CANADA NEEDS NEW SAVINGS VEHICLE
TO ENABLE THE BABY-BOOMERS’ RETIREMENT
Presented at:
28th International Congress of Actuaries
in Paris
From 28th May – 2nd June 2006
By:
Doug Andrews, M.B.A., F.C.I.A., F.S.A., CFA
Toronto, Canada
Telephone: (416) 247-4617
Fax: (416) 247-4617
Email address: [email protected]
June 2005
KEYWORDS
Baby-boomers
Canada Pension Plan
Canadian health care system
Canadian retirement system
Defined benefit plans
Defined contribution
Equity risk premium
Mandatory retirement age
Prefunding
Productivity
Tax-prepaid savings plan
ABSTRACT
Over the past fifty years, the relative size of the baby-boom generation has created a
demographic wave changing markets and adding cost burdens. As the baby-boomers begin to
retire, other markets are likely to be affected and cost burdens will arise in different areas.
This paper examines three areas where the retirement of the Canadian baby-boom generation is
likely to bring about change and add additional costs in privately-delivered retirement and
benefit plans:
•
reduction in the equity risk premium and the implications for pension and retirement
savings plans
•
elimination of mandatory retirement age and the implications for group insurance and
benefit programs
•
increasing longevity and pressure on health care costs.
The paper suggests that to manage costs for privately-delivered plans, and to accommodate
social changes likely to be demanded by the baby-boomers, pension and benefit delivery will
move increasingly toward a defined contribution approach. Such an approach will shift some of
the risks created by the baby-boom generation’s retirement, back to the baby-boomers.
It is argued that an appropriate policy response is the development of a multi-purpose, taxprepaid savings vehicle to be used to pay for health care expenditures in retirement or to provide
retirement income.
TABLE OF CONTENTS
I
Introduction........................................................................................................................1
II
The Equity Risk Premium and Return on Investments .................................................3
III
Demographic and Cost Pressures on the Canadian Retirement and Health Care
Systems................................................................................................................................8
Retirement ..................................................................................................8
Health Care.................................................................................................9
IV
Proposed Policy Initiatives To Ease The Pressures ......................................................12
Elimination Of Mandatory Retirement Age..........................................12
Proposed Vehicle For Partial Prefunding..............................................17
V
Conclusion ........................................................................................................................22
Endnotes........................................................................................................................................23
Bibliography .................................................................................................................................25
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Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
Presented at the 28th International Congress Of Actuaries
In Paris – June 2006
Page 1
I - INTRODUCTION
Canada experienced an increase in fertility rates during the period following the end of World
War II to the mid 1960’s. The generation boom between 1946 and 1966 has become known as
the baby-boomers, although, as Brown
1
has pointed out, this is not a homogenous group but
rather two radically different demographic subsets. The fertility rate peaked around 1959 at 3.9
children per eligible female and declined steadily for almost 30 years, falling to about 1.6
children per eligible female in 1987.
The fertility rate has been below society’s natural
replacement rate of 2 children per eligible female since 1972.
Demographically, two significant aspects of this change in the fertility rate are that:
1.
it created a large baby-boom generation;
2.
the generational base of the population pyramid that supports the baby-boomers is
comparatively smaller relative to the baby-boom generation than has been the case in the
past.
The 1960’s were an important decade for the introduction of social insurance arrangements in
Canada.
The Canada Pension Plan, a government-sponsored defined benefit pension plan
covering most employees and financed by contributions of employees and their employers, was
established on a pay-go basis, at a time when the leading edge of the baby-boom generation were
just entering the workforce. With this generation’s large size, it was possible to maintain a low
contribution rate, 3.6% in aggregate, and provide pensions to retiring workers that included
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
Presented at the 28th International Congress Of Actuaries
In Paris – June 2006
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credit for years of service prior to plan establishment. In 1997 given the lower fertility rates,
steps were taken to put the plan on a sound financial basis, including raising the aggregate
ultimate contribution rate to 9.9% and establishing an independent board to manage the
investment of “excess” funds.
Also, in the 1960’s universal health care was introduced to ensure access to hospital and
physician services for all Canadians without charge at point of service. The health care system is
funded from general tax revenues, although certain provinces have levied specific premiums or
taxes in respect of health care. No steps have been taken to fortify this system against the
financial pressures created by changing demographics.
