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The Real Problem with Public-Sector Pension Plans - C.D. Howe Institute

TORONTO, March 19, 2014 /CNW/ - While public debate has mainly focused on the "gold-plated" defined benefits of many public-service pension plans, the real problem lies in a flawed approach to managing compensation costs, according to respected pension expert Malcolm Hamilton.  In, "Evaluating Public-Sector Pensions: How Much Do They Really Cost?" Hamilton says the problem is government sponsors who typically underestimate the cost of guaranteeing pay-outs in the future, leading to the undervaluation of employee pension costs and the mismanagement of employee compensation.

"The problem is not with the defined-benefit plans per se, it relates to the mispricing of their guarantees, which leads to the over-compensation of employees and badly accounted-for risks to future taxpayers," says Hamilton. "This is particularly true in the federal public sector where plan members are insulated from investment risk, as compared to the provincial public sectors where members frequently bear half of the risk, if not more."

In the first of a two-part series on government employee pensions, Hamilton observes that public-sector pension plans in Canada have many virtues. 'They are generally large, efficient and well managed. However, there are large differences between the fair values of the pensions earned by public-sector employees and the "cost" of these pensions according to public-sector financial statements,' states Hamilton.

These differences arise almost entirely from the pricing of guarantees. Specifically, the financial markets attach high values to the guarantees embedded in public-sector pension plans while government financial statements attach little or no value to these guarantees. This means that pension costs are materially understated and, as a consequence:

  • employees in the public sector are paid more than is publicly acknowledged and, in many instances, more than their private-sector counterparts;
  • public-sector employees shelter more of their retirement savings from tax than other Canadians are permitted to shelter; and
  • taxpayers bear much of the investment risk taken by public-sector pension plans while the reward for risk-taking goes to public employees as higher compensation.

Hamilton notes that private-sector pension accounting standards long ago rejected the premise at the heart of today's public-sector accounting standards - that the cost of a fully guaranteed pension depends critically upon the rates of return that a pension fund can earn on risky investments even though the pension itself is totally unaffected by these returns.

Public-sector accounting practice books the returns that a pension fund might reasonably expect to earn as a reward for future risk taking long before the risks are taken, and this risk premium is used to reduce the reported cost of employee pensions. As a consequence, in a traditional defined benefit pension plan where pensions are guaranteed and employee contributions are fixed, the reward for future risk-taking goes to employees who, because their pensions are fully guaranteed, take no risk. Future taxpayers, on the other hand, will be expected to bear risk without fair compensation.

"Essentially, we have devised a complicated way to transfer wealth from future taxpayers to current plan members," notes Hamilton.

The good news, he says, is that once the accounting problem is recognized for what it is, the solution becomes obvious. "The risks that taxpayers are being asked to bear without compensation should be transferred, in whole or in part, to the plan members on whose behalf these risks are being taken."

This can be accomplished in a variety of ways, says Hamilton. Benefits can be tied to funding levels and/or to the performance of pension funds. Employee contributions and/or salaries can be tied to the cost of funding their pensions. "Many provincial governments have already started to move in this direction," notes the author.

The C. D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. It is Canada's trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review. It is considered by many to be Canada's most influential think tank.

For the report go to: http://www.cdhowe.org/evaluating-public-sector-pensions-how-much-do-they-really-cost/25181

SOURCE C.D. Howe Institute

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