Canada's Public Service Pension Problem?

Frederick Vettese, partner of Morneau Shepell and author of “Retirement Income for Life: Getting More without Saving More”, wrote a special for the Globe and Mail, When it comes to pensions, don’t follow Ottawa’s example:

It is a sad fact that only 20 per cent of private-sector workers are covered by pension plans in their workplace. In stark contrast, nearly 100 per cent of public-sector workers are covered. Of course, none of this is news; pension envy among private-sector workers is as Canadian as hockey and Timbits.

What is perhaps more interesting and less well understood is the garbled message the government is sending with the pension programs it provides to its own employees. I will single out the federal Public Service Pension Plan (PSPP), not only because it has more than half a million members, or because it is generous even by public-sector standards, but also because the federal government has the power to effect change in a way that would benefit millions of Canadians.

The classic defence of plans such as the PSPP is that everyone benefits when civil servants can retire in dignity. Besides the obvious advantages for the participants themselves, good government-sponsored pension plans create a benchmark for other employers to emulate.

In the case of the federal government, however, this rationale contains a fatal flaw. The last thing the federal government would ever want is for all private-sector employers to adopt pension plans like the PSPP. The consequences would be disastrous for both the Canadian labour force and for tax revenues.

Consider the labour force first. At present, we have about four workers for every retiree. Fifty years ago, that ratio was 6.6 to 1 and in another 20 years it is forecast to dwindle to just 2.3 to 1. Barring a robotic revolution, we will probably not have enough workers to keep the economy running.

Don’t count on immigration to make up for the looming shortage of workers. It is already running at the highest rate in a century (with the exception of 1956, when the Hungarian refugee crisis occurred); the general public is unlikely to want to see immigration rise much more, even if we had the infrastructure to support it.

A higher birth rate is another possible way to change the worker-to-retiree ratio, but it is not clear what, if anything, would cause the birth rate to rise any time soon. Besides, the impact on the worker-to-retiree ratio would be negligible for at least 30 years.

The inescapable conclusion is that the only viable way to ensure there will be enough workers in the future is to encourage people to keep working longer. Alas, the federal PSPP does just the opposite. The plan’s retirement rules incentivize long-term civil servants to retire as early as age 50. If private-sector employers had maintained similar pension plans all along, the labour force today would have roughly one million fewer workers.

The effect on income-tax revenues if everyone had a PSPP-like pension plan would be equally damaging. A C.D. Howe paper by Malcolm Hamilton estimates that the average Canadian worker contributes about 14.1 per cent of pay toward retirement. (This includes employee and employer contributions to registered retirement savings plans and pension plans but not tax-free savings accounts.) In the case of federal public-sector workers, the contribution rate could exceed 25 per cent in a year when the PSSP has a big deficit. If private-sector workers (and their employers) made tax-deductible contributions at that rate, overall tax revenues would drop by more than $15-billion a year. Clearly, the federal government would never allow this to happen.

The time has, therefore, come to change the federal PSPP to better reflect the public interest. (Or actually, to change it further. Some amendments were made during the Harper era though they did not go nearly far enough.) The plan is a relic from an era during which the country had more potential workers than the economy could absorb but this is no longer the case.

So what should the federal government do to set a good example for private-sector employers? First, it should remove all incentives within the PSPP to retire early. Employees could still retire early, of course, but with the same penalty that applies to all participants in the Canada Pension Plan. Retiring early in comfort may require them to save a little extra in an RRSP and/or a TFSA, the same as what most other Canadians already do.

Second, it should reduce total employee and employer contributions under the PSPP to 18 per cent of pay, including any deficit payments that may have to be made in the future. Even at 18 per cent, the amounts being contributed by, and on behalf of, federal civil servants would still be at the high end of the spectrum.

Of course, these recommendations will not go over well with all stakeholders. No doubt the public-sector unions would strenuously defend the status quo on the basis that PSPP members contribute a high percentage of pay and should be entitled to a generous pension benefit in return. On this point, I would note that over the 12-year period from 2006 to 2017, PSPP contributions by members constituted barely one-third of total contributions (37 per cent to be exact). In most large public-sector plans, member contributions fund 50 per cent of the total pension cost and that includes the cost of paying off any plan deficits that may arise. It is time the federal PSPP fell into line.

The effect of the suggested changes would not be felt immediately since new retirement rules can be applied only to future service. They are, nevertheless, important if the federal government truly wants to set a good pension example for the rest of the country.

I shared this article with two of Canada's best actuaries, Bernard Dussault, Canada's former Chief Actuary, and Malcolm Hamilton, a retired actuary who worked many years as a partner at Mercer and now writes policy papers for the C.D. Howe Institute.

Not surprisingly, Malcolm agreed with the author:

I agree that the federal PSPP is, from the taxpayers' perspective, a disgrace and that something should be done about it.

My description of the problem, and how best to solve it, is quite different.

Bernard provided a little more analysis and questioned the author's claims:

This article fails to point out that the federal government already took measures a few years ago to address the unduly rising cost of the Pension Plan for the Public Service of Canada (PPPSC) mainly by increasing the pensionable age from 60 to 65 for members hired after 2012.