As well as the two demographic factors mentioned above, a third demographic factor which will
affect the long-term cost of the system is that mortality rates are continuing to improve, and
especially for those age 65 and older. Between 1979 and 2002 life expectancy at age 65
increased by 2.6 years for men and 1.6 years for women, approximately a 2% to 3% increase 2.
This will have an effect on social insurance and private pension systems. It signals the need for
Canadians to have greater savings at retirement than was required in 1979.
This paper discusses several aspects of these demographic factors and the pressures they will
place on the retirement savings and healthcare systems.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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In Paris – June 2006
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The actuarial approach to lightening some of the future cost burdens due to demographic changes
is to save to reduce the future net cost, i.e., postpone current consumption to provide for future
consumption.
The paper examines the impact of demographics on the equity risk premium and observes that
equity investments are unlikely to provide the level of returns many currently expect. To create
greater opportunities for individuals to save and to enhance productivity, the paper proposes the
elimination of mandatory retirement age. Finally, the paper proposes the use of a tax-prepaid
savings plan, to which employees and their employers would contribute. The contributions
would be invested in, with the objective to improve, the health care system, and would be
credited with an investment return based on the underlying productivity assumption and health
care inflation.
II - THE EQUITY RISK PREMIUM AND RETURN ON INVESTMENTS
Most retirement plans include an investment in equities. The rationale for this is that over long
periods of time equities have achieved higher returns than bonds, i.e., there is an equity risk
premium to compensate equity investors for the additional risks taken. The purpose of this
section is to consider the impact changing demographics is likely to have on the equity risk
premium, and on other investments.
In other papers 3, I have described the equity risk premium assumed by Canadian retirement
plans, the impact on the Canadian retirement system if the equity risk premium is less than
anticipated, historical levels of equity risk premium and considerations regarding the future level
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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In Paris – June 2006
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of the equity risk premium. A primary purpose of those papers was to alert Canadians to the
assumptions regarding the equity risk premium being made, suggest that the assumptions are
aggressive, and warn regarding the impact of the equity risk premium being less than anticipated.
I will not repeat these considerations here; however, I believe they are valid and I refer the
interested reader to the other papers for further information.
The following table summarizes the estimated equity risk premium gathered from different
sources. As can be seen, there is considerable variation:
Various Equity Risk Premiums
Source
Description
Aon Consulting Survey
Summary of median forecasts for studies 2.2% - 4.0%
between January 1, 2001 and January 1,
2005, 10 year horizon
Canadian Economic
Statistics
Amount
1925 – 2004
3.96%
1955 – 2004
2.78%
1980 – 2004
-1.62%
1995 – 2004
-0.52%
2000 – 2004
-5.20%
1995 – 1999
4.55%
2004
6.02%
Silgardo
10 year horizon from 2002
3.45%
Bernstein
10 years ending 2012
-0.80%
Over very long historical periods the equity risk premium has been significant and positive;
although for shorter historical periods which include the five years ending 2004, the equity risk
premium has been negative. Since the equity risk premium is calculated as the excess return on
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
Presented at the 28th International Congress Of Actuaries
In Paris – June 2006
Page 5
equities over long bonds, a partial explanation for the more recent results comes from an
examination of the factors affecting the returns on the stock and bond markets. The stock
markets enjoyed an incredible bull run during the 1990s, with the valuations of many stocks,
particularly technology-related stocks, priced for perfection by 1999. The bubble burst in 2000
and stock prices declined sharply before beginning a period of gradual recovery.
With respect to bond markets, there has been a general decline in interest rates throughout the
twenty-five year period from 1980 that has provided very strong bond performance. What can
be expected going forward? Given the (historically) relatively low level of interest rates in 2005,
it is unlikely that there will be further significant declines in interest rates to generate capital
gains on bonds and to boost fixed income returns. Although some increase in interest rates may
occur, bond returns are not likely to change much over the next 10 years 4. Does this suggest
that the equity risk premium may become positive again?
