Driving the Economy and the Role of Pensions

Last November, the Canadian Center for Economic Analysis (CANCEA) published a report titled Economic Benefits of Canadian Public Sector Pension Plans (CPSPP).  The headline reads:

“CPSPP retirement benefits represent an important source of retirement income in Canada, totalling over 40% of all private retirement income in the country. Retired members live all around Canada and spend much of their retirement income in their local communities and surrounding areas. Through this pension spending alone, CPSPP members support over 794,000 jobs across the country (90.5% of the total contribution of CPSPP) and contribute over $74 billion to Canada’s GDP, which averages to $16.72 of GDP for every $10 of retirement benefits payments.”

Later in the report we are reminded that “In 2005, there were 2.65 million active members of CPSPPs, growing to 3.41 million active members as of 2019.”  I don’t know if our public sector pension system should brag that one of its great successes is a growing cohort of government employees.

Finally, we are told that “CPSPP operations in Canada contribute to economic activity as well. CPSPP operations support over 83,000 jobs in Canada (9.5% of the total contribution of CPSPP) and over $8 billion in GDP.”

The report goes on to talk about the jobs that spin off from these pension payments as well as government revenues that come from various forms of taxation.  In a moment of humility, the report stops short of trying to calculate the economic benefit and job creation that the more than $1.27 trillion invested assets create in Canada and around the world.

What is Missing?

The report generously credits our public service pension plans as key drivers of our economy.  We all want a healthy economy, so it is a message that is well received by many.

But if these pension plans didn’t exist, today’s plan members and their employers wouldn’t be required to contribute, which as I understand it is about the same amount annually at this stage as the benefits being paid out.  So, these pension plans give to the economy with one hand and take from the economy with the other.  If we reach back over past decades, member and employer contributions likely exceeded the benefits being paid – so were these plans bad for the economy in earlier times and what do they ‘owe’ our economy today?

Another thought experiment: if these pension plans didn’t exist would their members and employers save elsewhere creating the same economic impact under a different banner?  Before you answer, know that you can’t win.  First, there is no other vehicle in Canada that would allow the amount of tax deferred savings offered by a defined benefit registered pension plan with very generous benefits.  Second, there is no way that government workers and employers would fund benefits at this level if the costs were properly calculated (this has been discussed previously).  If someone wants to over-save for retirement then that is their business, but when they drag the taxpayers into paying for the over-saving then it becomes everyone’s business.

Is it possible that the authors of the report are a little biased?  Maybe not, but the sponsors of the report, the Canadian Public Pension Leadership Council sure are.

“CPPLC is a non-partisan group of senior public sector pension plan leaders from across the country. Formed in 2015, CPPLC is a registered not-for-profit Canadian corporation that represents 12 plans in seven provinces. CPPLC’s mission is to promote a thoughtful, evidence-based, national pension policy discussion. Participating pension plan leaders seek to help inform the ongoing debate about retirement security using research produced by CPPLC.”

Not only are taxpayers funding generous pensions for the public sector, they are funding ‘research’ that promotes how good it is for taxpayers to keep playing the game.

Finding Value

Don’t get me wrong.  I think saving for retirement is good for society.  When people have an adequate retirement income, they can live out their final years in dignity without having to work until their last breath.  Deferring income from working years to retirement on a tax deferred basis can, for many workers, move income from higher income working years to lower income retirement years.  Deferring taxable income also moves government revenues to the time when older citizens need greater medical care and other social supports.

In designing a retirement program, the three questions are: what benefit should we target, how much needs to be saved each year to reach the target, and what vehicles are best for accumulating and investing these contributions? 

Because employers choose the pension plan design, they need to infer what retirement income current and future employees want to target and marry this target with a contribution rate that employees want to defer from current earnings.  Early in my career many private sector employers, but not all, tried to match the 2% Final Average Earnings promises common in the public sector (almost always without indexing).  Late in my career however, few employees want to save at the rate that it takes to match the benefits provided in public sector pension plans.  Private sector employers have correctly read this signal and reduced pension benefits accruing to employees.

How did employers in the private sector figure this out?  Largely with help of the accountants.  The accounting profession in the 1980s started becoming concerned with the lack of transparency of pension costs for defined benefit pension plans.  As a result, financial statement reporting was overhauled and a system of putting a ‘fair value’ on pension costs was born.  We don’t have time to review the strengths and weaknesses of the system of accounting for pension costs – but what became clear in the process was that pension costs over the past 30+ years almost always rose as discount rates fell. 

Why DB and DC Have Both Failed

Incrementally, private sector sponsors concluded that their business could not absorb ever increasing pension costs and that most employees were not interested in pay freezes and higher pension contributions to solve the problem.  Unlike public sector sponsors, private sector sponsors could not keep pension costs down by taking increasing investment risks since the accounting rules gave limited or no credit to investment risk until the investment reward was earned.  This isn’t true in the public sector.  You can read more here.

From this staging ground, the move to defined contribution plans emerged.  Defined contribution plans offered the ideal solution to sponsors – guaranteed rates of contribution for the sponsor.  Investment risks were transferred from the sponsor to the employee and so too were the challenges that arise from setting a stable long-term contribution rate while investing in investments with market values that are rarely stable for any amount of time.

The DC industry has worked hard for three decades to educate plan members on capital markets, risk taking, and contribution sufficiency.  I don’t want to say this effort has been a complete failure, but it has been far from a resounding success.  We have learned that most employees don’t want to understand the capital markets, poorly assess their own risk tolerance, and chronically under-save for retirement.  Compounding these problems is the fact that many workers are prone to make emotional decisions based upon the media or the advice of a friend which often leads to the poor investment strategy of ‘buy high and sell low’.

Where Now?

The CPPLC want their plan members and the taxpayers that support them to believe that their pension plans are a key driver of the economy.  Although not in this paper, I have heard them argue in the past that workers that don’t have a defined benefit pension plan suffer from ‘pension envy’ and the answer is not to take away the DB plans from the public sector but to see them rise again in the private sector.

I do think that there is a place for a well-designed, judiciously invested, and properly funded defined benefit plan provided there is a sponsor willing to absorb the ups and downs of the contribution rate.  Our provincial legislators are twenty years late in figuring things out and we finally have a system in most provinces that is designed to assist sponsors in smoothing out these fluctuations in contributions.

It will be interesting to see if sponsors over time migrate back to defined benefit plans or if they continue to fight the fight of improving the outcomes for their defined contribution plan members.  To me a big part of this will be the ‘attract and retain’ part of the conversation and if worker shortages persist then maybe some visionary private sector employers will lead the way back to DB. 

In the meantime, the Target Benefit Plan which is a hybrid of fixed costs for employers and fixed benefits for employees gain traction.  These hybrid plans exist due to a relief valve if contributions prove insufficient, turning fixed benefits into ‘target’ benefits which allows for reductions in benefits that some workers think are guaranteed.  I have my reservations about these ‘in-between’ plans, but their current popularity may foreshadow a future where defined benefits are more greatly valued or they may just be deferring the pain that might be realized when benefit promises are guaranteed on paper without the backing of assets that are guaranteed to deliver.

As noted, the CPPLC’s mission is to “promote a thoughtful, evidence-based, national pension policy discussion”.  This is a good mission and we need to bring the subtleties of actuarial assumptions out of the dark and into the light so that we can all agree on the value of the pension promises that we are making. 

I encourage everyone to join the discussion.

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