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$58 Billion Debt Time Bomb?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
Kathryn may of the Ottawa Citizen reports that federal PS pensions a $58B debt time bomb, think tank says:
OTTAWA — The federal government's bookkeeping of its pension promises for public servants is out of whack with the real costs, understating Canada's national debt by $58 billion, says a report by a leading think-tank.
A study by C.D. Howe Institute on the "fair-value" costs of the pension liabilities for Canada's public servants, military and RCMP concluded the government's estimates are so understated that most of the surpluses racked up over the past decade should have been deficits.
"Experience in steel, cars, telecoms and other mature industries has shown how understating the cost and volatility of defined benefit obligations can lead plans to run accumulated deficits larger than their sponsors can cover, leaving pensioners short and/or taxpayers picking up the pieces," said the report. "We need to get a better handle on public-sector pensions before similar accidents happen on a more colossal scale."
To cover the real costs of federal pensions, C.D. Howe president Bill Robson, who co-authored the report, said public servants should be contributing 34 per cent of their pay to the plan every year -- and the RCMP and military would have to fork over 41 per cent of pay.
The big difference in costs lies in the way pension liabilities and assets are accounted for.
Robson said the way federal pensions are now accounted for is exposing taxpayers and public servants to "under-appreciated risks," he said.
Robson said he finds no fault with the chief actuary who reviews the pension accounts, or Auditor General Sheila Fraser, who audits the government's financial statements, because they are following the accepted accounting practices. But he argues the unravelling of other defined-benefit pension plans like Nortel and GM exposed the shortcomings of these practices.
Defined-benefit plans are supposed to have enough assets to back the promised retirement income, but they aren't always managed and accounted for that way.
The books typically "smooth" out the value of assets by using a combination of past and projected future prices. The liabilities are understated using discounted future payments that are unrealistic so pension obligations look smaller than they really are.
Instead, Robson said the government should use "fair-value" accounting, which uses current prices to value assets and liabilities as if a plan was being liquidated or wound-down.
"It's crazy to show promises on the books for less that it would cost to pay off that obligation," he said.
"Our quarrel is they are using these high investment returns and, we say, there is a better benchmark that more closely resembles what the pensions will cost."
For Canadians, the difference between the assets and liabilities recorded in the pension accounts is part of the national debt.
And lowballing the government's pension obligations in turn means the national debt has been understated by $58 billion, said Robson. The government recorded liabilities of $140 billion last year compared to $198 billion using C.D. Howe's fair value calculations. That means the debt is $522 billion, not the $464 billion recorded in the public accounts.
Fair-value accounting for pensions also turns the surpluses between 2002 and 2008 into deficits -- with last year's $7 billion higher than recorded.
The implications are huge, calling into question policy decisions made when the government thought it was racking up annual surpluses. The government went on a spending and hiring spree over the past decade, dropped the GST rate and cut corporate taxes.
The Conservatives are now racing to balance the books at a time when many say a demographic crunch has left Canada's economic potential at its lowest ebb in 40 years.
Pensions hit the national agenda with the collapse of Nortel and GM as angry workers and pensioners found pension funds didn't have the money to pay the pensions they were promised.
Not surprisingly, many pointed to the gap between the private and public sectors, which typically offer generous early retirement provisions and pension payments indexed to inflation.
The gulf between public- and private-sector pensions is an issue Finance Minister Jim Flaherty acknowledged he has to deal with in his pension reforms.
Federal unions believe the C.D. Howe study, which appeared as Flaherty met with his provincial counterparts in Whitehorse to discuss pension reform, put federal pensions on the table as the government struggles to find ways to reduce costs.
The private sector is abandoning defined benefit plans in increasing numbers for cheaper or more "financially sustainable" defined contribution plans.
In fact, the C.D. Howe report suggests the true cost of the plans could lead the government, like other employers, to convert its defined benefit plans to less volatile defined-contribution plans -- a proposal that would spark an all-out war with unions.
But Robson argues the unions should be pressing for change because it's their members who will be on the hook if the government doesn't fund the pension plans properly.
"Unions should also be concerned that the plan is largely unfunded. If they are looking out for the interest of their members, they should get more in this plan, so whatever happens to federal finances, that there are assets to back those obligations," he said.