The following discussion analyzes the question from a demographic perspective. Lifestyle
events for the baby-boomers have influenced asset values. As baby-boomers formed families,
demand for housing significantly increased real estate prices and, as baby-boomers increased
retirement savings and invested in equities, equity prices increased significantly. Some 5 suggest
that as baby-boomers retire they will wish to sell their equity investments to provide retirement
income or to invest in less volatile income-providing fixed income instruments. Given the size
of the baby-boom generation relative to the subsequent generations, there will be comparatively
few willing purchasers of the baby-boomers’ equity investments; hence, equity prices are likely
to fall substantially.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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In Paris – June 2006
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The logic of this argument is appealing, but because it deals with broad generalities it can be
misleading.
First, the baby-boomers are generally regarded to have been born during the
approximately twenty-year period 1946 – 1966; however, they will not all retire during a twentyyear period. Some will retire early starting about age 50 and others may continue to work to 75.
Second, at retirement age, not all baby-boomers will immediately sell their equity investments.
Some may sell at retirement but others may continue to hold equities in their investment
portfolios for the rest of their life, particularly if equity prices are depressed and if the investor
has sufficient income from other sources to meet income requirements. Third, a number of
retiring baby-boomers will have participated in defined benefit pension plans that have invested
in equities. If these defined benefit plans pay the pension to the baby-boomers from the pension
fund, the pension plan may have little need to sell equities, since pension payments could be
made from contributions and the yield on fixed income investments. Fourth, not all equity
investments will behave in the same fashion. The businesses of certain companies and industries
will benefit from the retirement of the baby-boomers just as the businesses of other companies
and industries may suffer. For example, long-term care facilities, financial planning and wealth
management, some forms of leisure and entertainment activities may be winners whereas child
care, extreme sports, and real estate may be out of favour. Accordingly, carefully selected
equities may not experience depressed prices just because the baby-boomers become net sellers
of equity. Fifth, Siegel
6
points out that many developing countries, such as India and China,
have much younger demographic profiles, and may be willing buyers of equities.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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In Paris – June 2006
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Finally, the argument about the impact of the disproportionate size of the baby-boom generation
on the subsequent generations of purchasers, applies to all types of investments not just equities.
For example, if all baby-boomers tried to sell their real estate at one time, prices would drop to
clear the market. Also, if baby-boomers wish to make significant investments in fixed income,
supply of funds will be large relative to available product, which will result in low yields. A
further consequence is that interest rates will remain low, possibly even declining further from
current levels.
Returning to an examination of the equity risk premium, the equity risk premium may remain
positive, because the equity risk premium is the defined as the excess return on equities over
long bonds. Even though it may be true that equities of certain companies and industries may
perform poorly, and that broad equity indices may be stagnant or declining, the equity risk
premium may remain positive, because bonds may generate even lower returns than they have
historically. However, the existence of a positive equity risk premium merely indicates that
better returns are available from investment in equities than from bonds, it does not show that the
return from any type of investments will be significant.
The consequence of the foregoing analysis is that unless baby-boomers have carefully selected
their investments to be ones that will benefit from the changing demographics, they are likely to
achieve a return lower than expected. The message is clear – there is a need for baby-boomers to
have larger savings for retirement than they anticipate, to provide a margin of safety to cushion
them against the adverse effect that changing demographics will have on all types of
investments.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
Presented at the 28th International Congress Of Actuaries
In Paris – June 2006
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Let us summarize investment returns over the life of the baby-boom generation. There can be
periods such as the real estate boom and the equity bull market of the 1990’s where babyboomers, in aggregate, have had an opportunity for significant investment gains. However, as
the baby-boomers retire, it is likely that investment returns will decline, in aggregate. Brooks
has examined life cycle portfolio choice and “finds evidence of significant asset market effects,
with the expected return on retirement savings of boomer cohorts up to 20 percent below returns
to earlier generations” 7.
Two important consequences of declining investment returns are the following:
•
Sponsors and administrators of defined benefit pension plans will face increased cost
burdens. Defined contribution plans, in which the members bear the investment risk, will
be presented as one way for sponsors to address this problem.
