumulated $400K at retirement to fund the 20 payments of $20K/yr. This means saving $10K/yr over the 40 working years, or (about) 17% of pay.
- In contrast, with a 4% return, Janet or John will have to save about $3K/yr, or only 5% of pay. For clarity, we assume the money earns 4% in both the pre- and post-retirement periods. The importance of this calculation should not be underestimated: earning 4% rather than 0% reduces Janet and John’s pension financing cost by 70%!
- The calculations also point to two uncertainties facing Janet and John: 1. They don’t know how long they will actually live, and 2. They don’t know what the return on their retirement savings will actually be.
- These two uncertainties raise a fundamental question: who will underwrite the shortfall risk between expected and actual longevity outcomes and between expected and actual investment return outcomes?
- Decades ago, employers underwrote the shortfall risks in the form of traditional defined benefit plans. At the time, this seemed like a reasonable thing to do. Workforces were relatively young and homogeneous, economic growth was robust, investment returns were strong, and regulatory and financial disclosure requirements were ‘soft’.
- These days are gone. Today’s retiree populations are relatively larger, workforces are older and less homogeneous, economic growth is less robust, investment returns are weaker, and regulatory and financial disclosure requirements are ‘harder’.
Not surprisingly, employers are far less keen to be pension risk underwriters today. That is why traditional DB plans are now under siege. It is also the reason why Janet and John are no longer members of an employment- based supplementary pension plan, and why an ORPP initiative has merit today.
Three Design Principles for Helping Janet and John
Setting out some ORPP design principles to guide how to best help Janet and John is a good place to start. Here are three:
- Keep it simple, sustainable, and smart: in contrast, actual pension designs easily veer towards complexity (e.g., participants don’t understand the pension contract), inflexibility (e.g., lack of choice), and unfairness (e.g., unintended wealth-transfers between plan participants).5
- Recognize and acknowledge path-dependency: pension arrangements that have been in place for decades (e.g., the CPP, traditional DB plans) cannot just be undone, or arbitrarily changed. Whatever reforms are instituted must recognize, and be consistent with the pension paths that got us to today.
- Take full advantage of Ontario’s strengths in pension governance: these strengths are formidable, and should be fully tapped.
Next comes an assessment of the ORPP proposal as it currently stands.
Four Current ORPP Proposal Shortcomings
With these three principles in mind, I see the current ORPP proposal falling short in four ways:
- The lack of a clear definition of the ORPP pension benefit: the ORPP currently proposes to eventually generate 15% of Janet and John’s average gross income up to $90K as a supplementary pension on top of current OAS/CPP benefits, or $9K/yr for Janet and John in our simplified example (i.e., 15% of $60K). This is to be financed through a supplementary 3.8% of salary contribution rate, split 50/50 between employee and employer.6 While the language of the proposed ORPP implies there is a payment guarantee to Janet or John somewhere in the plan design, there is no mention anywhere as to how, and by whom, this guarantee would actually be underwritten. There is also no explicit mention of the net return assumption(s) behind these calculations.
- The lack of a clear definition of an acceptable alternative supplementary pension design: the intent is to only require employers not already offering an acceptable supplementary pension plan to participate in the However, there is currently a ‘what is acceptable?’ question, with the government indicating that ‘acceptable’ plan designs should have a lifetime income ‘back end’. This definition would eliminate all current DC and Group RRSP plans, no matter how generous the contribution rate, from qualifying as an ‘acceptable’ supplementary pension plan.
- The absence of choice for Janet or John: for example, the ORPP is proposed to be mandatory, without giving Janet or John the option not to participate. This feature is especially problematical for low- income workers who stand to lose Guaranteed Income Supplement (GIS) benefits by being forced to participate in the ORPP.
- Not acknowledging the plight of the Janets and Johns who are currently saving using high-cost investment vehicles: as currently framed, the ORPP’s focus is on increasing the savings rate of middle- income workers without pension plans, and not on the equally-important issue of raising the management cost-effectiveness of the billions of dollars of already-existing individual retirement savings.7
In addition to these four ORPP shortcomings, there is a fifth lurking in the background. It is the ongoing lament that if only there was a federal-provincial consensus to expand the Canada Pension Plan, we wouldn’t need the ORPP. This view is being voiced not only by the Ontario Government, but also by the two federal opposition parties, by organized labour, and even by the Globe & Mail editorial board. In my view, this broad-based lament suggests a fundamental lack of understanding of the economics of the CPP, and of the importance of recognizing the path-dependency principle set out above.
