The Real Winners and Losers in Pensions?

Geoffrey Young, principal at Discovery Economic Consulting in Victoria and author of a recent C.D. Howe Institute study “Winners and Losers: the Inequities within Government-Sector Defined Benefit Pension Plans,” wrote an op-ed article in the National Post, Clerks fund pensions of deputy ministers:

Two budgets — in Ottawa and Ontario — have announced reforms to rich defined-benefit pension plans enjoyed by government employees. The federal government will raise employee contributions and the normal age of retirement to 65 for new employees, while Ontario will consider reducing benefits to future pensioners to help fund potential pension plan deficits.

Governments are scrambling to keep employee defined-benefit (DB) pension plans sustainable because their employees love them — yet many government employees would be better off if the plans were redesigned. These DB plans systematically transfer income away from groups of employees in occupations with slow wage growth to employees in occupations or careers with higher wage growth rates; this often means from low-income clerks to high-income deputy ministers.

The winners are employees whose earnings grow fastest over their careers — they are likely to enjoy pensions that exceed the value of the accumulated employee and employer contributions to their credit at retirement, while the losers are those who would be better off if they simply received the value of their contributions plus interest rather than rely on future payments from a discounted pension.

Canadian government employee pension plans defy the common-sense idea that saving more and working later in life will increase one’s retirement income. Instead, DB plans tie pensions of government employees to their length of service and to their highest five years of earnings. It does not matter whether the employee made large or small contributions before the five years that count toward the average.

Why five years? Perhaps the designers of the plans considered that is the time it takes to get used to living in a good neighbourhood, having a golf club membership and a cleaning lady, and spending two weeks in Europe every year. It sounds ridiculous, but there seems to be no other explanation why pensions are tied to only a few years of earnings.

Most taxpayers don’t care if government career clerks, secretaries and bus drivers contribute to support the pensions of their bosses, but taxpayers do have reason to be concerned that pensions mean that bureaucrats simply don’t work very long. Under government plan formulas, it makes no sense for most civil servants to work to 65.

Continuing past 55 or 60 often means giving up a substantial current pension for little increase in future pension. Those who continue to work because they like their jobs or because they came late to the pension plan are likely to be losers, paying more into the plan than they will draw from it. Thus government employees continue to give up the productive years from 55 to 67 while the rest of us will be working.

My recent study published by the C.D. Howe Institute suggests it is time to begin reforming government pensions. Plans should stop rewarding employees who can retire early at the expense of those who need to continue to work, they should allow people to move without penalty between the government and private sectors, and they should give a fair return to the contributions paid early in their careers by those whose later careers have not been rewarded with high earnings.

Most government pension plans tell employees that their payroll pension deductions and the percentage contributions put in by the employer are enough to finance the pension. If this were true, it would mean that every plan would have winners and losers in about equal numbers, and half of plan members would logically welcome change. In fact, though, most plans have fallen short of their investment targets and have steadily raised contribution rates. Today’s senior employees will resist change because they can hope that most of the cost of their pensions will be borne by the new plan entrants who will spend their careers paying higher contributions.

Perhaps it is understandable, too, that pension plan members, even those in dead-end jobs, should believe that they too will achieve a high salary near the end of their careers and become winners in the pension lottery, drawing a pension tied to those last few high-earning years.

Recent steps to raise contribution rates and retirement ages for future employees are a start, but if government pension plans are not to become a drag on the economy and the taxpayers, more fundamental changes will be needed.

Commenting on Mr. Young's findings, Fred Vettese, chief actuary at Morneau Shepell, opines in the Montreal Gazette, Winners and losers in civil service pensions:

The C.D. Howe has just published a commentary entitled “Winners and Losers: The Inequities within Government-Sector, Defined Benefit Pension Plans.” This paper, authored by Geoffrey Young, offers a little-seen perspective on public sector pension plans. It gives us an insider’s look at some of the characteristics of public sector plans that result in some members (the “winners”) deriving much more value from those plans than other members (the “losers”).

Conspicuous by its absence in this commentary is any reference to the public debate raging on the appropriateness of the public sector pension plans in the prevailing climate of austerity. On one side, groups such the National Citizens Coalition and the Canadian Federation of Independent Business have been very vocal in arguing that public sector plans are too generous while on the other side, the Public Service Alliance is doing its best to preserve the status quo.

