Thursday, October 16, 2014

Beyond Public Sector Pension Envy?

Adam Mayers of the Toronto Star comments, A closer look at our public sector pension envy:
Canadians who don’t have a pension often cast an envious eye at their friends and family who work in the public sector, maybe as nurses and hospital technicians, teachers, firefighters, police or municipal workers.

This is because 76 per cent of private sector workers don’t have a pension of any kind. But 86 per cent of public sector employees do. Most public sector pensions are the best kind — defined benefit plans paying a monthly amount for life. Many are adjusted for rising inflation.

If you were one of the have-nots, a diligent saver socking away all you could in a Registered Retirement Savings Plan, the 2008-09 stock market crash made you worth up to 40 per cent at the bottom. Markets have recovered — the current plunge notwithstanding — but even so, public sector pension envy has been on the rise. Safe. Secure. Indexed.

A recent Toronto conference on pension reform sponsored by Canada’s Public Policy Forum, took a closer look at the divide. Critics say public sector plans are unaffordable and unfair, and should be wound up. But would it really be cheaper and fairer to do so?

Billionaire investor Warren Buffett said this spring that public pension plans threaten the financial health of U.S. cities and states. He said everyone has underappreciated “the gigantic financial tapeworm” created when the pension promises were made..

Former provincial Conservative party leader Tim Hudak brought the debate out of the shadows in the recent Ontario election. He pledged to grandfather the current defined benefit model for public servants and move to defined contribution plans which shift a lot of the risk onto employees.

Defined benefit plans guarantee that monthly payment and you can sleep easier because professionals manage the money and your company has to ante up if there’s not enough in the pot.

A defined contribution plan is one where employer and employee contribute, but the size of the pension pot varies with market conditions. When you retire it’s up to you to invest and manage the money. The risk is yours.

About 12 per cent of private sector workers have a defined benefit plan, a number that has been steadily declining. Companies don’t like these plans because investment returns are hard to predict and whatever happens to markets the risk is all theirs.

Robert Brown, a retired professor of actuarial science at the University of Waterloo, told the conference that pension envy aside, it’s a bad, bad idea to wind up these public sector plans. Brown co-wrote a paper with colleague Craig McInnes that looked at the cost of conversion.

Brown summarized the finding by saying it will cost us a lot of money to cap the plans. Going forward, retirees would end up with a smaller pension and at the end of the day taxpayers would foot the difference with income supplements.

“It is a lose-lose,” Brown said.

Here are some of Brown’s other conclusions:
  • Private and public sector goals are different. It’s in the best interests of companies to cut costs and focus on profits. But when they off-load costs, they don’t care who picks them up. When the public sector does it, they offload the costs onto themselves, or another government.
  • Large, well-run defined benefit plans are efficient. They keep fees low and reduce risk by spreading their costs over a large number of plan members. They have a long time horizon which smooths out market ups and downs. These things help a defined benefit plan produce up to 77 per cent more income than a defined contribution plan with equal contributions, Browns said.
  • The risk of a public pension failing is far less likely than a private one.
  • The only way a defined contribution plan can lower costs is by decreasing benefits. In Nebraska and West Virginia where state plans were converted, they’ve partially switched back.
  • If public sector funds are capped and new ones set up, governments will have to run two funds in parallel for decades. If a legacy plan is underfunded the government is on the hook to cover the gap.
  • The conversions would carry a big political risk for governments in the form of job action and legal challenges. They would be seen as breaking contracts negotiated in good faith.
In the end the message wasn’t so much that public sector pensions are too rich, but that workers in private sector have been abandoned. Their employers are leaving them to make retirement decisions they are often ill-equipped to make, in an increasingly complex and unpredictable world.
You can read Brown and McInnes' paper here. I agree with Mayers, the message is not that public sector pensions are too rich but that the private sector has abandoned its employees, leaving them to fend for themselves in increasingly volatile and complex public markets.

Go back to read my recent comment on the brutal truth on DC plans where I discussed why defined-contribution plans are doomed to fail, ensuring more people will retire in poverty which will actually increase the social welfare cost to the state, increasing public debt:
...while shifting to defined-contribution plans might make perfect rational sense for a private company, the state ends up paying the higher social costs of such a shift. As I recently discussed, trouble is brewing at Canada's private DB plans, and with the U.S. 10-year Treasury yield sinking to a 16-month low today, I expect public and private pension deficits to swell (if the market crashes, it will be a disaster for all pensions!).

Folks, the next ten years will be very rough. Historic low rates, record inflows into hedge funds, the real possibility of global deflation emanating from Europe, will all impact the returns of public and private assets. In this environment, I can't underscore how important it will be to be properly diversified and to manage assets and liabilities much more closely.

And if you think defined-contribution plans are the solution, think again. Why? Apart from the fact that they're more costly because they don't pool resources and lower fees --  or pool investment risk and longevity risk -- they are also subject to the vagaries of public markets, which will be very volatile in the decade(s) ahead and won't offer anything close to the returns of the last 30 years. That much I can guarantee you (just look at the starting point with 10-year U.S. treasury yield at 2.3%, pensions will be lucky to achieve 5 or 6% rate of return objective).

Public pension funds are far from perfect, especially in the United States where the governance is awful and constrains states from properly compensating their public pension fund managers. But if countries are going to get serious about tackling pension poverty once and for all, they will bolster public pensions for all their citizens and introduce proper reforms to ensure the long-term sustainability of these plans.

Finally, if you think shifting public sector DB plans into DC plans will help lower public debt, think again. The social welfare costs of such a shift will completely swamp the short-term reduction in public debt. Only economic imbeciles at right-wing "think tanks" will argue against this but they're completely and utterly clueless on what we need to improve pension policy for all our citizens.

The brutal truth on defined-contribution plans is they're more costly and not properly diversified across public and private assets. More importantly, they will exacerbate pension poverty which is why we have to enhance the Canada Pension Plan (CPP) for all Canadians allowing more people to retire in dignity and security. These people will have a guaranteed income during their golden years and thus contribute more to sales taxes, reducing public debt.
Let me be even more brutally honest. As I watch Europe's deflation demons spreading, I worry that we're in for a protracted period of low growth and that what I saw on my recent trip to the epicenter of the euro crisis is a glimpse of the future of developed economies.

High unemployment, crushing public and private debt loads, reduced pension benefits and wages are not just a European problem, they can easily materialize everywhere and sink developed economies into a protracted period of debt deflation. This is what's spooking markets right now, the very real risk that deflation is coming and there's virtually nothing that monetary authorities can do about it.

Think about it. Joe and Jane investor are going to open up their monthly statements from their mediocre mutual funds which are likely underperforming in these tumbling markets and if they're getting ready to retire, they're going to be overwhelmed by retirement angst because they probably don't have enough to safely and securely retire in dignity.

And what about Warren Buffett's dire warning on pensions? I agree with him, America's looming pension disaster will not disappear but the answer isn't to scrap defined-benefit plans and replace them with defined-contribution plans. The answer is to reform them and introduce better governance akin to that of Canadian public pension plans.

In fact, Buffett's own pension strategy is not to scrap DB plans for supposedly "lower cost" DC plans and his pension wisdom clearly argues that fees matter a lot, which bolsters the case for large, well-governed public pension DB plans for every citizen.

Finally, it's important to remember that most people don't have Buffett's deep pockets, track record and lieutenants outperforming this market. America's new retirement reality is much more somber which is why I think now more than ever, it's time to go Dutch on pensions, ensuring every citizen can retire in dignity and not worry about the vagaries of public markets which are demolishing even the most sophisticated hedge fund investors (see clip below).

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