Canada’s Pension Challenge

May 28, 2009



Jim Leech

President and CEO, Ontario Teachers’ Pension Plan



Canada’s Pension Challenge



Chairman: Jo-Ann McArthur, President, The Empire Club of Canada



Head Table Guests



Robin Sears: Senior Partner, Navigator Limited, and Director, The Empire Club of Canada

Remi Frater: Grade 12 Student, R. H. King Academy

Grant Kerr: Associate Pastor, St. Paul’s United Church, Brampton

Jill Denham: Board Member, Ontario Teachers’ Pension Plan

Joe Lamoureux: President, Ontario Teachers’ Federation

Margaret M. Samuel: President, CEO and Portfolio Manager, Enriched Investing Incorporated, and Director, The Empire Club of Canada

The Hon. Kathleen Wynne: MPP, Minister of Education, Government of Ontario

Peter Giacomelli: Managing Director, Investment Banking, TD Securities Inc.



Introduction by Jo-Ann McArthur



Freedom 55 is a memory and for many “65” is the new “55.” As Canadians we don’t save enough in our RRSPs. That’s not new, but that was before they were slashed by the stock market declines. Private pension plans are a mess and fewer and fewer of us have them. We also are financially illiterate—present company excepted—when it comes to understanding what we actually need for retirement. The Learning Partnership honoured Jim Leech this month as a Champion of Public Education, so I’m sure he has some thoughts about that.



You may have read Jim Leech’s comment in last week’s Globe and Mail editorial that we’d all love to be rich, but what we really don’t want to be is poor. But a C.D. Howe Institute report showed that only one-third of Canadian households are saving enough to meet their projected basic household expenses by 2030, meaning that two-thirds of households are not saving enough to cover their non-discretionary costs in the future.



Jim is Canada’s highest profile pension executive. The Ontario Teachers’ Pension Plan is the largest single-profession pension plan in Canada, with $87 billion in assets as of the end of 2008.



He graduated from the Royal Military College of Canada with a BSc and holds an MBA from Queen’s University. He has also said, “You don’t want to lose the opportunity that a good crisis brings you.” I am pleased to now turn the podium over to Jim to give him that opportunity.



Jim Leech



Thank you Jo-Ann. Good afternoon Ms. Wynne, head table guests and members.



Pensions. If anyone had told me when I joined Teachers in 2001 that pensions would be front-page news every day in the national media around the world, I would have said they were dreaming. But here we are eight years later and that’s exactly what’s happened. Today in fact it is unusual not to see a pension story in your morning paper and for good reason. Pensions affect everybody—employees, taxpayers, employers, corporations, governments, and non-working Canadians. It is tough to find anybody or any organization untouched by the pension question.



As such, a very public debate has emerged. It is a debate addressing retirement security, pension affordability, realistic contribution and benefit levels, social responsibility, and retirement age; in other words, our future.



Now, God willing, it’s going to be some time before we endure another federal election in Canada, but when we do I believe that pensions for Canadians may be the issue that defines the campaign. I further believe that Canada’s pension champion will emerge from that debate. As Tommy Douglas and national medicare defined public debate in the sixties, the natural gas pipeline and C.D. Howe in the fifties, and Brian Mulroney and free trade in the eighties, pension reform could be the defining issue of the first decade of this century. What remains to be seen is who Canada’s pension champion will be and whether or not he or she will be successful in leading Canadians to badly needed reform. Now based on discussions I’ve had with officials in Ottawa, there’s little disagreement about the election-debate potential of this issue.



I’m here today to talk to you about that debate and I’ll do it in the context of three main issues. First, I’ll look at today’s pension reality. Second, I’ll address the silver lining of the economic crisis, which has raised the volume of this pension debate and of corporate governance issues that Teachers has been talking about for years. And third, I’ll discuss the increasing important role of pensions in the economy and Canada’s leadership in that framework.



So first the pension reality. Let me start with a look at our own membership at Teachers because we are at the leading edge of the demographic wave and we reflect the reality of a greying Canada. Teachers is what is considered a mature pension fund. That is to say, we have a declining number of active members who are contributing to the fund compared to the number of members who are actually collecting pensions. We currently have 1.6 to 1 ratio of active to retirees and we are moving to a steady state of one to one over the next decade or so. To put that into perspective, that ratio was 10 to one in 1970. We have 356,000 members. That includes 110,000 on pensions, 173,000 working teachers, and 72,000 inactive members. We administer one of Canada’s largest payrolls at $4.2 billion annually and we receive $2.2 billion in contributions annually. So the first $2 billion we earn every year is automatically earmarked for paying the difference between what is contributed and what is distributed.