As for the basic premise of the commentary, every actuary knows that there are winners and losers under a defined benefit pension plan. It is the opaque nature of these plans that masks the subsidies. In any defined benefit plan where the employer and employees each pay half the cost, some employees will derive greater value than others by virtue of their earnings level, life expectancy, retirement age or marital status. In some plans, the gap between winners and losers is especially large because of built-in subsidies that favour some members more than others. This is true of the public sector plans.

The subsidies take on various forms, with variations from one public sector plan to another. Members who retire early with an unreduced pension contribute at the same rate as those who retire later but their pensions are worth much more. “High-flyers,” to use Mr. Young's terminology, who rose through the ranks and enjoyed a steeper rise in pay throughout their careers pay for a smaller portion of their plan than the plodders. That is because they contributed to the plan when their earnings were much lower but they eventually receive a pension based only on their high earnings in the final few years before retirement. Married employees receive a more valuable pension than single employees so they, too are subsidized. In a sense, defined benefit plans subsidize the “strong” at the expense of the “weak” since those who are healthier, have spouses and get more promotions extract more value from the plan than their less fortunate counterparts.

Mr. Young suggests that these subsidies should be eliminated or at least minimized so as to close the gap between “winners” and “losers.” He acknowledges that people who are not in the public sector plans will hardly care whether these inequities are addressed or not. After all, even the “losers” are perceived to be winners in the eyes of a private sector taxpayer who is lucky to belong to a modest defined contribution plan assuming he or she has any pension coverage at all.

Mr. Young agrees that the public should nevertheless be concerned because the perceived flaws in public sector plans could be restricting the movement of workers between the public and private sectors and causing workers to retire earlier than is in the public interest, given that labour shortages may not be too many years off. Mr. Young proposes reducing the early retirement subsidy, eliminating the subsidy to married plan members and providing less generous pensions to high-flyers who had enjoyed steep increases in earnings.

It is possible that the problems highlighted by Mr. Young will eventually be rectified, but the pressure for change will come from an unexpected source: the plan members themselves. In the recent Ontario and Federal budgets, it was announced that steps would be taken to change the cost-sharing under the public sector plans in these jurisdictions to a 50-50 basis. Currently, employees pay significantly less than half the total cost. By moving to true 50-50 cost-sharing, plan members may be required to pay much more, but this will be difficult to put into effect because employees will balk at the cost. Remember that public sector plans can cost more than 30% of pay when one includes the costs to fund past-service benefits and no public sector plan currently comes close to requiring employees to contribute 15% or more of pay.

Assuming the government is adamant about applying the 50-50 cost-sharing (here I will suspend disbelief) then benefit reductions will almost certainly be necessary to achieve it. This is where Mr. Young's proposed changes will be given serious consideration. It is one thing to embed costly subsidies in a plan when the employer or the taxpayer is perceived to be paying the extra cost. It is a different matter if the members themselves are footing half the bill, since they become acutely aware that their high contribution levels are partly due to these subsidies.

Mr. Young's proposals have merit but they still ignore the elephant in the room: that Canada has a two-tier pension system that is under increased scrutiny. The changes he suggests to the public sector plans would be seen as major takeaways by the public sector unions but to everyone else, they will seem more like tweaks that will nudge the plans modestly in the direction of lower costs without doing much to close the gap between public sector plans and private sector plans. Even if the proposals are implemented, they are unlikely to still the voices of the private sector coalitions that are pressing for major reform.

Excellent comment and I agree with Vettesse, while Young's proposals may have merit, they will be perceived more like 'tweaks' to the broader public which has suffered the wrath of the great pension slaughter.

Importantly, these proposals do not address the great inequity that permeates private and public sector pensions and do nothing to make the case for boosting defined-benefit (DB) plans for all citizens, both in the public and private sector. Quite the opposite, critics of public sector DB plans will just harp on Young's findings as yet another example of government waste.

And while Canadians continue to whine over pensions, raising some good arguments against the faulty OAS plan, we're missing the bigger picture on pension reform and why it's absolutely crucial to expand coverage of defined-benefit plans to all citizens.

The Alliance for Retirement Income Adequacy (ARIA), made reference to this article citing David Chilton, author of the Wealthy Barber, to warn that millions of Canadians are facing a tough retirement without pension plans.