•
Because investment returns will likely be less than expected, individuals saving on their
own or through defined contribution plans will find that greater savings are required to
satisfy their retirement objectives. This will create challenges for many retirees to be
able to invest to achieve adequate income. One response may be to save more. Another
response may be to postpone retirement, to lengthen the income-producing and savings
period.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
Presented at the 28th International Congress Of Actuaries
In Paris – June 2006
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III - DEMOGRAPHIC AND COST PRESSURES ON THE CANADIAN RETIRMENT
AND HEALTH CARE SYSTEMS
Retirement
As I have discussed in another paper 8, the following components of the Canadian retirement
system are likely to withstand the pressures of less-than-expected equity risk premiums and
lower-than-expected rates of mortality: government-sponsored programs such as Canada Pension
Plan and Quebec Pension Plan; public sector pension plans; private sector defined benefit plans.
Although in the case of the latter there is potential for some plans to experience financial
difficulty resulting in benefit reductions 9. The main concern is the large percentage of workers
who are not included in a defined benefit pension plan and who have limited retirement
savings.10 Also, as just discussed, the return on most investments will likely be less than what
has been the case and less than anticipated, which will have significant ramifications for
members of defined contribution plans and individual savers. In general, Canadians should be
encouraged to save more for retirement.
Health Care
Whereas the retirement savings system with its combination of government-sponsored programs,
employer-sponsored pension plans, and tax-assisted individual savings vehicles, provides
programs and opportunity for Canadians to have adequate income in retirement
11
, the health
care system is not well placed for the pressures presented by an aging population. On average,
for an individual, health care costs increase as time to death decreases (which is correlated with
age). With an aging population, how much can health care costs be expected to increase?
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
Presented at the 28th International Congress Of Actuaries
In Paris – June 2006
Page 10
In Canada, health care is the primary responsibility of provincial governments.
These
governments receive transfer payments from the federal government determined by formula and
negotiation, but must raise the balance of costs by taxation. Most physicians’ services and
hospital services are provided to eligible citizens without charge at point of service and are paid
for by government revenues. The major portions of prescription drug expenses for eligible
citizens age 65 and over are also paid from government revenues.
Robson has calculated that assuming no change in transfer payments and tax rates that the
present value, calculated with a 6% discount rate, of unfunded health care expenditures for the
period 2000 – 2040 is $531 billion for Canada as a whole. This amount is slightly more than
50% of GDP, just short of the federal government’s net debt and roughly twice the aggregate net
debt of the provinces 12 (all figures from the year 2000).
Unless action is taken soon to address this unfunded liability, with the aging population and the
associated impact on dependency ratios, there is the potential for intergenerational conflict. The
following table shows the changing dependency ratio, at selected intervals over the period 2000
– 2040, of the age 65 and over group, who will be significant consumers of health care, to the
age 20 – 64 group, who will be expected to bear a significant portion of the tax burden.
Population Of Canada (in thousands) 13
2005
2020
2040
1.
Estimated number 20 - 64
20,152
21,928
22,367
2.
Estimated number 65 and over
4,219
6,655
9,766
3
Senior dependency rates (2/1)
21%
30%
44%
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
Presented at the 28th International Congress Of Actuaries
In Paris – June 2006
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The situation is likely to be worse than is suggested by these figures, for a number of reasons.
First, the figures presented are for Canada as a whole. Health care is primarily a provincial
responsibility.
The proportion of the provincial population age 65 and over, the rate of
unemployment by province, and the tax rates by province, all vary by province.
As a
consequence, certain provinces will face much heavier pressures than other provinces. Robson
calculates that the provinces of Newfoundland and New Brunswick and the Territories will face
the greatest pressures, whereas the pressures will be the least severe for the province of
Saskatchewan followed by Manitoba and Ontario
14
. Differences among provinces will create
calls for greater federal transfer payments and generate criticism that federal equalization
payments are unfair.
Second, the figures assume no change in service intensity. However, there is reason to suspect
that there will be increasing demands for increasing service intensity as the baby-boomers age.
The baby-boom generation has come to expect quick and high-quality delivery for other goods
and services and may demand the same for health care services. Moreover, technological
advances are likely to continue; however, such advances have a history of raising quality and
costs.
