Public pensions flawed in design: C.D. Howe Institute

Public sector pension plans have come under fire of late, particularly surrounding so-called gold-plated defined benefit plans — but the real problem, according to the C.D. Howe Institute, lies in a flawed approach to managing compensation costs.

Released last week, Evaluating Public Sector Pensions: How Much Do They Really Cost? noted that public sector pension plans struggle because government sponsors typically underestimate the cost of guaranteeing payouts in the future. That leads to the underestimation of employee pension costs, and thus the mismanagement of employee compensation, said Malcolm Hamilton, a pension expert with the public policy think tank.

“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,” Hamilton explained. “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.”

As well, there exists a wide gap between financial markets and government financial statements. Whereas the markets attach high values to the guarantees embedded in public sector pension plans, the government tends to attach little or no value to the guarantees. As a result, costs become understated, the report said.

For instance, employees in the public sector are paid more than is publicly acknowledged and, in many instanced, more than their private sector counterparts. Those same workers shelter more of their retirement savings from tax than others are permitted to, 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.

“Essentially, we have devised a complicated way to transfer wealth from future taxpayers to current plan members,” Hamilton said, adding that, “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.”

Then, the solution becomes obvious. Hamilton suggested benefits be tied to funding levels or to the performance of pension funds. Employee contributions or salaries should also be tied to the cost of funding their pensions — a direction provincial governments have already taken. 

This latest report from the C.D. Howe Institute is the first in a two-part series.