Robson said the government has several options to "level the playing field" between the sectors. It could reduce the value of public servants' benefits or allow Canadians to build pension funds as big as public servants by allowing them to sock more than 18 per cent of their incomes into RRSPs.
"If a pension this rich is desirable for everyone and not just public servants, then shouldn't we be allowed to save more than we are now?" said Robson.
The government could better fund the plan by increasing the contribution rates employees pay into their plans. Contributions to pension plans are shared 50-50 between public servants and the province in Ontario, Quebec and Alberta so many argue there's no reason federal workers can't fully pay their way.
Now, it should be noted that the C.D. Institute is a conservative think tank which often takes positions based on conservative political views. They have argued for a private sector solution to the pension crisis, which I strongly disagree with.
But on the issue of underestimating pension liabilities, they raise important points. This study is likely overestimating liabilities because taking everything at market price is simply ridiculous given that private market assets (real estate, private equity, infrastructure assets) tend to be overvalued or undervalued at extremes.
One can make the case (albeit a small one) that these private assets are now undervalued. The problem is that they can stay undervalued for a lot longer than investors think. And if we enter a deflationary environment - something which Hoisington has brilliantly analyzed in their latest quarterly commentary, Hard Road Ahead - then it's going to be a long tough slug for private markets.
Finally, I already discussed Mercer's little Alaska problem and the fact that according to some think tanks, like the British-North American Committee, governments of the US, UK and Canada are understating the true cost of public pensions. If true, then you got the seeds to the next debt time bomb. The hard road ahead is looking harder when you sit back and analyze the implications of all these pension liabilities, especially if you consider the possibility that they're grossly understated (read this Business Week article).
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Leo is there any defined benefit pension plan on the planet that is above water. Probably not. Guys this decade is going to be the battle between the unions and the rest of us. Heck this year 2010 will be the first year of this world wide civil war. Pension and wages will have to be clawed back and fast.
Defined benefit pension plans are an attempt at a well designed ponzi scheme. Unfortunately no ponzi scheme can
stay solvent in the real world where asset values rise and fall.
Municipalities have defaulted on pension obligations before I believe and a Judge reduced them some in Bankruptcy Court I believe (not 100% sure on that however but I am pretty sure it happened). I dont think States have that option like towns do however as far as that goes but I dont think a state has ever defaulted on pension payments either. The federal govt program only insures private defined benefit plans up to like 50k a year not state or municiplaity ones. This will get crazy in the next 10 years or so.
All things being equal, the future revenues will not cover the costs. As I understand it, the unfunded state sector pension liabilities in the UK are about £1.1 trillion, which is about 140% of listed debt. The fact this is all in theory index linked means it can't be inflated away. So, what will they do? I suspect a combination of some tax increases, some means testing of benefits, increase of official retirement age, taxing of payments and even more outrageous fudging of official inflation data.
As an aside, given how much fiddling with inflation measures will be required, I would avoid anything which has risk to understatement of inflation. This includes index linked bonds, such as TIPS, but also utilities with price increase capped by inflation. There is no legal definition of the means to calculate inflation, so there is not much that can be done to challenge this.
Are a portion of the pension fund assets depending on good returns or atleast average return of interest on the fixed income / money market portion ? If thats the case pension funds globally may be hurting ? Anybody have any thoughts on this question ? I am not knowledgeable enough...
Pat.
Governments deceive us to the same extent they deceive themselves. They fail to account (or even consider) the rapidly aging population and what that will do to tax revenues. Look at Ontario - the new bastion of "money down the drain" - their plan for the future is when everything "gets back to normal" - 25 billion in the ditch this year and they start a 1.5 billion all day kindergarten so that the unemployed parents have time to look for work (public sector job).
Leo, keep bringing his stuff - public sector pensions, the aging population and health care - that's what will sink the ship.
exportbank,
The ship has been sinking for a while, but nobody paid attention. I saw the asset bubble developing when I was allocating to all these private funds. The liabilities side is much more important and it will be a crushing blow, akin to death by Chinese water torture. This is why the Fed and other central bankers need to revive inflation expectations. Privately they're telling themselves "deflation is simply not an option".
Also, can you imagine if rating agencies started properly factoring pension liabilities into their sovereign debt calculations? It would be a bloodbath! But the rating agencies are not going to bite off the hand that feeds them. They will go after Greece but ignore debt problems in the US, the UK and Canada.
