Some months ago, I wrote a posting about both federal and state pension plans, the funding gap between their current balances and their future liabilities and how this was going to impact American taxpayers who are on the hook for the shortfall. Thanks to the C.D. Howe Institute, a Canadian think-tank, we now have a brief entitled "Ottawa’s Pension Gap: The Growing and Under-reported Cost of Federal Employee Pensions" which outlines how the issue will impact Canadian taxpayers. Let’s dive in and see what the authors, Alexandre Laurin and William Robson, had to say.
Canada’s public servants are beneficiaries of defined benefit pension plans (DB). Three of the largest federal government DB pension plans are provided to the Public Service, the Canadian Forces and the RCMP. On top of that, Members of Parliament and federal judges have special plans; those of MPs are considered by many to be the ultimate in gold-plated pensions since they qualify for the MP pension after just six years of service which they can collect at the advanced age of 55. How many of us could say that? According to theCanadian Taxpayers Federation, the current DB pension plan requires taxpayers to fork over $5.50 for every $1 contributed by any given MP. For your illumination, here is the Canadian Taxpayers Federation calculations for pensions and severance payments owing to the MPs that were defeated in the May 2011 General Election.
Back to the C.D. Howe brief. In the private sector, DB pension plans must calculate the difference between their future obligations and assets using actual market yields. Not so for public sector pension plans. Public sector plans are allowed to use made-up rates of return to value their plans. Unfortunately, generational lows in interest rates have made these assumed rates of return unreasonable, resulting in growing unfunded liabilities.
Canada’s public sector pension assets total $54 million in 2011, future accrued obligations total $213.3 million and unamortized estimation adjustments total $13.2 million for a total future liability of $146.1 million. However, if one replaces the government’s current smoothed liabilities of $213.3 million with a fair value approach that better reflects market rates of return that are currently available. Right now, the government is using a real assumed rate of return of 4.2 percent (note, that’s the nominal or posted interest rate plus 4.2 percent for inflation) on all fund assets for benefits that were earned since 2000. The government also uses a moving average of past nominal yields on 20 year federal bonds in its calculations, again, these rates are well above what one would expect in the past few years.
If an individual Canadian wanted to set up a pension plan that mirrored the plan available to Canada’s public sector workers, they would have to index their savings to inflation. The best measure of this index is a Canadian government real return bond. This is where the problem crops up. As noted in the previous paragraph, Ottawa is using a real return of 4.2 percent; unfortunately, the actual return on the real return bond is now just over one-half percent. According to the Bank of Canada website, real return bond yields have ranged from a high of 3.76 percent in December of 2001, falling to 0.53 percent in December 2011 with an average of 2.07 percent over the 10 year period. Here is a graph showing all of the data:
We can now readily see that the 4.2 percent real return is highly optimistic. The C.D. Howe recalculated the assets that would be required to fund Ottawa’s pension promises using a "fair value" 1.15 percent yield and finds that Ottawa’s obligations would rise from $213.3 billion to $285.2 billion. If one subtracts a new assets fair value of $58.6 billion, the unfunded pension liabilities rise from $146.1 billion to $226.6 billion, a difference of $80.5 billion. If one substitutes the current 0.5 percent rate on real return bonds, the future funding shortfall is even greater. Since the Canadian taxpayer will ultimately be responsible for these shortfalls, the $80.5 billion should actually be added to Canada’s debt. According to Statistics Canada’s latest economic and financial data report, Canada’s accumulated federal debt reached $568.140 billion as of September 2011. If we add in the realistically calculated unfunded public sector pension liabilities, the debt rises by 14.2 percent to $648 billion. Since, in fact, this $80.5 billion shortfall was accrued over a number of years, the surpluses of the past decade were actually smaller than reported and the deficits were larger. For example, the 2010 – 2011 deficit would have risen from its reported value of $31 billion to almost $47 billion, a rather significant change.
Another point of concern is the growth in the funding gap. Here’s how the growing gap between reported pension obligations and the fair-value estimate has looked over the past decade:
The authors suggest that the Canadian government has two ways to fix this mounting problem:
1.) Eliminate the final-salary-based DB plan and replace it with a career-average-salary plan and eliminate the early retirement option.
2.) Raise contribution rates to ensure that actual money inflow matches entitlements.
In summary, the rising gap between Canada’s public service pension assets and its future liabilities should concern every Canadian since we are all ultimately responsible for the shortfall. Just as Canada’s private sector employees are looking to retire, they may find themselves paying much higher taxes to fund their country’s public sector pensions. That will most likely be a terribly unpalatable prospect.
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