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Description
The Study in Brief
The problems of employer-sponsored defined-benefit (DB) pension plans in Canada raise two issues: the need for short-run measures to limit the damage; and the need for new pension models to prevent their recurring.
The DB sector's immediate preoccupations are the result of changes in the economic environment--in particular, a decline in long-term interest rates--that caused their balance sheets to deteriorate, and of changes in accounting standards to more market-based methods that revealed the underfunded state of these plans in stark form.
The immediate policy challenge is to ensure the recovery and/or restructuring of sick plans, and the continued health of sound ones. Extra time and financial scope to work off deficits are good, but current limits on contributions to plans should rise or disappear, while legislation to establish clear title to surpluses for sponsors who must cover deficits is badly needed.
Accounting standards should remain strict, however, to ensure that emerging problems are seen and addressed. It would be a mistake to privilege government-employee plans by relieving them of the same solvency requirements that apply to private-sector plans. Another wrong turn would be resorting to government-sponsored insurance to backstop plans, since this approach creates moral hazards and future liabilities for taxpayers.
In the longer run, policy should sustain and encourage a thriving occupational pension sector that helps individuals save for old age and helps finance the investment that underpins economic growth. But DB plans were in decline long before the recent crisis, and evidence is mounting that the classic single-employer DB plan has fatal agency problems--evident particularly in the tendency for these plans to mismatch assets and liabilities in ways that exposed them to risks far larger than sponsors or participants understood.
Rather than seeking to prop up the classic DB system, then, Canadians would do better to seek alternatives. Existing RRSPs and money-purchase plans tend to impose high decision-making and administrative costs on individuals. A better route would be to promote the development of plans with good features from both models. They could:
* be predominantly money purchase, but with a small and affordable minimum benefit;
* pool investment risk across a large number of individuals at reasonable administrative cost;
* gear contribution rates to a target payout; and
* steer individuals' portfolios toward an asset mix that would insulate them from fluctuating annuity prices as they approach retirement.
Even as Canadians seek to deal with the short-run problems of traditional DB plans, then, they need to develop new models that offer attractive ways to pool resources and save for retirement, while mitigating not only financial risk and longevity risk, but agency risk as well.
In this issue ...
Attempts to shore up the classic single-employer, defined-benefit pension plan are the wrong response to Canada's occupational pension problems. While tax and regulatory changes can help, Canadians need a new approach to retirement income that will pool risks, control costs, and avoid the agency problems that have put many pension promises at risk.
Employer-sponsored pension plans in Canada face an uncertain future. The value of the assets in many defined-benefit (DB) plans falls short of their obligations, and the benefits those plans promise are less secure than they once appeared. Much discussion of this issue takes for granted two policy priorities: repairing and/or restructuring damaged plans; and ensuring that the classic (single-employer) DB model continues as Canada's favoured approach to employer-sponsored pensions.
This Commentary accepts, with some reservations, the first of these propositions, but takes a highly skeptical view of the second. After a brief overview of Canada's pension system, it describes the current difficulties of DB plans and discusses some dos and don'ts for addressing them. It follows other recent observers in urging changes to features of Canada's tax code that impede the accumulation of surpluses above a certain limit, normally 10 percent of liabilities. It also recommends clarifying and strengthening sponsors' property rights in surpluses to remove disincentives to their accumulation--disincentives that not only contributed to current problems but make their recurrence more likely. At the same time, it supports accounting and reporting practices that make fluctuations in pension-plan balance sheets easier for all concerned to track.
This Commentary further suggests that current problems did not result merely from an unhappy series of financial accidents, but are symptoms of defects in the DB model itself. Hence, it concludes that the apparent ongoing decline in DB plans, particularly in the private sector, and the concomitant growth of money-purchase and registered retirement saving schemes, is not the deplorable development many commentators assume. (1) Rather, it a necessary prelude to a more thorough overhaul of employer-sponsored pensions in Canada.
Canada's Pension System and the Problems in its Private Sector
By international and historical standards, the publicly funded pillars of Canada's pension system are in good shape.
