Tackle the Pension Crisis Now?
Monday’s Nanos poll is a sharp reminder that many Canadians are quite concerned about their personal financial security. Yet they are optimistic about the strength of the economy and real estate markets.
Go figure. Maybe it is all the talk of government austerity, which is a far cry from what is badly needed in the United States or Europe, where events are making markets nervous once again.
Certainly, several legacy issues around pension issues continue to raise their rather horrid heads in public debate. A recent report of the Mercer index of pension funds shows that the average assets to liabilities ratio of Canadian pension funds is 63%, which is well below fully funded levels. Pressures continue to impact on employers providing retirement income plans for their workers and governments should make sure their regulations are up to date.
The role of regulation is to achieve efficient markets and stability. In recent years, the pendulum is shifting far too much towards stability as efficiency is becoming almost an afterthought.
A good example is the diminished role of defined-benefit plans for retirement income. Such plans provide fixed income for retirees until their death without facing the ups and downs of investment markets. They enable retirees to avoid investment risk as well as to share in “longevity risk” related to the time of death (sharing longevity risk also reduces the contribution costs).
Some Canadians prefer to cope with both investment risk and longevity on their own, but others are less willing to do so. Efficient financial markets transfer risk from those less willing to bear them to those who are willing to do so.
Most employers have been shifting from defined-benefit arrangements to defined-contribution plans for new employees. Similar to the risk attributes of RRSPs, the employee’s retirement income depends on the vagaries of financial markets. While the abandonment of defined-benefit plans was occurring before the financial crisis of 2008 due to a number of regulatory issues, the 2009 financial crisis pushed many public and private employers to abandon their plans, which required higher contributions to offset pension deficits just at the time they were facing severe cash shortages.
Federal and provincial governments took on some needed regulatory reforms in 2009, but many employers are still moving away from defined-benefit arrangements. This has become a classical market failure, with risks shifted to those less able to bear the cost, particularly Canadian employees with modest incomes.
Not all employers are abandoning defined-benefit pension plans and some are even enhancing their plans to give them an edge in labour markets that will be increasingly affected by skill shortages. A new innovation, the target pension, provides a less risky option for employees with adjusted pension benefits depending on market experience. Nonetheless, the continuing abandonment of defined-benefit plans is becoming a significant public issue that needs to be addressed.
This gets me to one fundamental issue impacting on pension fund shortfalls that should be addressed by regulators — the discount rate used for determining the value of pension liabilities. The Canadian regulatory approach has been to use a long-term government bond rate, which in 2008 collapsed to low values as the Bank of Canada took on monetary expansion to counter the grave credit crunch affecting world markets.
The choice of the discount rate matters a lot to determining the value of the pension liabilities. In the United States, pension regulators permit the use of a two-year average of highly rated corporate bond rates for discounting pension liabilities, which is notionally the cost of borrowed funds required to cover any pension deficits. Given the recent low interest rate environment, expected to continue for another two or three years, some are arguing for a longer average such as 10 years, since obligations are met over a long period of time.
What is not theoretically correct is to use riskless (government) bond rates for discounting expected future liabilities, which is too conservative an approach. Assumptions about expected salary costs and retirement provide uncertain values that should be discounted by a rate inclusive of risk reflecting future liability costs.
Neither is it appropriate to discount future liabilities by the expected return on the portfolio that can be used to determine funding, typically used by many pension funds. Future benefit payments are not as risky as the return on a stock market and therefore it is incorrect to use an expected return on the overall portfolio. Besides, many employers like to settle on high discount rates to minimize shortfall payments (some are still using optimistic rates of 8%).
It is time for Canadian regulators to use a more reasonable approach for assessing future liabilities, such as a 10-year average high-quality corporate bond rate. This policy should be introduced soon — its effect will be less important in the future when interest rates jump up anyway, when central banks try to deal with their bloated portfolios from quantitative easing. Current conservatively determined discount rates make it unfair for employers to maintain relatively sound defined-benefit plans.
If governments do not treat the collapse of defined-benefit plan arrangements through appropriate regulatory changes, then they will be left with only one option, which is to expand the Canada Pension Plan to provide more certain income to Canadians with modest incomes. Then taxpayers will have to bear the risk and that is not necessarily the right result.
Interesting article but I'm afraid that Jack Mintz and many other so-called 'pension experts' still don't get it. Canada and the rest of the developed world are on a collision course with widespread pension poverty and the only real long-term viable solution is boosting defined-benefit pensions for all workers in the public and private sector.
Instead, Mintz is harping on the discount rate as the 'cure-all' for our pension woes. He's right to claim that discounting expected future liabilities using the riskless government bond rates is too conservative and that using a 10-year average high-quality corporate bond rate might be more sensible, but this isn't the major structural problem plaguing Canada's retirement system.
