Two of Canada's largest unions (Air Canada and Canada Post) recently went on strike to save their defined-benefit pension plans against the wishes of the employer to switch new employees to defined-contribution plans.
What are these plans all about and why all the fuss?
As the name implies, a defined-benefit pension plan promises to pay you a defined benefit when you retire. This can be a flat benefit (you get a pension that pays $1,000 a year in retirement for every year of employment -- if you have 30 years of service you get $30,000 a year). Or it can pay out a percentage of your salary just prior to retirement (you get a pension that pays 1.5 per cent of final average pay for every year of employment -- 30 years of service yields 45 per cent of your final average pay).
So, in a defined-benefit plan, you know what annual benefit you will receive in retirement and you have a good idea of how much more you need to save on your own to be fully secure.
The risks of a defined-benefit plan are carried by the employer (although, in the long term, higher pension costs could force wages down).
The present environment packs a triple whammy of bad news for these employers. First, interest rates are very low, so the value today of retirement income to be paid many years in the future is not as significantly discounted (e.g., at four per cent versus eight per cent). Second, because of the financial crisis of 2008/09 and the mediocre recovery, pension plan assets are worth less than they were expected to be and pension plans are in the hole -- they owe more money to employees than they have in the plan (Air Canada has a $2.1-billion deficit while Canada Post's is $3.2 billion). Third, people are living longer and this means they collect pensions longer and company costs go up.
Adding to the concerns is the ratio of retirees to active workers that is now about one-to-one at both Air Canada and Canada Post. This matters, because the cash flow needed to pay benefits must come from worker contributions and investment returns. With the growing ratio of retirees to workers, the plan becomes more dependent on investment returns that are low today.
In these defined-benefit plans, the worker has a defined benefit and increased costs are the responsibility of the employer. This is bad news today but if the economy improves, good times for the employer could return.
The opposite is true for defined-contribution plans. Again, as the name implies, in a defined-contribution pension plan, it is the contribution that is defined with no commitment to how much will be paid out in retirement. For example, the plan may provide that the employer will contribute $1 to the pension plan per hour of work. Or it could state that the employer will contribute five per cent of an individual's pay into the plan.
Once the employer makes the contribution, however, that is the end of the employer's responsibility. If the stock market crashes or interest rates on investments are low, the worker will have a lower asset pool at retirement and, thus, lower retirement income. The worker, therefore, has no idea until very close to retirement what income to expect and how much more to save. Just imagine the difference between retiring in 2007 versus 2009.
It is also true that, even if investments work out as hoped for, the new defined-contribution pension plans being offered by Air Canada and Canada Post should not be expected to result in benefits as large as the defined-benefit plans they want to close.
For the level of benefits now promised to Air Canada and Canada Post workers, employer contributions in excess of 10 per cent of pay would be expected in today's climate. One would not anticipate the new defined-contribution plans being that rich.
So, the benefits being negotiated are important and real. Management will continue to attempt to pass the pension risks over to the workers by using defined-contribution plans and workers will work equally hard to retain their defined benefits.
That's the reason for all the fuss.
Indeed, that's the reason for all the fuss about pensions. Workers want to maintain their current defined benefit plans, but employers are telling them "we can't afford it so get used to the idea of defined-contribution plans."
In an op-ed to the Montreal Gazette, Bill Tufts, an employee benefits consultant and the founder of Fair Pensions for All, an organization devoted to public-sector pension reform, warns that the an unsustainable pension gap is growing:
The Gazette's July 4 editorial, "City hall is right to get tough on pension funds," applauded proposals from the city of Montreal to take steps to control its growing pension obligations.
Montreal's problems with public-sector pension affordability are being mirrored in the rest of Quebec and indeed the entire country. Canada has become a land of pension haves and have-nots. There is a growing gap between public-sector-employee pension benefits and taxpayers who fund those generous goldplated pensions but don't have one of their own.
The Gazette reported that the average police officer in Montreal is retiring at age 53 with a $59,000 annual pension. The average Canadian, by comparison, has only $60,000 saved in his/her RRSP.
