Thursday, December 6, 2018

The Dirty Secret Behind Canada's Pensions?

Philip Cross, the former chief economist of Statistics Canada, wrote a comment for the National Post, The dirty secret behind Canada’s supposedly ‘successful’ public-sector pensions:
The large and growing gap between public and private sector pensions is arguably the most striking feature of Canada’s retirement system. Defined-benefit pensions — or DB pension plans — the most sought-after and valuable workplace pensions, are now found almost exclusively in the public sector. Eighty per cent of public sector workers participate in DB pension plans. Only 10 per cent of private sector workers can make the same claim.

The demise of private sector DB plans has been neither sudden nor surprising. Participation rates peaked in the 1980s but eventually the collapse of interest rates in the early 2000s made DB plans prohibitively expensive. They now cost more than most private sector employers are prepared to pay and more than most private sector workers believe the plans are worth.

The mystery is not why DB plans have disappeared in the private sector; it is why they have continued to flourish in the public sector. If private sector employers can no longer afford even modest DB plans, how can public sector employers afford much more expensive plans — plans with larger pensions, earlier retirement and full inflation protection? This is the question Malcolm Hamilton and I looked at in a new paper, “Risk and Reward in Public Sector Pension Plans: A Taxpayer’s Perspective,” being released Thursday by the Fraser Institute.

Canada’s public sector DB plans frequently cite the “Canadian Pension Model” — the manner in which they are organized, governed, administered, funded and invested — as the reason for their success. A recent World Bank study attributes the success of the Canadian Pension Model to superior governance, economies of scale, innovative investment practices, responsible funding, visionary leadership, high pay and other virtues too numerous to mention.

That Canada’s public sector DB plans have done a superb job for their members is undeniable. No one would question the plans’ success; but we do question the reason for their success. It is due to large public subsidies made possible by practices that are neither admirable nor virtuous: bad accounting, poor governance, imprudent risk taking and inadequate financial disclosure.

To be fair, the responsibility for many of these failings lies not with the pension boards who administer the plans but with the employers who sponsor them. The fault lies with public sector employers, usually governments, who fail to represent the public interest when it conflicts with the interests of their employees. This does not mean that our pension boards are entirely without blame. They have become enablers of and enthusiastic cheerleaders for a badly flawed pension system. They have grown comfortable with a success they do not understand.

The narrative advanced by Canada’s public sector DB plans raises a perplexing question. If innovative investment strategies abetted by good governance explain their success, why don’t private sector employers adopt the Canadian Pension Model and provide comparable pensions to their employees? Our answer is that Canada’s public sector DB plans do things that private sector DB plans are prevented from doing — for good reason. In particular, public sector accounting standards allow public sector employers to materially misrepresent the cost of their pension plans. Private sector employers are prevented by private sector accounting standards from doing the same thing.

Taking investment risk is a legitimate tactic, provided that those who bear the risk also reap the reward. This is not what happens in Canada’s public sector DB plans. Consider the plans covering employees of the federal government. Plan members, whose interests are ably represented by powerful public sector unions, are handsomely rewarded for investment risk taken by their pension plans and borne by the public. The public, whose interests are poorly represented by the federal government, receives no reward for bearing this risk. To be clear, public sector accounting standards permit, but do not require, the deceptive accounting practices that make this possible. Governments are allowed to properly account for pension costs; they simply choose not to do so. By making this choice they subordinate the public interest to the interests of their employees.

Public sector DB plans cite their independence from government as a key to their success, freeing them to pursue profitable policies outside the purview of politics. But this independence is a flaw, not a virtue, of public sector pension governance. The plans take investment risk to advance the interests of plan members while the interests of taxpayers, who ultimately bear this risk, are ignored. Outside the public sector this would usually be called moral hazard, not good governance.

The assertion that Canada’s public sector pension plans have discovered a formula that makes them a model for the world to emulate warrants serious skepticism. The exceptional feature of Canada’s public sector DB plans is not “world-beating” investment strategies or good governance. It is the ability to enrich public employees by shifting large, undisclosed investment risks to taxpayers without fair compensation. By our estimate, this provides an unacknowledged $22-billion annual subsidy to Canada’s public sector DB plans and, ultimately, to the members of these plans. This large public subsidy, not the virtues of the Canadian Pension Model, explains the plans’ success. Without it, public sector DB plans would be no more viable than private sector DB plans.
The Fraser Institute put this out, Risk and Reward in Public Sector Pension Plans: A Taxpayer’s Perspective:
The most striking feature of Canada’s retirement system is arguably the large and growing gap between pensions in the public and private sectors. Eighty percent of public sector workers participate in defined benefit (DB) pension plans. Only ten percent of private sector workers can make the same claim.

