Monday, January 18, 2010

$58 Billion Debt Time Bomb?

Kathryn may of the Ottawa Citizen reports that federal PS pensions a $58B debt time bomb, think tank says:

OTTAWA — The federal government's bookkeeping of its pension promises for public servants is out of whack with the real costs, understating Canada's national debt by $58 billion, says a report by a leading think-tank.

A study by C.D. Howe Institute on the "fair-value" costs of the pension liabilities for Canada's public servants, military and RCMP concluded the government's estimates are so understated that most of the surpluses racked up over the past decade should have been deficits.

"Experience in steel, cars, telecoms and other mature industries has shown how understating the cost and volatility of defined benefit obligations can lead plans to run accumulated deficits larger than their sponsors can cover, leaving pensioners short and/or taxpayers picking

up the pieces," said the report. "We need to get a better handle on public-sector pensions before similar accidents happen on a more colossal scale."

To cover the real costs of federal pensions, C.D. Howe president Bill Robson, who co-authored the report, said public servants should be contributing 34 per cent of their pay to the plan every year -- and the RCMP and military would have to fork over 41 per cent of pay.

The big difference in costs lies in the way pension liabilities and assets are accounted for.

Robson said the way federal pensions are now accounted for is exposing taxpayers and public servants to "under-appreciated risks," he said.

Robson said he finds no fault with the chief actuary who reviews the pension accounts, or Auditor General Sheila Fraser, who audits the government's financial statements, because they are following the accepted accounting practices. But he argues the unravelling of other defined-benefit pension plans like Nortel and GM exposed the shortcomings of these practices.

Defined-benefit plans are supposed to have enough assets to back the promised retirement income, but they aren't always managed and accounted for that way.

The books typically "smooth" out the value of assets by using a combination of past and projected future prices. The liabilities are understated using discounted future payments that are unrealistic so pension obligations look smaller than they really are.

Instead, Robson said the government should use "fair-value" accounting, which uses current prices to value assets and liabilities as if a plan was being liquidated or wound-down.

"It's crazy to show promises on the books for less that it would cost to pay off that obligation," he said.

"Our quarrel is they are using these high investment returns and, we say, there is a better benchmark that more closely resembles what the pensions will cost."

For Canadians, the difference

between the assets and liabilities recorded in the pension accounts is part of the national debt.

And lowballing the government's pension obligations in turn means the national debt has been understated by $58 billion, said Robson. The government recorded liabilities of $140 billion last year compared to $198 billion using C.D. Howe's fair value calculations. That means the debt is $522 billion, not the $464 billion recorded in the public accounts.

Fair-value accounting for pensions also turns the surpluses between 2002 and 2008 into deficits -- with last year's $7 billion higher than recorded.

The implications are huge, calling into question policy decisions made when the government thought it was racking up annual surpluses. The government went on a spending and hiring spree over the past decade, dropped the GST rate and cut corporate taxes.

The Conservatives are now racing to balance the books at a time when many say a demographic crunch has left Canada's economic potential at its lowest ebb in 40 years.

Pensions hit the national agenda with the collapse of Nortel and GM as angry workers and pensioners found pension funds didn't have the money to pay the pensions they were promised.

Not surprisingly, many pointed to the gap between the private and public sectors, which typically offer generous early retirement provisions and pension payments indexed to inflation.

The gulf between public- and private-sector pensions is an issue Finance Minister Jim Flaherty acknowledged he has to deal with in his pension reforms.

Federal unions believe the C.D. Howe study, which appeared as Flaherty met with his provincial counterparts in Whitehorse to discuss pension reform, put federal pensions on the table as the government struggles to find ways to reduce costs.

The private sector is abandoning defined benefit plans in increasing numbers for cheaper or more "financially sustainable" defined contribution plans.

In fact, the C.D. Howe report suggests the true cost of the plans could lead the government, like other employers, to convert its defined benefit plans to less volatile defined-contribution plans -- a proposal that would spark an all-out war with unions.

But Robson argues the unions should be pressing for change because it's their members who will be on the hook if the government doesn't fund the pension plans properly.

"Unions should also be concerned that the plan is largely unfunded. If they are looking out for the interest of their members, they should get more in this plan, so whatever happens to federal finances, that there are assets to back those obligations," he said.

Robson said the government has several options to "level the playing field" between the sectors. It could reduce the value of public servants' benefits or allow Canadians to build pension funds as big as public servants by allowing them to sock more than 18 per cent of their incomes into RRSPs.

"If a pension this rich is desirable for everyone and not just public servants, then shouldn't we be allowed to save more than we are now?" said Robson.

The government could better fund the plan by increasing the contribution rates employees pay into their plans. Contributions to pension plans are shared 50-50 between public servants and the province in Ontario, Quebec and Alberta so many argue there's no reason federal workers can't fully pay their way.

Now, it should be noted that the C.D. Institute is a conservative think tank which often takes positions based on conservative political views. They have argued for a private sector solution to the pension crisis, which I strongly disagree with.

But on the issue of underestimating pension liabilities, they raise important points. This study is likely overestimating liabilities because taking everything at market price is simply ridiculous given that private market assets (real estate, private equity, infrastructure assets) tend to be overvalued or undervalued at extremes.

One can make the case (albeit a small one) that these private assets are now undervalued. The problem is that they can stay undervalued for a lot longer than investors think. And if we enter a deflationary environment - something which Hoisington has brilliantly analyzed in their latest quarterly commentary, Hard Road Ahead - then it's going to be a long, tough slug for private markets.

Finally, I already discussed Mercer's little Alaska problem and the fact that according to some think tanks, like the British-North American Committee, governments of the US, UK and Canada are understating the true cost of public pensions. If true, then you got the seeds to the next debt time bomb. The hard road ahead is looking harder when you sit back and analyze the implications of all these pension liabilities, especially if you consider the possibility that they're grossly understated (read this Business Week article).

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