Dump the conventional theory that your clients need 70% of their final annual employment earnings to sustain their living standards in retirement. Instead, a relatively new measure, called the Living Standards Replacement Rate (LSRR) is more accurate and is making headway in government, business and academia, says its creator.
Bonnie-Jeanne MacDonald, an actuary and academic researcher at Dalhousie University in Halifax, told a January Conference Board of Canada meeting on retirement readiness that she became skeptical of the accuracy of the “final employment earnings replacement rate” method a decade ago. This, despite the fact that it was being used around the world to determine how much pre-retirement income was needed during retirement.
So she began to research the highly touted formula, which MacDonald said “had a target with no validity.”
Planning for failure
“What keeps me up at night and what drives me to do the research I do is not that people actually fail to plan for retirement; the problem I see that is more critical is that people are actually planning for failure because they’re given bad advice about how much money they need.”
As Canadians live longer, an increasing number are concerned as to whether they will outlive their savings, especially with the prospect of costly long-term nursing care. But the final employment earnings replacement rate is not the way to go, even though it has been deeply entrenched, she said.
“It underlies our pension system, it drives all the research that we see that says whether people are prepared or are not prepared for retirement…and it’s also the backbone of all the financial planning software as far as I can tell.”
Using Statistics Canada’s LifePaths model, MacDonald studied whether a 1951-58 birth cohort that had reached a 70% final employment earnings replacement rate at retirement was in truth able to maintain their individual standards of living after they moved into retirement.
What she found were too many variables that could skew the results. The theory around that model goes that if there is a household income before retirement of say, $100,000, you would need annual income of $70,000 after retirement to maintain the same standard of living you had while working. Extending that theory, those who have a replacement rate higher than 70% should have a better standard of living after retirement, while those with less than 70% would have a poorer standard of living, she said.
But MacDonald said her research found that the traditional ratio had little predictive value. She discovered that even if people changed the formula a little bit they came up with vastly different answers. And what kept nagging at her was that no one had ever truly demonstrated that the replacement rate actually did the job everyone said it would.
Total standard of living
In addition, employment earnings in a single year do not represent someone’s total standard of living, MacDonald told the conference. On top of that, the current ratio doesn’t take into account variables such as household size, especially children, and whether there is an income-producing spouse – both before and after retirement.
While MacDonald had identified some problems, she now had to come up with a solution. “Replacement rates are so popular because they give us a way to measure how well people are ready for retirement. But we still needed a way to measure income adequacy.”
That brought up another issue: nobody really knows what their standard of living is while working. Keeping accurate records on everything from household costs to food and entertainment were unwieldly.
Full financial picture
But she said a new ratio, called the Living Standards Replacement Rate (LSRR), does exactly what the conventional replacement rate was supposed to do – but the LSRR is more accurate because it gives the full financial picture of the household.
She gave an example of one person who makes $50,000 gross and has four dependants (a spouse and three children). The person subtracts income tax, payroll deductions, child-raising costs, savings and rent.
A second person may make the same $50,000, but has an income-producing spouse and no children. When they subtract the taxes, etc. they could be left with a vastly different sum.
“This shows that just a small change in circumstances will hugely impact standard of living,” she said, noting that the entire financial picture taken over a few years, not just one or two, needs to be looked at as well to help determine income adequacy in retirement.
MacDonald said people won’t necessarily save more in reality but they will at least have a better idea of how much they need in retirement.
She said with Canada’s public policy aimed at ensuring seniors do not fall into poverty, there needs to be a better measure to determine standard of living in retirement and income adequacy.
Companies like Scotiabank and Canadian Tire are already using the ratio in Canada for their employees, and firms in the United States and elsewhere in the world are also moving to LSRR, she said.
“The LSRR provides a more accurate, understandable and consistent measure of retirement income adequacy,” she said.
Keith Ambachtsheer, director emeritus of the Rotman International Centre for Pension Management, told conference attendees that one of the best ways to ensure income adequacy is for people to be in a well-run workplace pension plan.
Workplace pension plans
A global pension index that attempts to measure quality of retirement income systems ranks Canada seventh out of 27 other countries.
“We’re six points away from being Number One so we ask ourselves: what would it take to get to Number One? And it’s actually one thing: if you look at what numbers one through six have in common it’s a requirement by employers to offer a workplace pension plan.”
Ambachtsheer said the federal government’s move to expand the Canada Pension Plan (CPP) is one of the ways to go about that. The enhancements are set to begin in 2019 and will see annual CPP contributions increase gradually over seven years. Once fully in place, the CPP enhancement will increase the maximum CPP retirement benefit by about 50% from the current maximum benefit of $13,110. In today’s dollar terms, the enhanced CPP represents an increase of nearly $7,000 to a maximum benefit of nearly $20,000.
In the meantime, Ambachtsheer said “old battles” continue between the benefits of defined benefit and defined contribution pension plans. Instead, discussions should be around ways to deliver income replacement in retirement.
Ambachtsheer also said that fees for financial products need to come down and that regulatory impediments that are hindering steps to move to income adequacy should be removed