With the collapse of interest rates in the early 2000s, DB plans became prohibitively expensive in the private sector, yet they flourished in the public sector. If private sector employers can no longer afford even modest DB plans, how can public sector employers afford much more expensive plans—plans with larger pensions, earlier retirement, and full inflation protection?

Canada’s public sector DB plans frequently attribute their success to the “Canadian Pension Model.” A recent World Bank study identifies superior governance, economies of scale, innovative investment practice, responsible funding, and visionary leadership as important features of this model.

Without disputing the virtues of the Canadian Pension Model, we attribute the success of Canada’s public sector DB plans to large public subsidies made possible by practices that are neither admirable nor virtuous: bad accounting, poor governance, imprudent risk taking, and inadequate financial disclosure. Responsibility for these failings lies not with the pension boards who administer the plans but with the employers who sponsor them. These employers, usually governments, fail to represent the public interest when it conflicts with the interests of their employees.

The narrative advanced by Canada’s public sector DB plans raises a perplexing question. If innovative investment strategies abetted by good governance explain their success, why don’t private sector employers adopt the Canadian Pension Model and provide comparable pensions to their employees? Our answer is that Canada’s public sector DB plans do things that private sector DB plans are prevented from doing for good reason. In particular, public sector accounting standards allow public sector employers to materially misrepresent the cost of their pension plans. Private sector employers are prevented by private sector accounting standards from doing the same thing.

Taking investment risk is a legitimate tactic provided that those who bear the risk also reap the reward. This is not what happens in Canada’s public sector DB plans. Consider the plans covering employees of the federal government. Plan members, whose interests are ably represented by powerful public sector unions, are handsomely rewarded for investment risk taken by their pension plans and borne by the public. The public, whose interests are poorly represented by the federal government, receives no reward for bearing this risk.

Public sector DB plans cite their independence from government as a key to their success. We argue that this independence is a flaw, not a virtue, of public sector pension governance. The plans take investment risk to advance the interests of plan members while the interests of taxpayers, who ultimately bear this risk, are ignored. These practices are best described as moral hazard, not good governance.

This paper questions whether Canada’s public sector pension plans have discovered a formula that makes them a model for the world to emulate. The exceptional feature of Canada’s public sector DB plans is not “world-beating” investment strategies or good governance. It is the ability to enrich public employees by shifting large, undisclosed investment risks to taxpayers without fair compensation. By our estimate, this provides an unacknowledged $22 billion annual subsidy to Canada’s public sector DB plans and, ultimately, to the members of these plans. This large public subsidy, not the virtues of the Canadian Pension Model, explains the plans’ success. Without it, public sector DB plans would be no more viable than private sector DB plans.
You can read the full report here and the executive summary here.

The report is authored by Philip Cross, the former chief economist of Statistics Canada, and Malcolm Hamilton, a Senior Fellow with the CD Howe Institute and a retired pension actuary who spent 33 years at Mercer where he advised large pension plans in both the public and private sectors.

These aren't two hacks, these are two individuals with extensive credentials, experience, and knowledge of public and private sector pensions.

I'll admit, my first reaction was "why the hell are Malcolm and Philip writing a report like this for the Fraser Institute, a right-wing think tank funded by Canada's powerful financial services industry?".

Moreover, it struck me as if the Fraser Institute hired two big shots with great credentials to puncture holes at Canada's large pension plans.

Why would they want to attack our venerable public-sector pensions? Because their very success represents an ominous and existential threat to the private sector, specifically to our big banks and insurance companies peddling high-fee, mediocre mutual funds.

Below, I will share some thoughts of mine. I also shared this paper with other "big shots" who have a completely different take on things. I will update this comment once people respond, if they respond.

Anyway, Malcolm and Philip are very sharp. They rightly note the collapse of interest rates since early 2000 has spelled the demise of private sector DB plans and state the following:
The mystery is not why DB plans have disappeared in the private sector; it is why they have continued to flourish in the public sector. If private sector employers can no longer afford even modest DB plans, how can public sector employers afford much more expensive plans — plans with larger pensions, earlier retirement and full inflation protection?  
First, you should all be aware Canada has some excellent large private sector DB plans as well. I am thinking of CN's plan managed by CN Investment Division headed by Marlene Puffer and Air Canada's Pension Plan managed internally and headed up by Vincent Morin who I recently profiled here.