On the other hand, improved productivity would reduce the burden. Robson’s calculations
assume an annual productivity rate of 1.6 percent, the average rate experienced from 1981 –
2001. In the future, if productivity could be increased to 1.9 percent per year and maintained at
that level, and all other assumptions remain unchanged, the unfunded liability would be
eliminated 15.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
Presented at the 28th International Congress Of Actuaries
In Paris – June 2006
Page 12
However, raising productivity significantly in service-intensive industries and economies can be
difficult since part of the productivity gains are normally shared with workers, in the form of
increased wages and/or improved benefits. In such situations, with an aging population of
workers and former workers, defined benefit plans provide a further drag on productivity gains.
The cost of defined benefit plans continues to increase over time as a percentage of wages, as the
group ages. A drive to enhance productivity provides another reason for organizations to wish to
replace defined benefit plans with defined contribution arrangements.
As will be discussed later partial prefunding is proposed as a way to begin to address these future
problems.
IV - PROPOSED POLICY INITIATIVES TO EASE THE PRESSURES
Elimination Of Mandatory Retirement Age
There are several social arguments to support the concept of mandatory retirement age:
1.
The age represents an indication of ability to contribute productively to society. As such,
it is generally appropriate to remove workers from the workforce at this age.
2.
It provides for transition in the workforce. As workers reach the mandatory retirement
age and retire, work opportunities become available for younger members.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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In Paris – June 2006
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3.
It serves the purpose of making a natural transition in the workforce, without the
requirement for severance payments, without the investment of resources to assess
competence to work and to terminate if competence is not present, and without the
associated anxiety with competency assessments and forced terminations.
4.
The period after mandatory retirement age could be considered a reward in recognition of
a long period of contributing to society. Rather than working and contributing to society,
retirement is a period to receive social insurance and other benefits from society.
Arguments opposing mandatory retirement age emphasize that the choice of any age is arbitrary;
moreover, arguments based on age when used to assess competency or significance of
contribution to society will not apply to all individuals and, even if generally true for large
groups, can be considered discriminatory when applied to specific individuals.
As society ages, there will undoubtedly be greater pressure to remove restrictions related to age,
such as mandatory retirement age. The balance of this section highlights some of the aspects of
changing demographics and certain of the implications for the design of retirement and benefit
programs related to the elimination of mandatory retirement age.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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In Paris – June 2006
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The table below shows data from the 1951, 1971 and 2001 censuses:
Census
Total
Population In Thousands At Age
Under 15 Years
15 - 64 Years
65 Years and Over
#
%
#
%
#
%
1951
14,010
4,250
30
8,673
62
1,086
8
1971
21,569
6,379
30
13,447
62
1,744
8
2001
30,007
5,726
19
20,415
68
3,866
13
Although the population increased significantly from 1951 to 1971, the proportions of the
population by broad age group remained relatively stable at 30%, 62%, and 8% for the age
groups under 15 years, 15 - 64 years and 65 years and over respectively, in those censuses.
However, by the 2001 census certain changes are noticeable:
•
The age 65 years and over group represents 13% of the total population.
•
The under 15 years group is smaller in total number than it was in 1971 and represents
19% of the total population.
•
The ratio of the age 65 and over group, i.e., an approximation for retirees, to the group
15-64 years, i.e., an approximation for working taxpayers, has increased from 13% in
1951 and 1971 to 19% in 2001.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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In Paris – June 2006
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These changing proportions will provide pressures in support of the arguments to eliminate
mandatory retirement age, because:
•
Some of the age 65 and over group will likely wish to continue to work and as this group
increases in size there will be increasing pressures from this group in this regard.
•
The size of the under age 15 group has decreased both absolutely and proportionately, so
there is a potential shortage of replacement workers as the under 65 group retires. An
obvious way to address this shortage is to eliminate mandatory retirement.
There are two other reasons to eliminate mandatory retirement age, as follows:
1.
Due to its low fertility rates, the baby-boom generation has not procreated sufficient
(potential) human capital to support itself, in the fashion to which it expects and as-hasbeen-accepted by earlier generations.
Accordingly, it will need to have available
additional (money) capital in order to mitigate a potential decline in income in retirement.
Many baby-boomers will not have saved sufficient capital by age 65. Permitting them to
work beyond age 65 will provide an opportunity for them to mitigate an unwanted
decline in retirement income.
2.
One key factor for Canadian society as a whole in being able to address the consumption
needs of its population, particularly as the ratio of workers to dependents declines, is
increased productivity, i.e., the ability to generate greater output per unit of labour.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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In Paris – June 2006
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Workers age 65 and over who are capable of working and who are motivated to work,
could play a role in raising overall productivity.