As can be seen in Table 4 on page 9 of the actuarial report on the Pension Plan for the Public Service of Canada (PPPSC) as at March 31, 2014 (http://www.osfi-bsif.gc.ca/Eng/Docs/PSSA2014.pdf), its current service cost is about 17.5% of payroll for the post-2012 hires, shared equally by the members and the government (employer), which is appreciably lower that the about 20.7% cost for pre-2013 hires. This favourably happens to fall below the prescribed fiscal 18% limit above which pension contributions are immediately subject to income taxes.

In other words, the government pays less than 9% of payroll for the post-2012 hires' pensions, which in my view is reasonable considering the important role that pension plans play for the alleviation of seniors' poverty.

Malcolm then followed up to state the following:

I think that you need to add a couple of things.

First, Bernard's description of the changes to the PSPP is quite misleading. Many members hired after 2012, specifically those hired under the age of 30, will be able to retire at the age of 60, not 65 as Bernard contends.

More importantly, only 50% of the cost of the PSPP is covered by contributions. The other 50% is covered by risk-taking. Since taxpayers bear all of this risk, they end up paying much more than Bernard suggests. For this, we can thank defective public sector accounting standards, which allow governments to claim, as does Bernard, that pension plans costing 40% of pay really cost 20% of pay.

In private sector financial statements, this would simply not be tolerated.

I thank Malcolm and Bernard for sharing their insights with me on this article.

I actually agree with both of them to a certain extent but let me explain. Like the author, Fred Vettese, Malcolm paints an overly dire portrait of the federal Public Service Pension Plan (PSPP).

For his part, Bernard points out facts which contradict the author's claims but he too doesn't address some issues which the author is right to point out and as such, is overly optimistic in his assessment.

In my opinion, the most important point that Fred Vettese addresses is the demographic shift going on in Canada (and elsewhere) where in a few years, we will have more retirees than active workers.

You know where I'm getting at with this? That's right, I want to see the federal Public Service Pension Plan (PSPP) adopt a shared-risk model which forces intergenerational equity.

In particular, I want to see conditional inflation protection adopted so if the plan experiences a deficit, retired members will experience a cut in inflation protection for some time until the plan is fully funded again.

In fact, conditional inflation protection is a critical factor behind HOOPP and OTPP's success and that of other fully funded plans in Canada.

It's mind-boggling that in 2018 we still have public sector unions demanding guaranteed inflation protection as if the rest of society owes it to them no matter what.

I'm sorry, I'm an ardent defender of defined-benefit plans but I absolutely need to see two key elements: 1) world-class governance and 2) a shared-risk model where if needed, contributions are raised, benefits cut (typically for a short time using conditional inflation protection) and/ or both.

We need to defend DB pensions but we also need to make them fairer and more sustainable over the long run.

One thing the article above doesn't address because it's a bit confusing is PSP Investments was incorporated as a Crown corporation under the Public Sector Pension Investment Board Act in 1999 to fund retirement benefits under the Plans for service after April 1, 2000, for the Public Service, Canadian Armed Forces, Royal Canadian Mounted Police, and after March 1, 2007, for the Reserve Force.

Notice it's focused on the funding needs of the Plans for service after April 1, 2000, and doing a great job providing an annualized return well above the required actuarial return set by the Chief Actuary of Canada. You can see PSP's fast facts on the Public Service Pension Plan here.

What about the funding needs of the Plans before April 1, 2000? Thus far, PSP hasn't had to worry about those, they are debt which is funded from the federal government's General Account but if they were all of a sudden responsible to fund those retirement benefits, it would be a big deal for the organization and put additional pressure on it because those Plans are in a deficit.

In my opinion, PSP should be responsible for funding pre-April 2000 Plans as well and this too would be fairer for taxpayers, not to mention better for all stakeholders.

I don't want to get into too much detail here but it's a big issue which is currently being discussed in Ottawa (it's been discussed for what seems far too long).

Lastly, I remind all of you that municipal and provincial debt isn't factored into total debt in Canada much like state and local debt are not included in the US federal balance sheet:

US state and local balance sheets have deteriorated significantly since the turn of the millennium and are staring down a nearly $2.5tn deficit - with some very optimistic assumptions - without the "full faith and credit" of the Federal government. pic.twitter.com/a4T319kBsR

— Αarοn Chan (@macrodidact) May 24, 2018

I mention this because I had a conversation with a friend of mine in Ontario who was asking me if the Ontario Government uses the pension surpluses to pad that province's balance sheet and I said: "of course it does". He then asked me if the Ontario Government can use those surpluses to spend on programs and I said: "of course not".

He also asked me why they're not amalgamating all these provincial public pensions (including HOOPP which is private) so the province can save costs. I told him it's never going to happen and there would be huge pushback if it did.

I leave you on this note, Canada's pension problems are a joke compared to what is going on in the United States.

Below, Thad Calabrese, NYU, and Kuyler Crocker, Tulare County Board of Supervisors, discuss why cities are investing in the market through the issuance of pension bonds.

Listen carefully to this discussion and especially listen to what professor Calabrese states on these pension bonds, he's spot on but he too neglects mention the real problem behind state and local pension deficits: years of neglect/ mismanagement, poor governance and no shared risk model.