Retirement Is Expensive. Here’s Why Pensions Can Help
The United States is not the only nation facing a retirement savings crisis. Many advanced, post-industrial democracies are struggling with similar challenges presented by an aging population. And just like in the U.S., these countries may have a variety of different retirement savings plans offered to workers.
Canada, a nation with which the U.S. shares many characteristics beyond a common border, is one of these nations. One thing Canada has in common with the U.S.: strong defined benefit pensions.
The strength of Canada’s defined benefit pension system (and of pensions in general) is detailed in an important report from the Healthcare of Ontario Pension Plan (HOOPP) called The Value of a Good Pension. The researchers at HOOPP identify five value drivers of a good pension:
- Fees and costs
- Investment discipline
- Fiduciary governance
- Risk pooling
The report explains how these five value drivers are efficiently managed in a defined benefit (DB) pension plan. Specifically, a good pension plan should help a worker achieve three goals:
- Saving income earned while working for future use in retirement
- Growing these savings through productive investment
- Converting these savings into a reliable stream of post-retirement income
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A good pension accomplishes all three goals through the five value drivers identified above. The inherent efficiency advantage of a DB pension over a defined contribution plan enables the pension to more effectively accomplish these goals.
The saving goal is easily achieved in a pension plan because saving is almost always automatic and typically mandatory. Most workers participating in a pension plan will begin contributing automatically when they begin working and will contribute at a predetermined amount. This overcomes a major initial hurdle to saving for retirement for many, which is starting to save in the first place. The research shows that people participating in voluntary, do-it-yourself plans tend to save less, save later, and save less consistently than those participating in a DB plan.
Defined benefit pensions achieve significant efficiency gains through lower fees and costs, better investment discipline, and fiduciary governance. These are all major advantages over do-it-yourself, defined contribution plans. Good pension plans have professional, in-house investment staffs who are able to avoid many of the common investment mistakes often made by those who are saving on their own.
Finally, risk pooling helps with both the investment side and the spend-down side of retirement savings. Risk pooling allows a pension plan to invest according to the average age of the plan, rather than to the life of an individual in the plan. This means a pension plan can invest more aggressively in equities as well as investing in a more diverse array of asset classes. It also means a pension plan can offer a lifetime benefit to members because it is not tied to a single individual’s longevity. Risk pooling is the single largest cost saver of the five value drivers examined by the researchers at HOOPP, representing 45 percent of the cost savings for a hypothetical worker in a good pension plan compared to the typical individual approach to saving.
The research considers the hypothetical example of a representative worker in Canada. For every dollar of contribution, she will receive $1.70 in retirement income by following the typical individual approach to retirement savings, whereas she will receive $5.32 for every dollar contributed to a good pension plan. With such a huge cost differential, it’s no wonder that many DC plans are looking to innovate for post-retirement years and bring the efficiency advantages of DB pensions to individual DC plans—which we should all welcome.
Retirement arguably is most expensive thing people will pay for, and having a good pension can help. The HOOPP report says it well: pensions are efficient vehicles to pay for something expensive: retirement.