However, if and when mandatory retirement age is eliminated, it will be important to make some
other changes to compensation and benefit practices to ensure that productivity gains are
realized:
•
Performance evaluation and human resource management systems must be improved, so
that workers, regardless of age, can be: advised of performance issues and development
needs; given sufficient time to achieve identified improvements; and in the event of
inadequate improvement, be removed from the job without sizable termination payments.
This is an important component of improving productivity.
•
Benefit programs must be restructured from defined benefit to defined contribution as the
age of the workers increases. For example, a long-term disability (LTD) plan with a
maximum benefit payment period to age 65 provides appropriate protection for most
workers. The defined benefit approach is a more satisfactory method of providing this
insurance, prior to age 65, than would be a defined contribution approach, since LTD
exhibits pure insurance characteristics, i.e., unpredictable losses of potentially sizable
amounts unrelated to length of employment.
However, in order to have non-
discriminatory compensation packages for workers older than age 65, an amount of
compensation should be provided to recognize the lack of formal LTD insurance and that
the worker is responsible for self-insuring or purchasing individual insurance in respect
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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In Paris – June 2006
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of the disability risk. Similar arguments could be made for life insurance, accidental
death and dismemberment insurance, some supplemental medical care benefits such as,
out-of-country care or significant drug expenses, i.e., provide coverage on a defined
benefit basis to age 65 and then provide a defined contribution, in lieu of insurance,
beyond age 65. Other medical care benefits and dental could be provided on a defined
contribution basis for workers of all ages using health care spending accounts, for
example.
Proposed Vehicle For Partial Prefunding
The financial pressures that the disproportionately large baby-boom cohort will place on the
retirement and health systems will be significant. Moreover, the pressures on the retirement
system will be exacerbated by mortality improvements, particularly if they are significantly
greater percentage-wise at the older ages. Partial or full funding has been suggested as a means
to prepare for this burden; however, to the extent that funding is through equities, a declining
equity risk premium may result in the accumulation of fewer funds than expected.
Nonetheless, a number of arguments can be presented for partial prefunding, including the
following:
•
Sinn 16 has observed that because the baby-boom generation has under-contributed to the
replacement of human capital through its low fertility rates, it is appropriate that it save
additional (money) capital in order to avoid either a reduction in expected standard of
living or receiving a disproportionate share of wealth transfer.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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•
Robson
17
acknowledges Sinn’s observation and has presented several further reasons to
prefund, including:
prefunding is a way to contain ongoing rises in tax rates that are associated with
demographic change;
prefunding is a way to alert citizens and policymakers to future problems if
spending outpaces the economy, making cost-effectiveness measures easier to
implement;
prefunding is attractive when economic growth rates are lower than returns on
savings.
•
In addition, this author suggests pre-funding as a partial solution to help individuals
address future cost pressures. There is considerable potential in the future for costshifting to individuals, as governments try to balance the demand for services and the
level of tax rates. A significant number of Canadians appear to have insufficient savings
for retirement, without contemplating further increases in costs or taxes.
Robson
18
advocates an approach to prefunding involving a Seniors Health Account funded
through a Seniors Health Grant. The account would be established by the federal government
and funded by amounts to be transferred to the provinces in respect of future health expenditures
based on demographics.
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Such an approach has the advantages of establishing a process to prefund, at least partially,
future obligations and it relates the funding to demographic factors.
My criticism of the
approach is that a system of government accounts based on interprovincial transfers is not
sufficiently public and may be subject to modifications as governments’ priorities change. I
propose a method of prefunding involving funds saved by the public and managed and invested
in a manner subject to public scrutiny.
There are two different aspects to “public” funds, involved in this proposal. First, the savings
would be generated from employment earnings. These funds contributed by the workers, rather
than by government, would raise public awareness regarding the situation they are designed to
address. This is an important consideration in order to prepare Canadians for a future of rising
health care expenditures. Second, these public funds would be managed by an independent
board, which should instill confidence that the funds are managed appropriately and will be
available when required. The Canada Pension Plan Investment Board, an independent board
established to manage and invest the “excess” funds developing to provide Canada Pension Plan
benefits, provides a good model to follow.