Now the average age for a new retiree today in the Teachers plan is 58. Each will have worked for 27 years of retirement and they are expected to receive their pensions for 30 years and a survivor pension will be paid for an additional five years. The average full starting pension last year was around $42,000 per annum. Now pension plans, public and private, were devised when retirement longevity was an oxymoron. Pensions were meant to bridge the gap between work secession and death. It was a short distance, given life expectancies at the time. When Canada chose a retirement age of 70 in the 1920s, life expectancy at that time was 61 years. So think about that. Nine years after you died on average, they let you stop working. In 1951, a means-tested pension was made available at age 65 when average life expectancy was 681/2. Now the Canada Pension Plan was introduced in 1966. Life expectancy then was 72. That was then. Longevity rates today are very different. In fact we have 2,300 pensioners in our membership who are over the age of 90 and that includes 80 who are over 100 years of age. We jokingly call ourselves a century club. But in all seriousness, it highlights the issues of the benefits sustainability and intergenerational equity, making sure the pension funds are there for today’s young people when they retire.



Now a little bit of education. Pension plans come in two basic flavours. You have defined benefit or DB and defined contribution or DC. The teachers’ plan is a defined benefit plan, which means that pensions are based on a formula of service and age. The pension benefit is predetermined and is not contingent on investment performance and it is an obligation of the sponsor. Benefits under a defined contribution plan on the other hand depend entirely on the market value of the fund in your account the day you retire. So they work exactly the same as an RRSP. The day you retire you open the box to see how much money you have to live on for the rest of your life. And if markets have been bad, your retirement lifestyle will be less than if markets have been booming. We all can name friends who have had to postpone their retirement because their savings were ravaged this past year. In other words, they didn’t have enough gold for their golden years.



Now the teachers’ plan is jointly sponsored by the Ontario Teachers’ Federation and the Ontario government. The teachers themselves make half of the contributions and the government or taxpayers make the other half. Together the OTF and the government determine contribution rates and benefit levels. They make the decision when shortfalls and surpluses occur. In the case of shortfalls, they must either reduce benefits or raise contribution rates together or both. Surpluses of course are happier decisions, because they get a chance to increase benefits or lower contributions.



Our sponsors’ recent adoption of conditional inflation protection was a step in the right direction. It creates somewhat of a defined benefit/defined contribution hybrid. Inflation protection is guaranteed to 50 per cent and acts as a defined concept, but inflation protection above 50 per cent is conditional on the financial condition of the fund, which sounds more like a DC concept. Now because we were a bit ahead of the pension maturity curve the partners have had to make some tough decisions such as this sooner than other plans. But those other plans will be making the same types of decisions. Our sponsors were right. These were the right decisions and I’m confident that our sponsors will continue to make the right decisions on their members’ behalf. As such, I’m really not as concerned about our plan or the members in our plan as I am for the 80 per cent of Canadians in the work force who have no employment-based pension plans whatsoever, and RRSPs have not proved to be the solution. Average RRSP balances are woefully short of the levels they need to be in order to fund a retirement. And that’s troubling. Let’s face it. As I said before, we all love to be rich but we really don’t want to be poor especially in old age when we are supposed to be enjoying ourselves. Also troubling is the private sector’s increasing move towards defined contribution plans and away from defined benefit plans, saying that they are unaffordable.



Now it isn’t that the DB model is unaffordable per se. It is that the DB model has been made unaffordable for sponsors by shortsighted tax rules and court decisions that effectively prevent sponsors from saving enough in good times to offset losses in bad times and weak-kneed management who out of expediency promised unrealistic levels of future benefits in order to dampen salary demands. Their strategy was to show good results today by pushing costs off to the next generation of managers. But the future has now caught up with them and pensioners are lined up, justifiably so, for the promised benefits. The truth is the DB plans are actually far better vehicles for pension saving from both a security and a cost basis for both the employees and sponsors. In fact a report by the U.S. National Institute on Retirement Security finds that savings in a defined benefit pension plan can deliver the same level of retirement income at almost half the cost of a defined contribution scheme. It says that the overall cost to employers and their workers was 45-per-cent lower for DB plans than it was for a DC plan.