Moreover, Jim Murta, an astute actuary, sent me these comments on Mintz's article:
- he says that some are arguing for a longer average such as 10 years - the argument is related to the amortization of plan deficits, not the discount rate
- the cost of borrowing funds to cover pension deficits is more than the highly rated corporate bond rate for most companies since most companies are not AAA
- the 8% discount rate is US not Canada. It surfaces in some US public sector plans, rarely in corporate plans. These plans have growing deficits due to investment losses.
- no one who has given any consideration to risk management would use a 10 year average of corporate bond rates to discount pension liabilities. It would be like saying that 2008 and all the global issues were simply blips that can be safely ignored.
- on the positive side, if companies could do what Jack suggests they could increase their executive compensation by whatever they don't contribute to the pension plan.
And Bernard Dussault, the former Chief Actuary of Canada, shared these comments on Mintz's article:
Mintz is dead wrong to claim the problem of DB plans is they "provide fixed income for retirees until their death without facing the ups and downs of investment markets." DB plans are all about managing assets and liabilities. If there aren't enough assets to cover the liabilities, then plan sponsors and members have to sit down to discuss all options to cover the pension deficit, including raising the retirement age, raising contribution rate, cutting benefits, cutting cost-of-living adjustments, and only in extremely dire situations will taxpayers be on the hook (not politically palatable in an era of austerity).He states that it is not appropriate to discount future liabilities by the expected return on the portfolio that can be used to determine funding. I do not see what can be more appropriate than the expected return on the portfolio to realistically assess the solvency ratio of a defined benefit pension plan. Any other assumption is not realistic but might be appropriate only if it is not overly conservative.He further states that if the CPP was expanded then taxpayers will have to bear the risk and that is not necessarily the right result. The CPP risk is actually assumed only by CPP contributors and their employers, not all taxpayers, and this is right as who else than those who contribute to a program should assume the risk?
Another beef I have with Mintz is the way he ended the article, claiming if governments do not treat the collapse of defined-benefit plan arrangements through appropriate regulatory changes, then taxpayers will have to bear the risk of expanding the Canada Pension Plan to provide more certain income to Canadians with modest incomes.
Mintz fails to point out that taxpayers already bear an enormous risk of the secular shift away from defined-benefit toward defined-contribution plans. Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP), a fully funded DB plans which delivered exceptional results in 2011, sent me these comments on transferring risk away from DB plans:
I have long argued that we need to expand coverage of DB plans to all workers in both the public and private sector. Moreover, many public and private DB plans need to be consolidated and rolled up into larger public defined-benefit plans with world class pension governance standards focusing on transparency and accountability.
There seems to be an underlying myth behind these discussions that defined contribution plans are cheaper than defined benefit plans. Actually, facts show that the reverse is true.
The cost of operating defined benefit plans such as HOOPP is a fraction of the cost of operating the typical DC plan. And switching from a DB to a DC plan doesn’t save the employer any money if the contribution rates remain the same.
Switching from DB to DC plans is really about risk transference. By switching from a DB to a DC plan employers are shifting the risk of future underfunding from themselves to the employee and ultimately to the social welfare system. Savings to the employer are only achieved by lowering the employers contribution rates.
Government employers should view the decision to shift from DB to DC differently than corporate employers. You could say that corporate employers are acting rationally by shifting from DB to DC plans. This allows them to shift risk off of their balance sheet onto the employee and the social welfare system.
However, if you are the government, you are simply shifting the risk from one bucket to another – from you the government as employer to you the government as the administrator of the social welfare system.
In fact this shift makes the problem worse. Due to the higher cost of administering DC plans, for the same contribution levels they produce lower pension incomes (a UK study found that they produce pension incomes which were 50% lower for the same contribution rates!) creating a greater strain on the social welfare system.Front end contribution rates are a function of investment returns and the back end benefits. The front end costs can only be reduced by reducing the back end benefits. Who bears costs and risk are a function of plan design and these issues can be dealt with within a DB structure.
Canadians are right to be quite concerned about their personal financial security as they too are suffering the repercussions of the great pension slaughter. Most of them are left fending for themselves in this wolf market dominated by big banks, their big hedge fund clients and multi-million dollar high-frequency trading platforms used to manipulate share prices, fueling unprecedented volatility, scaring the hell out of retail and institutional investors.
If we're going to get serious about tackling the pension crisis, we got to stick to the facts and realize that we need to expand DB plans to all workers and get the governance and funding right. All other proposals will fail miserably, placing taxpayers on the hook as social welfare costs soar to unsustainable levels as our population ages.
Below, watch an excellent overview of HOOPP as well as a clip on delivering the pension promise. Reading their 2011 Annual Report, was struck by something I read at the beginning (image above), namely: "82% of HOOPP members reported they would not consider taking a job that did not offer HOOPP." Do you blame them? All Canadians should have access to a DB plan like HOOPP and enjoy the dignity of retiring in security, regardless of the market's vagaries.