There are other great private sector DB plans all over Canada that are doing very well but in general, yes, they are becoming dinosaurs as the large public sector plans grow exponentially.

As to the question "how can public sector employers afford much more expensive plans — plans with larger pensions, earlier retirement and full inflation protection? ", Malcolm and Philip conclude it's all due to "deceptive accounting practices" by governments that do not properly account for pension costs.

By their estimate, this provides an unacknowledged $22-billion annual subsidy to Canada’s public sector DB plans and, ultimately, to the members of these plans, all on the back of Joe and Jane schmuck Canadian taxpayers who don't reap any benefits from the success of these plans.

Now, people reading this on the National Post are understandably upset. Steve Douglass comments:
Just to ensure that I understand, I read this article twice. My interpretation is that Canada's public sector DB pension plan has been enriched by the unauthorized swiping of $22 billion of taxpayers' funds. This interpretation, if I'm correct, doesn't make me very happy. It is one more in a seemingly never-ending stream of disappointments from a government which, once focused on serving the taxpayers, now views them as nothing more than a piggybank.
I totally understand, I'm a conservative guy when it comes to my personal economic views, so it's not surprising the conservatives reading this newspaper are thinking exactly what Steve Douglass and others commenting are thinking.

The problem? They're not reading the comment carefully and are not getting the full picture to understand how the success of these plans adds to government tax revenues over the long run.

I'm suspicious of the $22 billion figure Malcolm and Philip claim is an unacknowledged annual subsidy to Canada’s public-sector DB plans but will let experts take issue with their methodology.

What I do know without a doubt is the success of Canada's large DB plans is unambigously good for the economy and government tax revenues over the long run.

Go back in time to read a comment of mine citing a study on the benefits of our large DB plans. More people retiring with dignity and security, even if they are all public sector workers, means more spending on goods and services, which translates into more government revenues and a better economy.

So, even though I am an unwavering, unapologetic economic conservative in my views, it's a no-brainer for me that we need to enhance, promote and expand our large public-sector DB plans. It's smart retirement policy, it's good for the economy, and it's good for our tax base and will reduce the debt over the long run.

None of this was discussed in the report and that represents a serious deficiency which understandably is not in line with the intent of the authors and the spin the think tank funding them wanted to put on their findings.

What else? The authors ackowledge the immense success of Canada's large public sector DB plans but question the reasons behind it:

That Canada’s public sector DB plans have done a superb job for their members is undeniable. No one would question the plans’ success; but we do question the reason for their success. It is due to large public subsidies made possible by practices that are neither admirable nor virtuous: bad accounting, poor governance, imprudent risk taking and inadequate financial disclosure.
This is where I winced. Bad accounting, poor governance, imprudent  risk taking and inadequate financial disclosure?

Really? Have they read the annual reports of these large public-sector DB pensions in detail? There are sections on first-rate governance, accounting, disclosure up to wazoo on everything from investments to compensation, to you name it.

This is not the authors' area of expertise. For example, we can criticize Canada's large pensions for using leverage to juice their returns and maybe they should report levered versus unlevered returns, but make no mistake, they're not taking imprudent risks, quite the opposite, they're taking intelligent risks using derivatives and a AAA balance sheet they earned through years of great performance, not government subsidies.

The last thing I want to mention here is the problem isn't Canada's large public-sector DB pensions, the problem is that we haven't created more of them to respond to the needs of millions of workers in the private sector who are getting the big shaft, relying on mediocre, high-fee mutual funds in their individual retirement accounts.

That's the real crime going on, the dirty secret (not so secret anymore) at Canada's large financial services firms raking in billions on fees on the backs of unsuspecting retail investors who are getting screwed on their retirement over the long run.

This is the brutal truth on DC plans and this is why we need more, not less, large, well-governed public-sector DB plans to address the retirement needs of millions of Canadians falling through the cracks, facing pension poverty during their golden years as they risk outliving their savings.

Again, I welcome all responses to this comment and will update this comment to publish all of them either here or in a follow-up comment. Feel free to email me at LKolivakis@gmail.com and please be succinct and to the point. Thank you.

Below, an older clip from when I discussed America's 401(k) nightmare. As the default retirement plan of the United States, the 401(k) falls short, argues CBS MoneyWatch.com editor-in-chief Eric Schurenberg. He tells Jill Schlesinger why the plans don't work. Same goes for RRSPs so listen.

Update: Make sure you read the follow-up comment, More on Canada's Dirty Pension Secret, where you will see what experts said about this comment and the report the Fraser Institute put out.

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