The police officer will collect a pension every year for the rest of his/her life, worth an estimated total of about $2.6 million until age 84. The way things are set up, many public-sector workers will collect more income in retirement then they earned during their working careers.
This pension gap has been growing over the past 30 years and has now reached a level that is unsustainable economically, politically and socially. Taxpayers are being shortchanged and, without reform, things are only going to get worse.
In an upcoming book that I am co-writing entitled Pension Ponzi, will show how the Canadian government and hence taxpayers have gone into serious debt to fund this significant transfer of wealth into public-sector pension plans.
Those who favour the status quo like to point out that public-sector employees deserve their plans because workers pay into them. They are only reaping what they have sowed, in other words. But this is a very weak argument.
Take Hydro-Québec as an example. In early 2009, the utility implemented a questionable accounting concept called pension smoothing that "smoothed out" or spread out over a number of years the $3.1-billion pension loss that it incurred in 2008.
Pension smoothing allows Hydro-Québec to present a picture of its pension situation that underestimates the problems it is facing. Hydro's accounting manipulation only postpones the necessary reforms that will ultimately be required to keep the plan afloat over the long term.
Where pension smoothing was tried in San Francisco, the public defender said: "It is like telling your spouse that you lost only $500 in Las Vegas instead of the $5,000 you actually lost, because you are spreading your losses over 10 years."
A fairer estimate of the cost to taxpayers is to look at the actual cash pumped into the Hydro-Québec pension plan. As the accompanying graph shows, the utility has had to pump $869 million in special contributions into the plan from 2008 to 2010 to help boost the assets.
Reforming public pensions will not be easy. In the United Kingdom last week, close to 750,000 public-sector employers protested on the streets against raising the retirement age for public-sector workers to 66 from 65. In Canada, public-security workers can retire as early as age 50, with the rest of the public sector eligible to retire at age 55.
Montreal municipal pensions are particularly expensive for taxpayers because the concept of final average salary is used to calculate benefits. This means that the average of the highest three, or five, years of salary earnings is used to calculate the pension benefits (typically equal to 70 per cent of that average). Part of the U.K. pension reform would see a move toward calculating benefits based on career average salary. This needs to be done here in Canada as well.
We should also be looking at moving toward hybrid pensions. In a hybrid plan, the employer's pension contributions go into a traditional defined-benefit plan, while the employee's contributions fund a defined-contribution plan.
This way, any future shortfalls in the plan after the employee retires do not necessarily fall solely on the shoulders of taxpayers.
Taxpayers need to fight hard for public-sector pension reform. Too many taxpayers without pensions of their own are being asked to pay too much money out of their own pockets to finance the pensions of public-sector workers.
THE HEAVY BURDEN OF HYDRO-QUÉBEC PENSIONS
Pension benefits paid out by Hydro-Québec grew by almost 50 per cent from 2006 to 2010 - from $420 million to $602 million. From 2008 to 2010, the utility has had to pump $869 million in special contributions into the pension plan to help boost its assets going forward.
Hydro-Québec pensions: contributions and benefits
2006 2007 2008 2009 2010 Total
Employee contributions $54 million $66 million $84 million $118 million $120 million $442 million
Hydro regular contributions $319 million $5 million $291 million $295 million $296 million $1.206 billion
Hydro special contributions $62 million 0 $149 million $370 million $350 million $931 million
Pension benefits paid out $420 million $460 million $510 million $551 million $602 million $2.543 billion
And finally, Jonathan Chevreau of the National Post writes on myths of defined benefit pensions:
Tuesday’s blog and Wednesday’s column on Keith Horner’s proposal for a National Defined Benefit pension plan grafted on to the CPP adds fuel to the eternal debate about the relative benefits of DB pensions and the more market-driven DC (Defined Contribution) plans that are displacing many employer DB plans.