Why CPP Expansion is the Wrong Way to Go
The CPP was established 50 years ago in response to the recognition that the Canadian seniors’ poverty rate was unacceptably high. The Plan was set up as a pay-as-you-go system, with payroll deductions quickly converted into modest pension, long-term disability, and death benefit payments. In the beginning, with all workers contributing, and only a few people eligible to collect CPP benefits, it was a low-cost system. However, after 30 years of operation (i.e., by the mid-1990s), the system had matured considerably. By then, rising future CPP benefit payment projections implied future pay-go contribution rates would rise to unacceptably high levels. A federal-provincial consensus was reached to quickly double the CPP contribution rate to its current level of 9.9% of pay. This would create a large-enough reserve fund (to be managed by the CPPIB) so that under reasonable economic, demographic, and investment return assumptions, the 9.9% of pay contribution rate could be maintained into the indefinite future…..and that has been the case so far.8
The reason for this brief recounting of CPP history is to point to the significant wealth-transfer embedded in its 50-year history. Essentially, in the beginning, younger generations of Canadians ‘gifted’ CPP benefits to older generations. The measure to move the CPP from a 100% pay-go system to a 25% prefunded system was intended to prevent any further wealth transfer of this kind in the future. To ensure this, the CPP reformers of the 1990s amended the CPP Act to require that any future CPP benefit enhancements would have to be fully pre-funded. That is, any proposed benefit enhancement today cannot go the ‘pay-go’ route. Instead, it would have to be priced, and paid for as the enhanced benefits accrued over time.
All this exemplifies the importance of recognizing the path-dependency principle set out above. As part of the CPP story, the prefunding requirement raises fundamental questions I have not seen addressed by the CPP expansion enthusiasts. Here are three examples:
- What discount rate are they proposing to use to price any benefit enhancement?
- Will these benefit enhancements be guaranteed? If so, by whom?
- How do they propose to ensure that future generations will not be underwriting the risk that the CPP benefit enhancements we are granting (and pricing) ourselves today are too rich?
My suspicion is that consciously or unconsciously, the CPP expansion enthusiasts would like to do an end-run around the ‘no more wealth-transfers’ safeguards put in place by the CPP reformers of the 1990s. This is not a place we should be going.
Making the ORPP Work for Janet and John
The simplest, most direct way to help Janet and John is to enrol them in an understandable, stand-alone ORPP which sits on top of the current CPP/OAS/GIS structure, and has four key features:
- A design that aims for (but does not guarantee) a post-work income replacement rate based on sensible contribution rate/investment return assumptions. The goal could be the 15% income replacement rate and the 3.8% contribution rate in the ORPP proposal, but it would have to be clear to Janet and John that underlying these numbers are plausible work-period length and net investment return assumptions. The design is life-cycle-based. This means that Janet and John need to have access to a cost-effective, long-term, return-compounding investment instrument, and to a cost-effective, guaranteed income-for-life instrument, as they travel through their financial life journey. There should be an ‘auto-pilot’ transition mechanism to guide the weightings of their exposure to each instrument based on their age. Janet and John should be able to override these ‘auto-pilot’ rules if they so choose.9 The design must also feature a user-friendly member communications protocol. Janet and John should be given regular reports on how their financial life journey is unfolding. Working backwards from their pension goal on their hoped-for retirement date, are they ‘on track’? And if not, why not, and what are the possible action implications for them?10
- Auto-enrolment into the ORPP of all Ontario workers without a qualifying employment-based pension plan: this would be a mandatory employer requirement. However, there would be an opt-out clause for Janet and John if they choose not to participate in the Plan.11 The ‘opt-out’ feature is especially important to Ontario’s workers with permanently low incomes. They would be subjected to GIS claw-backs if they eventually collected ORPP The value of this opt-out feature should be clearly spelled out to them in ORPP communications.