There are four main reasons for this. First of all individuals in a DC plan must plan to live for a very long time. They have to save to provide income out to the maximum on the actuarial table, because you don’t want to run out of money four years before you die. Because individuals cannot pull a longevity risk, they are forced to accumulate more in their DC plan than they would for an equivalent DB plan, which can actually be based on actuarial averages. So DB plans avoid this over-saving by pooling longevity risk for large numbers of individuals. Secondly, DB plans are ageless. They can perpetually maintain an optimally balanced investment portfolio. Individuals on the other hand must downshift dramatically in order to reduce the risk-return allocations as they get older. The transaction costs in this rebalancing are prohibitive.



Third. By pooling your savings in a DB plan the participants can afford to engage professional investment advisors, something that the average worker in a DC plan cannot afford. When I compare the returns I realize on my own self-managed RRSP I certainly know, compared with those at Teachers, I could use with some expert advice. And fourth, the cost. The DC plan and RRSPs are usually invested in retail products that carry large administration fees, sometimes as high as 2 or 3 per cent per annum. If you contrast that with the cost at Teachers at only 15 basis points, the extra 1.85 per cent over a working lifetime is enormous.



As we said in our submission to Ontario’s Arthurs Commission on Pension Reform the social cost that the private sector’s shift to defined contribution plans will impose on the future have not been widely acknowledged. Members of such plans will retire with inadequate income. Their combined individual defined contribution shortfalls will dwarf the valuation shortfalls of the defined benefit plans today and will impose obligations on future governments possibly for further retirement income assistance. We also told Arthurs that defined benefits have only become more expensive because our legislators have made them so with arcane rules and regulations and very inflexible structures.



Take for example the federal income tax excess surplus rule. This rule precludes further contributions to a pension plan once the plan surplus hits 10 per cent. In our view the rule is counter-intuitive. It limits the opportunity to enhance pension plan funding when the investment climate is conducive to growth. And we at Teachers experience this obstacle not only as a plan administrator ourselves but also as an investor in companies that face the same constraint.



So we as a society are in a bit of a pickle. We have defined benefit plans that are being terminated left, right and centre and are being replaced by defined contribution plans that are totally inadequate. But a wholesale shift from pure DC to pure DB is not necessarily the panacea. It’s time for a new model, which we refer to as a hybrid model.



The current market chaos should be the wakeup call to everybody—companies, the government, and citizens—that our current pension plan needs to be overhauled and as a society we can’t afford to ignore the need for progressive reform anymore. We could take some lessons. The British, the Dutch and the Aussies for example. The British acted on a Turner Commission Report in 2001 with some major undertakings. Similarly the Dutch also undertook a national overhaul. Their new model is an amalgamation of pension plans merging smaller and larger funds, which allows the smaller fund to share their investment risk and reap the benefits of diverse vocations. The Dutch also bought ongoing sustainability by setting guaranteed pensions to a career-average compensation level rather than the top five. Employees then can purchase additional credits through a DC overlay should they wish. In other words it’s a hybrid DC/DB plan. We consider those pretty brave moves.



In our view at Teachers, there will never be a better time than right now for Canada to undertake similarly visionary pension reform. The economic storm clouds that started in 2007 and turned into a recession in 2008 and continue today have made discussions like this possible. Governments, corporations, labour, everyone has seen the damage wrought on many pensions and other investment accounts. Now I must say that we were pleased to see that the federal and provincial finance ministers seemed to come out of their meeting earlier this week with an appreciation for this concept—the concept of an overlay. And Premier McGuinty is right to insist that the feds take the lead here, but he is also right to say that Ontarians cannot wait forever. So we look forward to seeing more from this initiative very soon we hope. Now like any great decline it is not the fall itself, but the abrupt stop that causes damage. However there is a silver lining to these economic storm clouds and I mention two things.



First they’ve moved the pension issue to the front pages of the newspapers. They have given rise to a debate that’s gaining volume and that people are listening to. And it has taken this economic crisis for people to accept that their concern is real and that’s okay because at least today there’s an audience listening.