While Horner comes down in favor of a DB-like enhanced CPP, he also looks at two alternative proposals built around the DC model, one of them compulsory, the other voluntary. The government’s favored proposal of Pooled Registered Pension Plans (RPPPs) falls somewhere in the middle between the two DC schemes. We’ll look at this more in the coming weeks.
After the blog ran I heard from pension consultant Greg Hurst, president of Vancouver-based Greg Hurst & Associates Ltd. In a lengthy email followed with a telephone interview, Hurst confessed to being “driven crazy” by the many DB myths that come up in any of these debates about DB versus DC pensions.
As you can read in various Hurst-authored articles in Benefits Canada, he has been a vocal opponent of CPP expansion and is in favor of some kind of private-sector DC plan like the PRPP — however, he shares with Big Labour a reluctance to simply turn PRPPs over to Bay Street’s fund companies, banks and insurance companies.
Money In equals Money Out
Hurst began by saying he once learned from a wise actuary the valuable lesson that “money in equals money out.” Seemingly simple, but DB pensions get very complex when they start to factor in the dimensions of time and pooling of risks and rewards.
But both DB and DC pensions are still subject to some simple arithmetic similar to what the wise actuary once stated:
Money In equals contributions plus investment gains.
Money Out equals benefit payments, expense payments and investment losses.
In practice, both DB and DC pensions are usually invested almost identically across diversified portfolios of stocks, bonds and other asset classes. The fact that plan members in DC pensions often are confronted with a myriad of investment choices tends to drive up their costs and poor decisions by unsophisticated members tends to result in lower investment returns than a pooled diversified portfolio might yield.
Pure “no-choice” DC plans can be simpler than DB plans
Hurst says a “no-choice” plan would be a “pure DC” plan, one that is simpler to administer than a DB plan. The result is lower expense payments, which leaves more for benefits.
On the other hand, DB plans do have the advantage of longevity risk pooling, which is normally absent from DC plans unless they offer life annuities at retirement. The two types of plans also have differences in timing of contributions relative to delivery of benefits — what Horner’s study refers to as “risk pooling between age cohorts.”
Generational conflicts and the 3-D HurricaneThen there are the kind of intergenerational funding conflicts that were touched on in last weekend’s blog on the coming 3-D Hurricane baby boomers are facing in many western nations. [If you've not yet read it you may wish to do so now: that particular blog has generated a large number of web "hits." 3D refers to demographics, debt and deficits]
As Hurst puts it, increasing longevity, the demographic “bulge” of boomers moving to the benefits phase and intermittent periods of economic recession all come into play.
The tendency is to raise benefits while holding funding steady, which has resulted in pension crises around the world, particularly in France, Greece and even the UK. The prudent thing should be to build excess funding reserves in anticipation of adverse demographic and economic conditions but few governments and almost no private employer pension plans have done this, Hurst says.
Why reformers are tempted to build on the CPP
A notable exception is the Canada Pension Plan, which was put on a firm foundation in the 1990s. Perhaps that’s why so many current proposals for reform, including Keith Horner’s, try to build on that firm base.
Hurst says Horner’s paper is an “excellent treatise” but says its principal failing is in assessing the risks of the “critical differentiators” noted above.
We’ll close with this direct lift of Hurst’s email to me:
How can the significance of such risks be ignored in the context of riots in Europe and widespread media coverage of the state of public sector pension plans in the U.S. and elsewhere? The current policy direction being followed in Canada is to preserve the stability of our current government programs, and enhance them with stronger, more universal DC arrangements.
The former provides a strong basic level of pension, while the latter can empower individuals to ensure their own retirement income security with far less exposure to the demographic and economic risks that have undermined the security of DB plans worldwide.
I'm not going to argue against the fact that the pension gap between private and public sector workers is growing or that demographic and economic risks have undermined the security of DB plans worldwide, but the critics of enhanced CPP are distorting the facts to suit their political agenda.
The most important fact lost in this debate is that defined benefit plans can work if you get the funding right and when administered properly using world class governance standards, these DB plans outperform DC plans. I think people like Greg Hurst and even Bill Tufts have a lot to lose if CPP expansion takes hold, which is why I take everything they write with a grain of salt.