Using Robson’s calculations I estimate that an initial annual contribution of 1% of total earnings
would be a reasonable starting point to meet the health-expenditure shortfall through 2050,
assuming current tax policies, among other things. I would suggest this contribution be split
equally between employees and their employers; consequently, it would not be a heavy burden
for either party.
The money would be managed and invested by an independent board,
established by the federal government for this purpose.
Canada Needs New Savings Vehicle To Enable The Baby-boomers’ Retirement
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In terms of the tax treatment of these contributions, I propose a different approach than that used
for the Canada Pension Plan or registered retirement plans of all types.
In those plans,
contributions are tax deductible, investment earnings are tax exempt, and payments or
withdrawals are fully taxable. Kesselman and Poschmann 19 have described how such a system,
when combined with income and support payments and transfers, has the effect of imposing high
rates of tax on lower income recipients. They argue that a more equitable approach, from a taxtreatment vantage point, is a vehicle that they refer to as “Tax-Prepaid Savings Plans” (TPSP).
In a TPSP, contributions are made with after-tax income, investment income is exempt from tax,
as are payments and withdrawals. However, this approach avoids the drawback of high effective
rates of tax being faced at retirement by low-income recipients.
I propose that all the
contributions be deposited to a TPSP. The employer contribution would be treated as taxable
income to the employee, so the employee would pre-pay the tax on the total accumulation.
The tax revenues generated by both the registered approach and the TPSP approach have the
same present value; however, there is a difference in timing of receipt of tax revenues by
government tax collectors, i.e., tax is paid at the beginning with TPSP, but tax is only paid later
on receipt of payments or withdrawal from Canada Pension Plan or registered retirement plans.
An advantage to government to implement prefunding using the TPSP is that there is no change
to current tax revenues.
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In terms of the investment of the contributions, I propose that:
•
the money be invested in the health care sector by the independent board; and
•
the annual return on investment be set at 1.6 percent plus the rate of health-care inflation
in the year.
This proposal is made for several reasons:
1.
As discussed in the section regarding the equity risk premium, investment in equities may
not provide the level of returns historically available. Also, aging boomers are likely to
prefer a fixed income return to an equity return. This investment provides fixed-incomelike returns.
2.
There is a need for investment in the health-care sector to renew infrastructure, install
technology and enhance productivity. These funds would provide needed capital for
these purposes. Society would benefit by having these funds available for health-care
investments. Since the health-care sector is one that will become increasingly important
as the demographics change, positive equity risk premiums may be available on
investments in this sector.
3.
The 1.6 percent is the productivity assumption included in Robson’s calculations on
which the contribution of 1 percent of earnings has been based. As presented in the
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section regarding health care expenditures, productivity is an important factor
determining the sustainable level of health care expenditure given the current tax
structure. By requiring an investment return of the productivity assumption plus the
health-care inflation rate, there will be a built-in performance measure and performance
incentive. To the extent that investment performance in the health-care sector leads to
productivity improvements and to reductions in health-care inflation, all parties gain. To
the extent that there are productivity declines or health-care inflation increases,
contributors are apparently shielded (although they may face rising tax rates or costshifting). The federal government would be required to support any shortfall in returns,
by way of an increased transfer payment but directed to the fund established.
V - CONCLUSION
The financial pressures on the retirement and health care system attributable to the demographics
of a disproportionately large baby-boom generation combined with increasing longevity, are
inevitable. However, Canadian society will be better placed to absorb those pressures by taking
certain measures to reduce the rigidity and lack of flexibility of the current system. This paper
has examined certain aspects of the current system which will be profoundly impacted by the
aging of the baby-boomers. The following proposed actions will better prepare Canadian society
to handle the demographic pressures.
The sooner they are implemented, the more easily
Canadians will be able to deal with the demographic implications.
•
Eliminate mandatory retirement at age 65. Such action should be accompanied by a
change in compensation packages to ensure that older workers receive some financial
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compensation in lieu of employer-arranged insurance.
Moreover, performance
evaluation systems must be refined to ensure that workers who are unable to do a
competent job are retired, regardless of their age.
•
The expected return on equities, and most other investments, will decline as babyboomers liquidate or convert their accumulated assets. Greater savings than anticipated
will be necessary to meet retirement income objectives.
