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Canadian public sector pension plans, which collectively manage more than $1.2 trillion, appear to have sufficient resources to pay pensions far into the future. Because of their positive attributes (including low costs and independent governance), and favourable comparisons to US public sector pension plans, it has been suggested the Canadian system should be used as a model to be imitated by others.
This would be a mistake.
Why? Because the Canadian public pension system is destined to fail. Because of its critical design shortcomings, it is only a matter of time before these Canadian plans become underfunded and require taxpayer assistance and/or wholesale restructuring.
To come to this conclusion, we’ll examine the following:
Conflicting accounting rules
Regulations
Variability of returns
Human nature
Pension plan performance relative to market performance
The lack of preparations to address serious shortfalls
Recent historical and current experience
How these factors interact
Lastly, recommendations will be offered to address the structural problems of the current Canadian pension system which would, if implemented, move the system closer to a model for others.
Background: The Funded Ratio
The funded ratio is the standard by which pension plans measure their financial status.
It is defined as:
As a measure of financial strength, the funded ratio has both pros and cons. Let’s start with the pros.
Pros of Funded Ratio
The funded ratio measures the ability of a pension plan to meet its obligations, which is the point of running a pension plan. The higher the ratio, the better a plan’s ability to pay its obligations. A very low funded ratio (for example, less than 80%) indicates severe challenges in being able to pay pension benefits.
Focussing on the ratio can guide how a plan sets its investment goal. Noting that the funded ratio can only fall if the asset return falls short of the increase in liabilities, the investment objective should be to ensure that the asset return at least matches the increases in the liabilities.
Cons of Funded Ratio
Different accounting rules are applied to the numerator and denominator of the funded ratio. Market rates apply to the numerator, yet different, modelled rates are used in the denominator. Because modelled rates are based on the subjective “expected return” of the assets, which are significantly higher than market rates, a future dollar is worth much more as an asset than as a liability.
These different valuation methods mean that the funded ratio depends upon the expected return of the assets.
Because plans have discretion over the expected return (also known as “discount rate”) they can influence their funded ratios.
Long run expected return is unknowable, even if you believe you know the expected return of every asset. Every pension plan is dynamic (and has been historically), with periodic portfolio rebalancing, investments in newly created assets, asset allocation shifts, etc.
As the following example illustrates, a typical pension plan having a 100% funded ratio actually has assets which are only 67% of the financial value of its liabilities.
Example
A typical pension plan uses an expected return of 6% while the long-term market interest rate is actually 3%.
Most pension plans agree that for every 1% reduction in the expected return, the “value” of liabilities rises by about 16%.
Let’s say, in this example, that a pension plan calculates a “value” of liabilities of $100 million using a 6% rate.
To find the “true” economic value of its liabilities, you would use the market interest rate of 3% as the discount rate (the same rate used to value interest rate assets).
The increase in the value of the plan’s liabilities would be (expected return – interest rate = 6% - 3% = 3%) * 16%, which is 48%
Thus, the economic value of the pension plan’s liabilities is $100 million + 48% of $100 million, or $148 million.
If the plan has a 100% funded ratio at a 6% expected return, the value of its assets is 100% of the “value” of its liabilities, or $100 million.
But, using the economic value of the liabilities of $148 million, one gets a funded ratio of
$100 million/ $148 million or 67.6%
Even if the funded ratio of the pension plan was stated as 125%, that would mean assets of $125 million and a true ratio of assets to liabilities of: $125 million/ $148 million, or 84.5%.
This means that pension funds have financial deficits even when their stated funded ratios indicate a surplus. Their business model is to negate these deficits by earning high enough investment returns in the long run.
Not Delivering on Expected Returns
Pension actuaries describe expected return as the rate of return on assets that will be exceeded 50% of the time and not met 50% of the time. While people may argue about what the appropriate expected rate of return is, a more critical question is: “What are the consequences of not meeting the expected return?”
The answer is that the funded ratio falls if the expected return is not met, even if the actual return is positive.
For example, if a plan with an expected return of 6.1% earns a 0.1% asset return for one year, its funded ratio will fall by about 6%. If this trend of a 0.1% return occurs for 5 years, this hypothetical plan would lose about
of its funded ratio even though it didn’t lose any money on its assets.
The Hidden Liability: Reducing the Funded Ratio in Good Times
Another, potentially larger, risk to pension funding is that pension plans reduce their funded ratios in good times (either on a mandated or voluntary basis) by decreasing contributions or by increasing benefits. These future reductions are an unaccounted-for “hidden liability” of pension plans. They can leave plans with inadequate finances to weather an inevitable downturn of investment returns.
Canadian pension regulations force Canadian plans to suspend their contributions or expand their benefits to reduce their funded ratio when it hits 125%. In addition to this regulation, there is also the human tendency for pension plan boards to voluntarily lower contributions or raise benefits as their funded ratio rises above 100%, because they perceive that they have ‘surplus’ funds, and do not account for the unpredictability of future returns.
With regard to a ‘surplus’, under commonly used assumed returns, even a funded ratio of 125% still means that there is an economic deficit.
Caps on and voluntary reductions of the funded ratio are a bad idea because returns follow a variable and random path. Even if the long run assumed average return of 6% materializes, the annual results will never be 6%, 6%, 6%, 6%, and so on forever, but will follow an irregular pattern. A period of good annual returns will be followed by a period of poor annual returns, and vice versa. When poor returns materialize, the savings that could have paid for the ensuing loss of funded ratio have instead already been spent.
