The Diminished Expectations of Age

On May 14th, Power Financial CEO Jeffrey Orr told shareholders that “the vast majority of Canadians are on track to sustain their standard of living in retirement,” and cautioned against implementing the proposed Ontario Retirement Pension Plan (ORPP) or expanding the Canada Pension Plan (CPP).  Orr’s remarks to Power Financial’s annual meeting (fittingly held at the Shangri-La Hotel in Toronto) were covered in the Toronto Star and the Globe and Mail.

That Power Financial, which controls Great-West Life and Investors Group, would oppose expanding public pensions isn’t particularly noteworthy.  As Bruce Little recounts in his book Fixing the Future, insurance companies and financial institutions actively resisted the creation of the CPP in the 1960s, and have periodically fought attempts to improve it since then.  What makes the news coverage of Orr’s remarks worth mentioning is that newspapers again uncritically repeated the findings of a problematic February 2015 study by McKinsey and Company entitled, “Building on Canada’s Strong Retirement Readiness.”

In the wake of its publication, many media outlets chose to simply repeat McKinsey’s findings that the vast majority of Canadians are saving enough for retirement. However, the report itself is ultimately unable to substantiate its headline claim that widespread insecurity over retirement incomes is overblown, and targeted solutions aimed at a small fraction of undersavers are called for.

In the pension reform debate, the 70% figure commonly used as the hurdle for income replacement in retirement is a gross rate. Stripping out fluctuations in taxes paid, saving and dissaving over the life course, the standard for net pre-retirement income replacement rates is 100%; in the transition from work to retirement, one would want to experience continuity in living standards, defined as “consumption possibilities.” McKinsey acknowledges that a net replacement rate (what they measure using a “Retirement Readiness Index”) of 100% means that a household can maintain the same level of consumption in retirement that it had prior to retirement.

However, McKinsey doesn’t use the 100% hurdle, because they claim households voluntarily reduce their consumption in retirement. According to McKinsey, households in the lowest income quintile in retirement only consume at 80% on average of their consumption level in pre-retirement, and all other quintiles consume at 65% (on average) of their pre-retirement consumption.

So “maintaining their standard of living in retirement” no longer means that households have a 100% net replacement rate and the same degree of consumption possibilities in retirement. “Maintaining their standard of living in retirement” now means that the poorest households consume at 80% or more (on average) of their pre-retirement consumption level, and all other quintiles consume at 65% (on average) or more of their pre-retirement consumption.

Having significantly reduced households’ consumption possibilities by assumption, McKinsey reports the good news that only 17% of households fall below the reduced standard of living threshold, while 83% exceed it.

The problem is that McKinsey provides no empirical support for their assertion that retirees consume at an average of 65% and 80% of their pre-retirement consumption. In particular, they fail to reconcile this assertion with Statistics Canada findings and other studies that conclude the opposite. Sébastien LaRochelle-Côté pointed out in a brief 2012 note that “despite a decrease in income, consumption tended to remain relatively stable among aging Canadians, at least in their seventies.” In fact, “twenty years after reaching age 50, households in this cohort had an average income replacement rate of 84%, but were still consuming more than 95% of what they consumed at the start of the period on average.”

The previous year, Amélie Lafrance and Sébastien LaRochelle-Côté wrote that “when controls were introduced for the declining size of aging households, consumption levels remained relatively stable as households aged. Indeed, households in their early 70s consumed 95% of the level measured for the same cohort in its late 40s.” They went on to note that “this result is consistent with U.S. studies based on longitudinal data finding that retirement is associated with negligible decreases in consumption in most population groups.”

The issue of appropriate replacement rate targets is certainly complex, and a single gross replacement rate ‘rule of thumb’ of, say, 70% isn’t all that useful (see MacDonald and Moore 2011 for a discussion).  But as the McKinsey study acknowledges, a 100% consumption replacement rate is the broad objective for preserving living standards in retirement. Despite this, the McKinsey study assumes from the get-go that consumption possibilities on average will fall in retirement.

And this is perhaps the most significant aspect of the study: it rationalizes the coming drop in post-retirement consumption possibilities that many have warned about. It would be a significant setback to accept such diminished expectations in retirement as the ‘new normal’, however. Lower consumption possibilities will constrain the ability of many seniors to adequately confront inflation, longevity, health and other risks in retirement. McKinsey’s own study found that a third of households currently retired report wanting to spend more, but feel financially constrained, and this share is very likely to grow as the baby boom cohort passes into retirement.

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