On the future of pensions in Canada

8 minute(s)

Pensions as my parents knew them are dead. Not only do they not make sense for the next generation, they never made sense to begin with.

Pensions were negotiated without full consideration for the long-term liability they represent, creating unsustainable systems whereby new contributions only pay retiree income and are not actually saved for contributors' own retirement, making the fundamental assumption that populations and economies will grow continuously and infinitely - an assumption that cannot be taken for granted. Private pensions are also unprotected, leaving pensioners holding the bag if/when things go wrong (eg. Sears, Nortel, Indalex, and more).

These shortcomings are exacerbated by the changing environment: Increasing lifespans, a growing informal + self-employed sector, sustained low-rate environment, and shrinking populations all put pressure on this model.

This is a critical issue for Canada.

There is a $3T retirement gap as of 2015, which will balloon to $13T by 2050. 12M working Canadians have no workplace pension, and thus relay on private savings or Canada's social security benefit which totals ~$20K, enough to avoid poverty but not enough for a dignified quality-of-life. Less than 20% of Canadians have enough private savings to adequately supplement public coverage.

This means that most Canadians risk late retirement, and/or insufficient income to last through retirement. It means that for the average Canadian, over 4 decades of full-time work is insufficient for peaceful, dignified rest in their old age.

Pensions for the next 50 years can be secured but will require novel solutions. In Canada's context, there is specifically an opportunity in government-managed reverse-mortgages.

Reverse-mortgages allow homeowners to exchange home equity for regular income while living in the property, and can mimic traditional pension cash-flows. Currently, they have complex structures and concerns have been raised that lenders take advantage of this, but a government-managed program could avoid such pitfalls.

Consider the following “base case”: a retiree with a $500K home enters a reverse-mortgage at 5.49% and other conservative assumptions are held (eg. <3% annual home appreciation vs. 5.65% actual over the past 30 years). This would deliver $1,500 monthly for 15 years, nearly matching the maximum benefit from public coverage while leaving over $100K in equity. In a highly conservative case where the home value doesn't increase at all, 14 years of income could be sustained before equity is exhausted (ie. net value becomes negative).

Almost $200K woudl be paid in interest which can create sticker shock, but it's important to remember the unique benefits:

  • Saved rent expense incurred otherwise by downsizing into a rental or through a sale+leaseback.
  • Income isn't taxable, and thus doesn't reduce public pension benefits eligibility.
  • Downside protection where if the home value decreases, mortgagors never owe more than the fair value of their home.

A reverse-mortgage program allows retirees to maintain their retirement quality of life and still potentially pass on meaningful inheritances. To enable wide-spread reverse-mortgages, the government will need to play a role in managing the ecosystem, starting by redesigning the product.

Note: I am not recommending specific policy, focusing instead on the high-level steps to achieving desired outcomes. “Canadian government” is used as a general term to include federal and provincial regulators/policymakers, including agencies such as OSFI.

The Canadian government will need to support the development of new reverse-mortgage products engineered for the mass-market retiree in mind. This would include three key features:

  • Standardized terms that simplify the purchasing experience and decrease up-front costs (eg. origination fees). This is critical to reducing the barrier to entry.
  • Integration for end-of-life care that allows reverse-mortgagors to vacate the premises while continuing to receive payments (or sell the home early) to pay for end-of-life care. This is critical to ensuring that the product caters to the full lifecycle of retirees's needs.
  • Payments pegged to inflation that ensure mortgagors sustain their quality of life in real terms. This is already possible today [and in the full version of the essay, is modelled into the illustrative cases.]

Beyond these design elements, the government should drive two broader shifts:

  • Mutualize the insurance that mortgagees pay to cover the risk of declines in property value. By aggregating coverage across providers (eg. underwritten by a global reinsurer), the government can drive economies of scale, leading to lower interest rates.
  • Rebrand away from “reverse-mortgage” which may connote “giving up” home equity. Instead, a “home equity pension” (HEP) or similar branding would frame the product to what it really is: a method of unlocking the value of a lifetime's worth of investment in property.

These initiatives enable HEPs that are more affordable, purpose-fit, and socially admissible.

The government will also need to open the market to a greater number of providers - specifically, Canada's largest banks.

These institutions have the expertise, balance sheet, and footprint needed to serve Canadians. For example, consider the T1 capital ratio of Canada's largest banks as of Q3 2019:

  • RBC: 13.00%
  • TD: 12.00%
  • Scotiabank: 13.00%
  • BMO: 11.70%
  • CIBC: 12.70%

The Basel III requirement is 10.50%.

Today, these institutions do not offer HEPs due to their conservative nature and the strict governance frameworks they are subject to. By encouraging their participation (eg. allowing IRB calculations for HEPs), the government can foster greater competition in the market and enable seamless access (these banks already serve most Canadians, have them KYC'd, etc.).

Such a program would not be without its downsides.

It is critical to note that this proposal is not perfect, with several limitations to consider:

  • Doesn't serve everyone: By 64, 80% of Canadians own their primary residence (and this has increased over time), indicating that reverse-mortgages can help many. However, those who don't own a home and don't have other savings will need to rely on the social safety net. The net of income supplements combined with the country's universal healthcare and public housing program offered by the CMHC can ensure retirement even for those with limited resources.
  • Limits intergenerational transfers: A HEP usually terminates with the sale of the home. This contravenes the social desire to leave assets behind for descendants, but as explored in the models above, a HEP can still leave cash behind while funding the desired quality of retirement life. To mitigate this further, the government should explore how HEPs may be designed to be tax-neutral vs. property transfer, so that retirees and their descendants are not disadvantaged for unlocking the value of a home earlier.
  • Relies on increasing home prices: Presuming a growth in housing prices introduces risk, as this may not always hold true. However, even in a highly conservative case with 1.5% growth while working and no growth in retirement, a HEP can provide meaningful income for 10+ years.
  • Increases exposure to the housing market: The Canadian market may become doubly exposed to housing (on regular mortgages and on HEPs). With regular mortgages, this is offset by CMHC insurance. For HEPs, a similar insurance program could be instituted, underwritten by a global reinsurer rather than the CMHC to spread the housing market risk.
  • Facilitates concentration of wealth over generations: Those who rely on home equity to fund their retirement will deplete the asset, while those with other savings will be able to retain the asset and pass it on to their children who can continue to capture its appreciation. It is unclear without significant simulation and modelling whether the widespread use of HEPs will exacerbate this beyond what would otherwise be experienced, but this is worth flagging for further investigation. For this essay, a detailed examination of this risk was considered out of scope.

HEPs drive value for retirees, financial institutions, the government, and society; they can plausibly be negotiated for wide-spread use.

HEPs allow retirees to draw stable income and give descendants confidence that their parents are comfortable. They allow institutions to earn new revenue and acquire assets that have outpaced the S&P500 for 20+ years. They allow the government to secure pensions without raising new funds (ie. increasing taxes). Most stakeholders (if not all) likely benefit from such a program, and thus negotiating it - with collaboration between the public and private sector - should be feasible. A starting point would be a series of roundtable discussions between banks and Canadian regulars to design principles for the new product, model the program in greater detail, and explore concerns/complications surrounding its deployment.

In conjunction with the expanded use of HEPs, three regulatory pillars should also be enacted to drive greater access and adoption of pension programs.

The Canadian pension system can benefit from other policy shifts. First, pensions should be made portable, with easy switching between employers/geographies, driving greater access. Second, all companies above a certain size should be federally required to provide pensions, further driving access and adoption. And finally, all pension programs should mandatorily be “opt-out” instead of “opt-in”, further driving adoption.

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