Similarly, in Britain, a recent study reveals that one in six will retire with no pension:

Prudential's Class of 2012 study has revealed that one in six people planning to retire this year will depend on the state pension to fund their retirement as they have no other pension.

The figures come from Prudential's Class of 2012 research, which provides insights into the financial expectations of Britons planning to retire this year.

Women are more than twice as likely as men to have no pension; 20 per cent of women retiring in 2012 will depend on the State Pension compared with just 8 per cent of men.

The average person planning to retire this year will look to the State for 34 per cent of their income, with state pension payments set to rise to £107.45 a week for single people from the 6th April 2012. Company pensions (35 per cent) are the second highest source of income and the remaining 30% comes from a mixture of savings, investments, personal pension savings, part time work and money from family members.

The research also shows that one quarter (26 per cent) of people retiring this year either overestimate by more than £500 a year what the State Pension pays, or simply do not know.

"While the state pension is a safety net for pensioners in the UK, it should only ever be regarded as part of an overall retirement plan," Vince Smith-Hughes, retirement income expert at Prudential, said.

And in the United States, sweeping pension reforms across all states are threatening defined-benefit plans everywhere. Nowhere is this more evident than in Illinois, the pension basket case you forgot about, where an increasing number of state workers are rushing to retire before reforms are passed by the state legislators.

Finally, Yahoo Daily Ticker's Dan Gross interviewed Josh Barro, who writes about economics and U.S. public policy for Forbes.com, about the growing public pension crisis in the U.S. where states are choosing bondholders over public sector employees:

Around the country, state and local fiscal pictures are starting to look better. Tax revenues rose in every state in 2011, and while states continue to have structural budget gaps to close, this year's gaps are a small fraction of the ones states were dealing with in 2009 and 2010. But one big problem continues to show little improvement-- unfunded pension liabilities.

Measured on a market value basis, these unfunded liabilities (combined with those for retirees' health care) exceed $4 trillion, which is more than the total amount of bond debt outstanding from states and localities. And because of the way pension accounting works, most states and local governments can expect to see continued sharp rises in required payments into pension funds at least through 2014. While most parts of states' fiscal pictures are improving, this one continues to deteriorate.

In 2010, the pension problem prompted Meredith Whitney to warn of an impending spate of state and local defaults, as governments struggle with promises they can't afford to keep. But in practice, we are seeing that states are treating payments to bondholders as job one. It's rare for debt service to make up more than a few percentage points of a state's budget, meaning that there is little to gain from stiffing bondholders, while there is a lot to lose. I expect no general obligation bond defaults by states and only a smattering by localities, hardly something that will amount to a crisis.

Last year, when the small city of Central Falls, Rhode Island entered receivership, the state passed a law to move bondholders to the front of the priority list for payment, making it essentially impossible for municipalities to default on bond debt. Meanwhile, the state enacted an aggressive pension reform that both cut benefits that workers can earn in the future and froze cost of living adjustments-- effectively reducing the benefits that current workers and even retirees had earned in the past. It didn't matter that Rhode Island is a state with politically powerful unions; a loss of access to the bond markets was far scarier to state lawmakers than anything the unions could do.

And Rhode Island isn't the only state that has withdrawn previously earned pension benefits: Colorado, Minnesota, New Jersey and South Dakota have all passed laws that retroactively reduce benefits through changes to COLA formulas. The largest pension fund for teachers in Illinois, where pension benefits are constitutionally protected, has warned that retirees' benefits are at risk anyway due to the fund's dire funding situation.

But while states have shown a surprising inclination to abrogate pension benefits already earned, they generally are not doing enough to make sure they don't make unaffordable promises in the first place. Rhode Island's reform will reduce the cost and the fiscal risk associated with pension benefits going forward. But in most states, pension reform has not significantly changed the nature of the benefits offered or sufficiently reduced their cost. That means that in the next recession, states will be back in the same place they are today, struggling to come up with cash to pay for pension benefits that are wildly more expensive than anyone realized.

Watch the interview below. Barro is right, all pension roads lead to Rhode Island, and while some reforms are necessary, the move away from defined-benefit plans will just exacerbate pension poverty and fuel the great pension slaughter. In the grand scheme, this just means there will be more losers than winners in pensions. That's the real elephant in the room that all politicians are ignoring, one that will ultimately end up costing societies a lot more in social and healthcare costs.