•
Most Canadians need to save more for their retirement years. Substantial tax deferrals
are available to support retirement savings. TPSP should be developed to provide a way
of saving in respect of health care expenses.
•
Some savings by workers in respect of future retirement income or expenditures could be
invested in the health care system to enhance productivity. If the invested funds are
credited with a rate of return based on an assumed rate of productivity plus the health
care inflation rate, there will be appropriate incentives to increase productivity and
control health care inflation. Moreover, savers will be shielded, at least partially, from
the pressures that the changing demographics will inflict on the health care system.
•
High productivity is an important factor in helping Canadian society to cope with the
financial pressures. A workforce that includes competent people of all ages combined
with savings being available for investment will be well positioned to achieve
productivity gains.
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ENDNOTES
1.
Brown, Robert L.: Impacts On Economic Security Programs of Rapidly Shifting
Demographics.
2.
See for example Statistics Canada. 2004. Announcement regarding “Deaths, 2002”
3.
See Andrews, Doug: An Examination Of The Equity Risk Premium Assumed By
Canadian Pension Plan Sponsors and Andrews, Doug: The Impact Of The Equity Risk
Premium and Population Aging On The Canadian Retirement Savings System.
4.
Aon Consulting Survey On Expected Returns.
5.
See for example, Parker, Thornton: What If Boomers Can’t Retire?: How to Build Real
Security, Not Phantom Wealth.
6.
Siegel, Jeremy J. : The Future For Investors Why The Tried and The True Triumph Over
The Bold and The New.
7.
Brooks, Robin: Life Cycle Portfolio Choice And Asset Market Effects Of The Baby
Boom, p.1
8.
Andrews, Doug: The Impact Of The Equity Risk Premium and Population Aging On The
Canadian Retirement Savings System.
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9.
In Canada only one jurisdiction, Ontario, has a pension benefit guarantee fund.
Accordingly bankruptcy of an employer with an underfunded pension plan may result in
benefit reductions for pension plan members.
10.
See Andrews, Doug, op.cit., p. 14-17
11.
Critics have argued that the system could be improved by raising tax-assisted savings
levels which affect those with higher incomes and by implementing savings vehicles
which are taxed differently to benefit those with lower incomes. Nevertheless, Canadians
have a relatively well developed array of vehicles to provide retirement income.
12.
Robson, William B. P.: Will The Baby Boomers Bust The Health Budget? Demographic
Change And Health Care Financing Reform, p. 11. Brown and Suresh in Further
Analysis of Future Canadian Healthcare Costs have suggested that a better methodology
to use to project future health care costs is to separate costs for survivors and decedents.
Using the information from the Brown and Suresh paper suggests that Robson’s
projections may be overstated by approximately 2%, which is not sufficiently significant
to change the thesis of this paper. In their paper, Brown and Suresh suggest that the use
of advance directives could reduce future health care costs significantly. There are a
number of policy initiatives that could be considered to reduce future health care costs in
Canada. In Mitigating the Impact of Rising Health Care Costs: A Discussion of Partial
Prefunding Alternatives, I suggest a few including euthanasia. This paper focuses on
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partial prefunding through tax-prepaid savings plans, with savings invested in the health
care sector. It does not consider other possible policy initiatives.
13.
Calculated using data from the Actuarial Report (21st) on the Canada Pension Plan as at
December 31, 2003.
14.
Robson, William, B. P.: op.cit., p.18
15.
Robson, William, B. P.: Time and Money: The Fiscal Impact of Demographic Change in
Canada, p. 20
16.
Sinn, Hans-Werner: Why A Funded Pension System Is Useful And Why It Is Not
Useful?
17.
Robson, William, B. P.: “Will The Baby Boomers Bust The Health Budget?, p. 23”
18.
Ibid, p. 20
19.
Kesselman, Jonathon and Finn Poschmann: A New Option For Retirement Savings: TaxPrepaid Savings Plans.
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BIBLIOGRAPHY
Andrews, Doug: An Examination of the Equity Risk Premium Assumed by Canadian Pension
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The Impact of the Equity Risk Premium and Population Aging on the
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Aon Consulting: Survey On Expected Returns, 2001 – 2005.
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