- The ‘qualifying pension plan’ definition: to qualify as an alternative to the ORPP, an employment-based pension or retirement savings plan should have a contribution rate at least as high as that of the ORPP.12 In my view, it is important that employers can choose an alternative provider to the ORPP, as long as it has the same (or superior) design features to those of the ORPP.13 Fair, transparent competition will lead to better outcomes for Janet and John.
- Open architecture: this feature would allow Janet and John to move any retirement savings they have already accumulated on their own into the ORPP if they so choose.
A fifth requirement to make the ORPP work for Janet and John is to ensure that it is set up as an arms-length institution with a stakeholder value-creating mindset. Ontario did this in 1990 when it, together with the Ontario Teachers Federation, created the Ontario Teachers’ Pension Plan. Today, OTPP ranks #1 in the world in long-term investment performance and benefit administration quality.14 Janet and John deserve no less.
- Keith Ambachtsheer is Director Emeritus of the International Centre for Pension Management at the Rotman School of Management, University of Toronto. He is a member of the Ontario Government’s Technical Advisory Group on Retirement Security. See paper appendix for full bio.
- The paper benefitted from a number of expert reviewer comments. However, the views expressed here are solely mine.
- ORPP critics observe that the targeted group of middle-income, private sector workers retiring with insufficient savings is relatively small today. The question is: will that still be the case 20, 30, 40 years from now? There is a plausible ‘will not be the case’ scenario that justifies the ORPP initiative (i.e., more student debt, later workforce entry, and no more ‘wind-in- back’ boosts from robust economic growth, and from robust financial and real estate markets, as was the case in the last 20, 30, 40 years).
- See “The Feeling’s Not Mutual” by CCPA’s David MacDonald (February 2015).
- For example, the life-cycle theory of personal finance suggests a simple pension-generation design that starts out accumulating retirement savings and converts most of these savings into life-long annuity payments as people age. Actual pension designs (e.g., with names like ‘shared risk’ and ‘target benefit’) continue to force plan members into ‘one-size-fits- all’ structures that ignore the different risk appetites of the young and the old, invoke arbitrary actuarial assumptions, and lack clear property rights.
- An important complication here is the claw-back feature of the Guaranteed Income Supplement (GIS) for low income workers. Requiring low-income to save for retirement in a way that would reduce their future GIS payments is obviously counterproductive. We note below that the simplest way to deal with this problem is to introduce an opt-out feature into the ORPP and plain, clear language indicating that the plan is not designed for low-income workers.
- The White House has just indicated that President Obama’s speech to the AARP will say “the rules of the road do not ensure that financial advisers act in the best interest of their clients when they give retirement investment advice, and it’s hurting millions of working and middle class families…” Where do Prime Minister Harper and Premier Wynne stand on addressing this issue?
- See Bruce Little’s 2008 book “Fixing the Future” for the full story.
- See my paper “Taking the Dutch Pension System to the Next Level: A View from the Outside” for a more detailed exposition of this life-cycle-based approach to pension design. It can be accessed via the KPA Advisory Services website. At least in the Netherlands, the importance in plan design of distinguishing between long-term return compounding risk and short-term capital value risk is beginning to be appreciated.
- Rapid progress is being made in the design and implementation of these kinds of communication protocols. NEST in the UK and QSuper in Australia are two of the global leaders.
- The government-sponsored NEST program in the UK has this opt-out design feature. It is experiencing a 92% retention rate.
- We agree with the Government’s sentiment that all ‘qualifying’ plans should, like the ORPP, have an ‘income for life’ back-end. Employers should have to explain its absence if the plan they offer doesn’t have one (this does not mean that the employer should necessarily be the longevity risk underwriter….for example, it could be provided competitively by the insurance industry, using transparent longevity and investment return assumptions).
- NEST CEO Tim Jones recently expressed this view to me: competition has made NEST a better, more customer-oriented pension services organization in the UK.
- See Claude Lamoureux’s article “Effective Pension Governance: The Ontario Teachers’ Story”, RIJPM, Fall 2008.