Here’s an example of how the regulatory funded ratio cap of 125% could wreak havoc on a pension plan given variation in returns, even when expected returns are met, and even when assets never decline.
Suppose that over the next 25 years, the average assumed return of 6% is achieved. But let’s assume that it occurs as 12% annually for the first 13 years, and then 0% for the next 12.
Recall that the funded ratio of pension plans increases when realized returns exceed assumed returns, and falls when they fall short.
Without voluntary or mandatory surplus reductions, the funded ratio would rise sharply after 13 years of continuous steady gains. But, because of the regulatory limit and possible voluntary actions, reductions would indeed occur. Thus, the funded ratio would be 125%, or less, at the end of year 13.
Then, for the next 12 years, the actual return is 0% instead of the assumed return of 6%; hence, the funded ratio falls by 6% every year, or
Hence, at the end of this 25-year period, even though the average return was 6%, the fund is at a ratio of only
– basically insolvent.
Is this just raising hypothetical scenarios regarding what could happen in the future?
No.
Around 2000, there was a real-world effect of funding caps. Canadian plans were forced to either sharply decrease contributions or increase benefits to stay below the cap, which, at the time, was a funded ratio of 110%. Staying under this cap severely challenged the ability of Canadian plans to weather the 50% stock market decline which occurred in 2001-2003. Many of these plans struggled to regain a 100% funded ratio for many years afterward.
Comparing Pension Performance to Historical Market Performance
The past 35 years have seen a bull market run of unprecedented length and magnitude. For example, the S&P 500 stock index has increased in value by 25-fold in 36 years. Despite the fact that the expected returns of Canadian public pension plans exceed market interest rates by an unprecedented margin, most plans have funded ratios of around 100%.
Given the above discussion, how does one characterize the performance of a pension system which has yielded “break even” results on a generous metric of performance that assumes favourable investment results occurring indefinitely into the future, after more than three decades of historic rises in asset prices?
Objectively, mediocre – at best.
It is possible that future investment returns could be even stronger than in the past three and a half decades. Unfortunately, even better performance in returns won’t result in exceeding the 125% funded ratio cap. However, it is equally, if not more, likely that investment performance over the next 35 years will not be as strong as in the past few decades. If that scenario plays out, it would seem reasonable to expect funded ratios to fall well below 100%.
Risk and Crisis Response Planning
If returns don’t meet expectations, or are too variable, the plans’ funded ratios will fall, eventually eliciting a voluntary or mandated response.
Contributions could be raised (note that contributions are currently about 30% of salary)
Future earned benefits could be lowered
Inflation adjustments to benefits could be eliminated
Pension benefits already accrued by members, including benefits currently being paid, are not available as a way to address under-funding. Because these benefits are legally sacrosanct, the ability of pension plans to respond is limited.
Even if a pension plan took all of the actions at its disposal, it could offset only about a 20% funded ratio shortfall.
Anything more than 20% represents an unpredictable scenario, but tax-payers would have some cause for concern. There is no reassurance that the available measures would be sufficient nor fully employed to render government intervention unnecessary.
Is the infusion of public funds into pension plans just another hypothetical scenario?
No. It’s already happening.
In the U. S., there have already been many cases in which governments have borrowed money (to be paid back by taxpayers) in order to shore up their struggling public sector pension plans.
Plan Maturity and Rising Stakes
As pension plans “mature” the stakes of underfunding become ever higher.
When pension plans are “young”, as many Canadian plans were in the 1980s and 1990s, most of their contributions are yet to be collected and invested in the market. Thus, the impact of investment losses on the plan’s assets is relatively small; ultimate success is largely dependent on future investments. This low impact of losses on a young plan allows it to take more chances in its investing approach.
However, as pension plans “age”, as all plans do, the impact of investment losses grows. For “mature” plans, most of their contributions have already been collected and invested, so future investments have only a limited capacity to offset current shortfalls.
Plans grow in size over the years, but not much where it is needed, namely, in the number of “active”, contribution-paying members. If contribution increases are to be used to offset funding shortfalls, the same number of people are asked to “support” the potential losses of an ever-higher asset base.
Some plans can mature into a situation where assets shrink over time because benefits paid annually exceed the contributions collected. For such plans, the pattern of gains and losses is crucial. Losses in the near term are particularly problematic, as they have to be “made up” in the future on a smaller asset base.
Conclusion
Canada’s public pension system contains structural defects which put pension members and taxpayers alike at risk.
What Can Be Done?
Given how the funded ratio is measured, 100% is not nearly high enough as a target as it reflects an actual financial deficit. Moreover, it leaves a fund at too great a risk for serious funding shortfalls. Any funded ratio less than 125% should be treated as a problem.
Caps on the funded ratio need to be removed or set much higher. Because periods of poor returns will eventually occur, plans will again face funding challenges as a result of caps taking effect as they did in the years after 2000. Voluntary funded ratio reductions also need to be limited to avoid the same consequences.
Plans should commit to credible blueprints for dealing with serious underfunding scenarios. This will only be possible, however, if they have the ability to reduce accrued pension benefits, at least to some extent. Only then will they even be able to address being more than 20% under-funded.
Should Canada’s public pension system take these steps, it would significantly reduce the risks to both members, employers, and tax payers, and more closely resemble a model for others to emulate.