The first pillar consists of the Old Age Security and the Guaranteed Income Supplement, which provide basic support for those without significant other income in old age. The federal government runs them on a pay-as-you-go basis. Their benefits--about $13,350 annually for a single person with no other income in early 2007, and $21,650 for a couple--are modest and, being indexed to consumer price inflation rather than wages, should prove manageable for the federal treasury over the long haul (Robson 2006). They are both subject to income-related clawbacks, however: 15 percent for the OAS between incomes of about $61,000 and $100,000, and 50 percent for the GIS for all non-OAS income. Combined with ordinary income taxes and other geared-to-income benefits for seniors, these clawbacks create high effective marginal tax rates that discourage work and saving among low- and middle-income households. (2)
The second pillar is the Canada Pension Plan (CPP) and its Quebec counterpart (the QPP). These compulsory, contributory defined-benefit programs cover essentially all paid and self-employed workers: about 90 percent of the labour force contributes to them in a given year. The CPP and QPP pay maximum annual retirement benefits of about $10,360 a year. A reform package in the late 1990s raised C/QPP contribution rates to 9.9 percent of covered earnings, a level intended to be sustainable for decades. Since they have an accumulated unfunded obligation to older participants, these plans, like social security programs nearly everywhere, require new participants to pay more than an actuarially fair rate for their benefits. However, prudent investment of the funds now accumulating in them will make their long-term viability a function of the performance of the economy as well as of the taxing powers of governments.
Canada's pension system also has a substantial private voluntary/contractual component. The bulk of Canada's labour force participates in employer-sponsored Registered Pension Plans (RPPs) and/or Registered Retirement Savings Plans (RRSPs) on either an individual or group basis. Roughly one-third of all workers belong to RPPs, and slightly more than that have RRSPs (there is some overlap between the two); among tax filers reporting incomes of $60,000, more than 90 percent of employees participate in RPPs and/or RRSPs. (3) The voluntary-contractual component of the system is the focus of much current anxiety. In particular, DB plans--which covered some 95 percent of public-sector and 75 percent of private-sector RPP members as late as 2005 (Horner 2007, Fig. 3.9)--are covering fewer workers. Their sponsors account for a declining share of total employment, and few new plans are starting up.
The Difficulties of Defined-Benefit Pension Plans
The essential feature of DB pension plans is that sponsors promise members a given pension upon retirement--sometimes a specified dollar amount; more usually an amount linked to pre-retirement earnings. In principle, therefore, RPP members can be certain about their incomes in retirement, and are spared the planning forced on people who must provide for themselves. This feature makes many commentators like DB arrangements. They contrast them favourably to the defined-contribution (DC) alternative, under which sponsors make payments on members' behalf into a fund, and members bear the risk that the pension this fund yields will be less (or more) than they expect. And they also prefer them to RRSPs, whether group or individual, whose holders also bear investment risk, and may choose how much, or little, to contribute as well. Notwithstanding these judgments, however, the underfunded state of many DB plans in Canada means that the retirement incomes of their members are less secure than they once seemed.
The obligations of most DB plans, furthermore, are liabilities of their sponsors, many of which are entities with publicly traded shares and debt obligations. To the extent that the pension-plan troubles of particular companies or governments are not fully reflected in share and bond prices, investors may not allocate their saving efficiently. Mispricing of this kind would not simply be an issue for individual entities and investors, moreover. Were problems in one sponsor's pension plan not properly reflected in the price of its securities, plans of other entities holding those securities would appear sounder than they are, and the financial obligations of those entities would tend to be over-valued--a pyramid of mispricing that raises a prospect of systemic risks. (4)
Recent surveys (Armstrong 2006) show that Canada's DB pension plans are in better shape than they were in 2003, largely thanks to the recovery of equity markets. A longer perspective, however, shows that DB plans as an approach to pensions are under pressure. The fraction of workers in any kind of pension plan covered by DB arrangements slid sharply during the 1990s, before the onset of the recent concerns. (5) Money-purchase plans are becoming more important (OSFI 2005, 44-45), not simply because old DB plans are being wound up, but because so few new ones are being created. These longer run trends suggest that Canadians need to ask whether the DB model will figure as prominently in the contractual component of their pension system in the future as in the past, and whether policy should respond either way.
The Immediate Problem: Underfunding
The scope of the sector's most immediate problem, underfunding, is well-documented by regulatory authorities at the provincial and federal levels. The Financial Services Commission of Ontario (FSCO) is the largest single regulator of private pension plans in Canada: about 40 percent of the total.... |
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