Second and separately, the recession has brought renewed attention to an issue we and other global and institutional investors, pension plans and others have long advocated against. That is supersized executive compensation packages such as those CEOs receiving 300 times as much as the average U.S. worker without regard for performance or risk. Although I don’t yet have Canadian statistics, according to the New York Times, the biggest U.S. pay package hits were in the financial-services sector and they were down about 40 per cent. Well today’s trends towards lower compensation continue. As Stephen Davis, of Yale’s corporate governance, said, “It remains to be seen whether these are annuals or perennials.”



So if this pay decline does continue, there remains hope that our schools’ best and brightest won’t automatically head straight to Wall Street or Bay Street. They might consider other more worthwhile careers. God knows the world doesn’t need another credit default swap. Now the pension dilemma is ubiquitous. It’s attracting growing attention. Fortunately it is also attracting the attention of smart people who are keen to find workable solutions. With that attention comes opportunity. As home to three of the country’s and indeed the world’s largest and most innovative pension plans and to Rotman’s International Centre for Pension Management (ICPM), Toronto is developing into a world centre for pension excellence where thought, ideas, and theories can be raised, incubated and implemented. With our large pension plans we are major ICPM supporters and will be an active participant along with other leading plans at their symposium here in the next 10 days.



Robert Fulford once said, “My generation of Canadians grew up believing that if we were good and very smart or both, we would someday graduate from Canada.” I like to think that the opposite is now true. Some of our best mathematicians, administrators, and investment professionals are working in Canada’s pension industry today. I believe that the critical mass will continue to grow and attract experts from around the world to come here to work in Toronto.



Canada’s pension plans are well regarded internationally for their innovation, the same reason they became such an important force in the investment industry. That’s why, as gut-wrenching as this period is, I have to say that I feel fortunate to be where I am, because pension plans now represent a new breed of financial institutions. We have the power to combine a large capital pool for the long-term investment horizon, something that is extremely novel in today’s market. Think of it this way. As of the year 2007, the estimated total value of pension plans in the world’s 11 major economies was $25 trillion. Probably a little bit of a haircut today, but to put that in context U.S. GDP at that time was about half of that. In September, the head of Belgium’s Association of Pension Funds went so far as to say that pension funds worldwide create a lot of stability in the markets because we don’t move in times such as now. We look long term. We create stability because of the amount of assets in pension plans that support the markets. Stability of course is a relative thing, but pension plans have been called the financial industry’s investment cushion.



We are now looking at the confluent of two major forces—boomers who are retiring and who are used to getting their own way with the worst economic crisis in the lifetime of the majority of Canadians. As such, pension plans offer not just a measure of market stability but a respected voice for pension reform, which could in turn lead to national retirement stability.



This situation has been brewing for years. Peter Drucker warned about it in the sixties. He said then that the current generation was postponing chaos to the future generations and in the book, “While America Aged” by Roger Lowenstein, he recounts the horror stories of politicians passing the buck or lack thereof to future generations. And we in Canada have done the same. I agree with Lowenstein when he writes, “Changing this pattern will require political courage and also realignment across society.” He is right when he calls on business, government, and labour to stop behaving like credit-card junkies who can charge the bill to our kids and even their kids. They should work together instead to craft the best possible pension solution for all parties of all ages.



Today the pension debate has really been at the margin. The length of time sponsors have to make up shortfalls, the posting of letters of credit to back deficits, changing some investment rules and even amalgamating several funds to reduce cost are all really good ideas and they will help the people who are currently in pension plans, but they will do nothing for the millions of Canadians who have no pensions whatsoever.



And so I return to my original point. The pension challenge may be the defining issue of Canada’s next federal election. Whether or not it is depends on whether or not the courage exists for our pension champion whoever he or she may be to rise and tackle the issue responsibly. The time for pension myopia is long past. We need our leaders to make decisions beyond the next political term, the next employment contracts or the next labour negotiations, because at some point we all expect to retire. How comfortably we can do so depends on decisions that are made or not made today. Thank you very much.



The appreciation of the meeting was expressed by Margaret M. Samuel, President, CEO and Portfolio Manager, Enriched Investing Incorporated, and Director, The Empire Club of Canada.