For many Canadians, and indeed, the world, the Canadian model of pension management is worth emulating. Public sector plans are well-managed, innovative and skilled at earning above-average returns. But Malcolm Hamilton, a senior fellow at the C.D. Howe Institute, finds a troubling flaw: taxpayers receive no benefit for the risks they bear.
Canadian Investment Review put that to debate, with Hamilton defending the motion “Taxpayers bear a disproportionate share of the risk in public sector pension plans and do not get the benefit of the investment rewards” before the audience at the 2016 Risk Management Conference.
“Twenty years ago, Canada’s public sector defined benefit [DB] plans were trying to do something that was easy,” he says. “They were trying to earn a 6% return in a world with 6% long-term interest rates. For the past 10 years, they’ve been trying to do something a lot more challenging. They’re still trying to earn the same 6% return, but they’re trying to do it in a world with 3% long-term interest rates.”
That means they’re trying to earn a 3% risk premium – or $36 billion on $1.2 trillion in assets.
The problem is that the plans themselves don’t bear risk: people do, in this case the members and the taxpayers. Some public sector DB plans are classic DB – taxpayers bear all of the risk. Others are jointly sponsored – taxpayers bear only half of the risk. Overall, Hamilton figures that taxpayers are bearing about two-thirds of the risk and are therefore earning two-thirds of the risk premium, about $24 billion per annum. Since they receive nothing in return, public sector DB plans are propped up by an unacknowledged $24 billion annual subsidy.
Real risk sharing
Hugh O’Reilly, President and CEO of OPTrust, argues that the government’s roles as taxpayers’ representative and as employer have to be considered separately. With Ontario’s jointly sponsored pension plans, there is risk-sharing between government and employees, and, for example, governments can and do take contribution holidays and they count surpluses on their books.
“Ontario’s jointly sponsored pension plans are, I think, the highest and best form of running a defined benefit plan because there’s fundamentally risk-sharing in a bunch of ways,” he says. “There’s risk-sharing in that both are equally responsible if there’s a deficiency in the pension plan.”
This is in contrast to the private sector, where pension assets are the purview of the company; when companies run into difficulties (O’Reilly used to argue insolvency cases in court), employees may find pension promises to be worth little.
For Hamilton, this does not address the $24 billion subsidy. He would prefer to see public sector plans move to target benefits, with members bearing all of the risk – just as they receive all of the benefits. When the federal government proposed legislation permitting such a system, the unions argued, Hamilton says, that “this change will shift all of the risk from government (i.e., taxpayers) to members and that is completely inappropriate. The unions basically acknowledge that federal employees take none of the investment risk — but their contributions rely on a 4% real return in a country where the real return on safe investments, like government bonds, has averaged 1%, not 4%, for a decade.”
But, O’Reilly counters, risk premia change over time. What’s key is “If people retire on inadequate pensions that result from using unrealistic assumptions or inappropriate accounting methodologies, which have nothing to do with how the plans operate pensions, here’s what happens: pensions get reduced. That is what is happening in the Netherlands where they have a crazy approach for setting discount rates and where it’s low. If people are going to have inadequate retirement incomes, where did that come from? That comes from taxpayers.”