Last week, the Fraser Institute released and then withdrew a study, Canada’s $254 Billion Iceberg: Public-Sector Pension Liabilities, on Canadian public sector pension plans.
From the news releases, one can piece together the argument: federal and provincial government pension plans have $254 billion more liabilities than assets. Thus, government pension plans should move from defined benefit to defined contribution.
The study and its conclusion would have seemed credible, packaged with attractive charts and tables, pages of citations and plenty of data. Unfortunately, according to the Association québécoise des retraité(e)s des secteurs public et parapublic (AQRP) the Fraser Institute underestimated the funding of Quebec’s public sector pension plans by $45 billion. This caused the Fraser Institute to withdraw the study.
Conceivably, they could correct the error and reissue the report. Even at $209 billion, the hole looks big. Is the argument valid, though?
Ideology as Scholarship
It’s not particularly surprising that there was an error. The depth of analysis produced by opponents of public sector pensions is shallow. Pensions are necessarily complicated. Some public sector plans provide pensions to hundreds of thousands of workers with various plan designs and invest many billions of dollars. New trustees on pension plans can take years to develop a complete command of the subtleties of funding, investing and operating pension plans.
A complicated area, like pensions, is fertile ground for ideology masquerading as scholarship. One can easily identify figures and package them in convenient sound bites. Even if a research report acknowledges nuance and provides qualifications, few will read more than the newspaper headlines.
To conclude a need to move from defined benefit plans to defined contribution plans, one must ignore or devalue significant benefits of defined benefit plans like:
- Administrative efficiency,
- Investment efficiency,
- Risk pooling of individuals outliving their savings,
- Successful risk/contribution sharing mechanisms to improve defined benefit plans for governments, like those already in place in British Columbia, and
- Employees want defined benefit plans, as shown through collective bargaining.
Are Unfunded Pensions a Bad Thing?
One fact underlying the Fraser Institute analysis, and the analysis of other opponents, is existence of pensions with more liabilities than assets. Assuming $209 billion is correct, this amounts to an eye watering figure.
It seems automatic to say that unfunded pensions are a bad thing. Assets equaling liabilities limits the risk of participants in the case of sponsor bankruptcy and it limits the sponsor’s risk of a past obligation becoming unmanageable.
In certain circumstances, particularly for large public sector sponsors, a policy involving unfunded pension plans can be reasonable. For example, consider the government of Canada. Suppose that it has two options for dealing with its defined benefit pension plans:
Option 1: Pay for pensions for its employees on a pay-as-you-go basis:
- No fund would be established.
- Employee pension contributions would be deposited into general government revenue.
- An expense for the value of pension accrued in a year would be included in the government’s income statement.
- The liability for the pension obligations would be captured on the government’s balance sheet.
Option 2: Create and contribute to a pension fund:
- Contributions to the fund would provide for the cost of accruing benefits (approximately the same value as the bookkeeping expense in the previous option.)
- The fund would be invested in the capital markets, likely in a mix of stocks, bonds and alternative investments.
- Pensions would be paid to members from the fund.
Option 1 has some advantages. The government does not need to borrow money to prefund pensions under Option 1. Option 1 involves less risk of poor investment performance than Option 2 because assets are not invested in stocks, bonds and other investments. In addition, the government’s tax base presumably has some positive relationship to asset prices. So, that Option 1 performs better than Option 2 in periods of capital market underperformance means that it will perform better during a period when the government’s tax base is under pressure.
Up to April 2000, the federal Public Service Pension Plan was funded based on Option 1 above. The liability for this period remains an unfunded bookkeeping entry on the government of Canada’s financial statements. The value of this obligation at March 31, 2011 was $96 billion dollars.
Had the government been funding a separate fund for a long time we would have about $96 billion lower unfunded pension obligations and about $96 billion more owed to bondholders. One could argue it would be better to have government obligations to pensioners, rather than bondholders: there are no covenants on obligations to pensioners.
When pension opponents decry unfunded liabilities, they fail to acknowledge that, accompanied by accrual accounting, pay-as-you-go funding can be reasonable for bankruptcy-remote governments. A big chunk of the unfunded liability was consciously taken on as a rational policy decision, not only in the federal Public Service Pension Plan, but also in various provincial plans. Unfunded liabilities do not represent an iceberg with hidden costs that may sink our economic ship. Governments are aware of the costs and they are being managed.
Summary
While opponents can overstate their case, it is true that public sector pension plans face pressures. Low interest rates and increasing life expectancy increase costs. Some plans may need to address long-term costs and risk sharing between the sponsor and the participants.
But, the strains facing pension plans don’t eliminate the need for defined benefit public sector pension plans. Cost effective plans become more important as interest rates decline: a larger proportion of individual plan returns will be lost to fees. The key benefit of defined benefit plans, pooling the individual risk of outliving your money, is more important as the return environment becomes more challenging.
A valid discussion exists on the future of defined benefit public sector pension plans. It will not come about from those opposing their existence altogether.