When it comes to managing pensions, optimism is a cardinal sin.
But there's evidence to suggest that many Canadian pension funds are built on unrealistic expectations regarding their returns, putting at risk the financial plans of many future Canadian retirees.
"Nobody likes to hear this but it's a bitter medicine we all need," said Moshe Milevsky, co-author of Pensionize Your Nest Egg and a finance professor at York University's Schulich School of Business. "Otherwise, we get into a situation like many states in the U.S., where they have deficits of 50 or 60 per cent because of unrealistic assumptions."
Say a big pension plan doesn't make as much on its investments as it anticipates. It would need to save more today to avoid a deficit.
But try telling a plan administrator to consider lowering forecasted returns and you're likely to be shown the door. Those returns are used to discount future liabilities, in order to put a current value on all the future payments to a plan's members.
"The first reaction is, 'That's going to make my plan more expensive,'" Mr. Milevsky said. "They have to set aside more money; they often have to go to their participants and say you have to contribute more."
That's a tough sell.
Consider the Canada Pension Plan. While Canadians are told that CPP is fully funded, its liabilities from 2019 onward are discounted at a real rate of 4 per cent. Factor in an inflation rate of 2 per cent and CPP expects a nominal return on its assets of 6 per cent a year – every year. Other Canadian administrators use rates as high as 8 per cent.
"I think this is too aggressive," Mr. Milevsky said.
Discount rates are set by actuaries based on long-term averages of past returns. That's just not good practice, according to C.D. Howe Institute.
"Forecasts based on past performance should not form a basis for decision making, as they consistently point in the wrong direction," the think tank said in a new report.
Returns over the next several years aren't likely to match historical averages, the report said. Instead, it forecasts a real return of 2.7 per cent over the next decade on a portfolio split evenly between stocks and long-term bonds.
"A lower discount rate would increase [defined benefit] pension plans' liability valuations and also lead to a substantial increase in their annual servicing costs," C.D. Howe said.
Individual savers and those in defined contribution plans need to beware the dangers of overoptimism as well.
The savings required for retirement using more conservative returns are far higher than when using the typical pension plan forecast.
Take an individual who saves over the next 30 years and reaches a $100,000 pre-retirement salary. To secure a 70-per-cent income replacement, that person would need to save 20 per cent of gross income using C.D. Howe's outlook. That's 45 per cent higher than under the rosier scenario that most pension plans currently operate under.
"If you are saving for retirement and make unrealistically high assumptions about what your portfolio will earn, then you will be disappointed," Mr. Milevsky said.
So could those Canadians counting on CPP benefits if the pension fund fails to live up to its own expectations.