One huge point of contention I have with the "Greg Hursts" of this world is that they claim a “no-choice pure DC” plan would be a lot simpler to administer than a DB plan, resulting in lower expense payments, which leaves more for benefits. This is pure and utter nonsense. The last time I blasted Jonathan Chevreau on my blog, in another entry on Canada's pension myths, I stated the following:
Last week it was Jonathan Chevreau of the National Post who criticized the Liberals' proposal, dragging "Big CPP" into Canadian politics. I ripped into that analysis, and I'm going to rip into this one too. The National Post should be ashamed of itself for publishing this drivel. I'd love an opportunity to openly debate the likes of Jonathan Chevreau, Neil Mohindra and anyone else who blindly supports the private sector "solution" and openly questions the benefits of Canada's large defined-benefit (DB) plans without basing their analysis on facts. Then again, what else do you expect someone from the Simon Fraser Institute to write? It would be nice if he disclosed how many banks and insurance companies fund this institute.So, while people worry about the "Pension Ponzi," I'm far more worried about "Pension Poverty," which I see growing by leaps and bounds over the next decades. It's high time Canadian policymakers get their collective heads out of their asses, stop reading the right-wing drivel Mr. Chevreau and the National Post publish and start listening to real pension experts like Bernard Dussault, Canada's former Chief Actuary and others who actually know what they're talking about.
I'm too tired and cranky to go through all the arguments I went over last week. Do the large DB plans take too much equity risk? Yes, they do, both in public and private equities. Do they invest in alternative assets like hedge funds, real estate and infrastructure? Yes, most of them do invest in all these asset classes (except hedge funds; a few funds don't invest in external hedge funds) and they also have internal alpha strategies to lower their costs. Are these alternative asset classes "riskier" than bonds? Yes, but over a long period, they're typically a lot less risky than stocks and they offer important diversification benefits.As far as the "administrative costs" of the CPP, they are shared by Human Resources Development Canada and the Canada Revenue Agency, which is good. These agencies are delivering great service at a very low cost. The private sector wouldn't do a better job at administering the CPP.
Finally, as I mentioned in my comment on the "Big CPP," most Canadians are clueless about CPPIB's investment partners, but I assure you that no defined-contribution (DC) plan can invest in Brevan Howard, Bridgewater, Apax, Lone Star, Texas Pacific Group or any of the other top private funds listed on their site. This is an important source of alpha, on top of the internally generated alpha, adding basis points on their policy (benchmark/ beta) portfolio. Over the long-term, all that alpha adds up, which is why CPPIB pays these managers big fees for delivering meaningful alpha.
If Mr. Mohindra and Mr. Chevreau can find me a low cost ETF that delivers a performance remotely resembling that of these top fund managers, then I will listen to their arguments. Till then, I suggest the National Post stops publishing these spurious comments from biased "experts" who spread disinformation and perpetuate myths claiming Canada's large DB plans can't do a better job than the private sector in managing our retirement savings. They are doing a better job and they should be given increasingly more responsibility to continue delivering low cost pension fund management to as many Canadians as possible who are willing to pay premiums for a secure retirement.
If we're going to solve the pension crisis once and for all, we need concessions from all stakeholders, but we also need to leverage off our smartest resources and avoid so-called "experts" who pander dangerous ideas that will only ensure more pension poverty down the road. They are hazardous to the pension health of our great country and I will call them out every single time.
Bernard Dussault, Canada's former Chief Actuary, sent me these comments:
Regarding Rob Browns’ analysis of the “Why The Fuss Over Pensions” (more specifically with respect to DB plans), my view remains that there would essentially be no fuss if DB plan sponsors were not allowed to take contribution holidays and were compelled to amortize any emerging pension surplus or deficit over a pre-determined number of years (5, 10, 15?). Moreover, the high ratio of pensioners to active members is not a financing pension issue per se. The issue is the lack of assets/liabilities matching, a matter that can easily be addressed by plan administrators but often overlooked.