CFA Society Toronto held its Annual Pension Conference on April 24, 2014. The conference featured Malcolm Hamilton speaking on “The Problem with Public Sector Pension Plans.” Hamilton, who is a former partner at Mercer, recently retired after 33 years and is currently a Senior Fellow with the C.D. Howe Institute. He has acted as consultant to large Canadian pension plans in both the public and private sectors. We sat down with Hamilton to find out why he thinks public pension plans are problematic.

Do you think retirement advice is flawed on the whole?

We’ve created a very complicated system in terms of what people need to do to get the most for their retirement years. Frankly, it’s too complicated for many experts. Neither very low income people nor young families with children should save in Registered Retirement Savings Plans (RRSPs). People with modest incomes should use Tax-Free Savings Accounts (TFSAs) because in retirement the money will come out without a reduction in the Guaranteed Income Supplement (GIS) that these people are entitled to.

Why is the pension system so complicated?

Each program is built without any consideration of the other programs. Looked at in isolation, the RRSP is a wonderful thing; so is the TFSA and the GIS. But when the TFSA was being designed, I don’t think anyone asked how people will decide whether to use a TFSA or a RRSP. The programs were devised largely for political reasons. There are eight programs all crammed together, and the government expects people to understand the claw-back provisions, the tax provisions, and so on. This defies a normal individual’s ability to understand. The only way to figure it out is to develop spreadsheets and models.

So what is the average citizen to do?

They can’t cost-justify the time they would spend to understand, so they go out and ask for advice. If you are reasonably affluent, say $100 ,000 to $150,000 per year, most of what you read is good advice. If you are in the $30,000 to $40,000 range, most of what you read is nonsense. Nobody is looking for the $30,000 to $40,000 client, and nobody is writing books or newspaper and magazine articles for them because they don’t buy books or read the financial sections of newspapers. It makes it very difficult for them to get good advice.

At the Pension Conference, you talked about Public Sector Pension Plans (PSPPs). Are they great or horrible?

They’re both. In Canada we have several well-designed, well-run, and well-governed PSPPs. They are widely admired. The problem is the way the government determines what that pension is worth.

To price it, governments follow funding or accounting practices and use a discount rate that is the rate of return that they think the pension fund will earn. This expected return is typically about CPI (Consumer Price Index) + 4 percent because the fund intends to take a lot of investment risk and intends to be well rewarded for doing so.

The government tells the employees, “We’re promising you a guaranteed benefit; it doesn’t depend at all on how the fund performs.” We know what a fair, guaranteed, long-term rate of return is because the federal government sells long-term inflation-protected bonds. Those bonds give investors a return of about CPI + 1 percent.

The three percent difference is the reward the pension fund expects to receive for taking a lot of risk over a long period of time. That reward properly belongs to the people who take the risk, not the people who receive guaranteed pensions. The members’ pensions do not depend on whether the fund does well. The risk is taken by taxpayers, yet the reward goes to public servants. That’s unacknowledged additional pay from the federal government. The cost of the public sector pensions is being misrepresented.

What should be done about this mismatch?

That’s where we get into target benefit plans. You could ask pension plan members to pay for the guarantee, or you could roll their pensions back, or you could cut their salaries. But if you price the benefit properly, few would voluntarily pay for it in a low-interest environment once the real cost of the guarantee is factored in.

The fix is obvious: get rid of the guarantee. The benefit becomes a target, not a guarantee, and CPI + 4 percent becomes the target return. Members’ benefits will move up and down with the return on the fund. They get the risk, and they get the reward. Alternatively, if they want a guarantee, they can de-risk the plan and pay for the guarantee by collecting smaller benefits. No longer will taxpayers be expected to provide expensive guarantees for free.

Are things different in the provincial public sector?

In the federal plan, the government bears all of the risk. In most provincial plans, both members and government bear the risk. At the Ontario Teachers’ Pension Plan, the members bear half the risk through the contribution rate because if the returns are bad, the contribution rate goes up. When risks are shared, the government pays half, and the teacher in the classroom pays the other half. Until recently, retired teachers had fully guaranteed benefits and bore no risk. Going forward, this will gradually change, and retired teachers will bear some of the risk through cost-of-living adjustments that are tied to fund performance.

To be viable and sustainable in the long run, pension plans must take risk (to keep costs down), manage risk (to get the greatest return for the least risk), and allocate risk to members, former members, and employers in a sensible, equitable way. If taxpayers are expected to bear risk, they should receive fair compensation for doing so. Today, this doesn’t happen.

How does this compare with the private sector plans?

In the private sector, pension accounting uses AA corporate bond rates. The public sector uses the expected return on the pension fund, including the return the fund expects to earn from risk-taking. If the public sector followed private sector practice and recognized the fair value of guarantees as part of compensation, the merits of converting to target benefit plans would be obvious.