Good analysis, Leo.
In the People's Republik of Kali, state public pension liabilities grew 2,000 % the past decade. State revenue by 24 %. So said Arnie in his State of Disunion address.
It's a shocking disconnect that can only end badly when the madness of public deception finally ends.
Leo, thx for the article. Do I understand you correctly when you say the ratings agencies DO NOT factor pension obligations into a govt's debt calculations? Wow. Perhaps this was understood by all but me, but it just struck me as...'misleading', is perhaps a nicer word than I was originally inclined to use. Do all ratings agencies follow this protocol?
b.e.
No, they factor pension liabilities but the key is how do they calculate pension deficits? By following the accepted accounting practices which tend to "smooth out" valuations of assets and using discount rates that understate liabilities. If the ratings agencies took a harsher approach, it would be a bloodbath in sovereign debt markets.
Have not been too tech yet, so how bout this. Valuations: 'Merica is worthless, and it is the main driver behind this "Global Village" (what a dump!) The Dollar is a scam, fractional reserve lending is a scheme, and what else do you need to think about? P/E? Market share? Sorry, but, "Its All O-Ver" (clapclap, clapclapclap)!
This is it. When people realize that pensions are as real as the Doe'Larrs that they put in their accounts, they will cry. Then they will run. Too bad they had never ran before. If they had run with us, they may have had a chance, they would have been in shape. But now, it is too late, they will not get it. We could duck tape the truth to their foreheads. They will never get it. Ever. It is hard for anyone to understand that the system was set up to fail, let alone sheeple. Bulls go moo, sheeple go ba(rock), and the dollar just goes. Always has, always will. The plan from the start. Jekyll Island right? Bye bye dubai.
I don't view this as a "crisis." I'll take a wild guess that sometime in the near future, like out in Illinois, the day will come when the pension liabilities will simply not be funded and the governments involved will shrug and say, "sorry." If I am to be worried or scared about the untold millions of government employees whose retirement dreams are thus shattered, the answer is I am not. I am certainly not interested in being taxed to meet those obligations, unless of course I too, in the private sector, am to be magically provided with a pension, instead of gaping at the black hole where my 401k used to be. In fact, I think my answer is "sorry, but your ticket on the S.S. Free Ride has been canceled." The same applies to those who call Social Security and Medicare huge liabilities - they are not, they are simply government programs in the nature of wholly unsecured, inter-generational promises, that can end tomorrow if there is insufficient cash in the bank. Game over.
Thats fair. So let me ask, you live where? The Wilderness? Away from all people? You can farm and have ample land to do so I take it. Seeds? Oil? All that jazz? Good luck Ned! Live and let die, Viva la Rev, Solo amigo!
That's cuz you don't own a counterfeiting operation like Ben and Timmy do. They can fund everything--- and faster---than you can say Game over.
Not that easy, Ned. Governments can't just walk away from their contractual obligations. Contract law states explicitly that those pension liabilities have to be paid. Public sector unions will take it all the way to the Supreme Court and win if governments told them to piss off. These are powerful and organized unions. Barring an economic calamity (like sovereign debt default), those pension liabilities will be paid. Worse case scenario, they will hike taxes to pay them.
As an aside, a cab driver told me this morning that the city of Montreal has hired full-time cops whose sole job is to patrol the streets and hand out speeding tickets. They are so cash-strapped that they are resorting to anything to bolster the public finances. The cab driver told me they are even thinking of putting water meters in Montreal. That's a complete joke! Canada has more water than it knows what to do with.
I guess my point is that debts that cannot be paid, will not be paid, no matter how many courts say so. So while I agree with you that there is a debt bomb out there in the form of pension liabilities, the notion that forcing payment in the face of sovereign default (de jure or de facto, the latter being evidenced in the continual "postponement" of contributions to public pensions in municipalities across the US) or failing that, taxing the citizenry to pay for the comfortable retirement of the King's servants will strike many more than me as a non-starter.
Now, your mileage on this may vary considerably in Canada, and if the funding of these pensions is considerably more likely there, and your citizenry more disposed to submit to confiscatory taxation regimes to support the pubic dole, I think I should reconsider my long-held bias against considering government employment in Canada, especially since such bias has rested for so long on the thin reed of my recognition that I am not even a citizen of that fair and generous land.