By William B. P. Robson (C.D. Howe Institute) & Alexandre Laurin (C.D. Howe Institute)

Ottawa provides its employees with defined-benefit pensions that promise relatively generous benefits to a large current and former workforce. Being largely unfunded, these plans require future taxpayer support. They also create taxpayer risk because the economic value of the benefits they will provide can fluctuate by tens of billions of dollars annually. Current accounting practices understate this burden and the risks these plans create for taxpayers and, potentially, for the employees themselves. Official figures on the current cost of these plans and their accumulated obligations are based on notional interest rates that are too high for this kind of commitment. Since pension promises are guaranteed by taxpayers and indexed to inflation, the appropriate rate for discounting the value of future payments should be the yield on federal-government real-return bonds (RRB), which for years has been much lower than the assumed rate in official figures. Correcting this distortion would produce a fair-value estimate of $245.9 billion for Ottawa’s unfunded pension liability at the end of 2016/17 – around $27,000 per family of four and $96 billion higher than the reported number. Because the unfunded pension liability is part of Ottawa’s debt, applying this fair-value adjustment raises the net public debt from the $631.9 billion reported at the end 2016/17 to an adjusted $727.9 billion. Recent federal pension reforms raised participants’ share of the funding costs for these plans: for the main Public Service Plan, the reforms aimed at a 50:50 split between contributions from participants and contributions from the government as employer. Still, using notional interest rates that are higher than the appropriate ones means that the reported costs of these plans – and, therefore, the contribution rates that determine participants’ shares – are too low. Even the higher employee contributions anticipated by the reforms would leave the taxpayers’ true share far above 50 percent. A fair-value approach to the current service cost would ensure that participants and taxpayers share equally the actual cost of accruing benefits. Even 50:50 sharing of federal pensions’ actual costs as they accrue would leave taxpayers exposed to fluctuations in the value of previously earned benefits. Ottawa could protect taxpayers from this risk by capping employer contributions at a fixed share of pensionable pay. To relieve taxpayers of their current sole responsibility for risks in the federal plans, Ottawa would need to switch to a different type of plan with benefits based not only on salary and years of service but also on the plans’ funded status. Such plans, already common in much of the provincial public sector, have a variety of labels – shared-risk and target-benefit are two common ones. Their common feature is that when things do not go as expected, the plan sponsor and the employees share the costs and benefits of the new reality. More economically meaningful reporting of the plans’ benefit values and their cost to taxpayers would foster improvements in Canada’s retirement saving and income system generally. And it would foster reforms that would provide federal employees with better-funded pensions and taxpayers with protection against risks too few know they face.

Source: SSRN