Canadian Investment Review

When Contributions Are Too Low

Written by Scot Blythe on Thursday, February 3rd, 2011 at 2:13 pm

pennies in jarWith most Canadian private-sector workers lacking access to a defined benefit (DB) pension plan – and with the ones who do facing Nortel-like catastrophes – naturally attention turns to the apparently greater resources of the state. Hence the preference of many union and retiree advocates for a beefed-up CPP, rather than encouragement for greater private savings through opt-out defined contribution (DC) plans such as the proposed Pooled Registered Retirement Plan.

This misses the point that higher CPP contributions must take away from RPP and RRSP savings room –  unless the federal government wishes to increase significantly its tax expenditures for retirement savings, which, theoretically, are now at 27.9% of earnings.

In any case, state resources are not infinite. As the developed world ages, pensions are becoming the defining issue in state policy, all the way from early retirement provisions to higher contribution rates to the transfer of risk from taxpayers to consumers.

Leo Kolivakis at the Pension Pulse blog notes some recent developments in Sweden and Utah.

The Globe and Mail recently reported on Swedish pension arrangements. “Swedes contribute 18.5 per cent of their pay to the system: 16 per cent to the NDC and 2.5 per cent to a private account where money is invested in mutual funds of their choice.” What’s interesting, for a state pension, is that while the contribution rate is fixed, the benefit, above a certain threshold, is not. It depends on market returns.

Thus, as a consequence of the global meltdown, “[p]ensioners, who had enjoyed years of higher payments following the changeover to the new system in 1999, suddenly faced a cut of 3 per cent in 2010 and 4.3 per cent in 2011.”

The widely praised Dutch model faces similar difficulties. Apart from state benefits, there is a  mandatory occupational scheme, which is now banging up against higher longevity costs, leading to a decision over whether to provide inflation protection. And then there’s underfunding, which, for some occupational plans, means lower pension benefits for existing retirees.

Those are European examples where benefit rates are being reduced to match investment returns.

In North America, however, the options seem rather more limited. Reducing benefit rates for pensioners is not on the table – short of bankruptcy. So the solution is a two-tier pension system, DB for existing employees, DC for new hires – even in the public service, which has generally cleaved to a DB model.

In Utah, it’s looking grim, reports the Wall Street Journal: “Utah’s constitution bars pension changes for current workers—short of an imminent financial crisis in the fund—so the legislature created a defined contribution plan for all new hires starting this year. The state contributes 10% of each worker’s salary (12% for public safety workers and firefighters), a generous amount by private company standards. If they wish, new workers can choose a defined benefit plan, but the state contribution to such a plan is no longer open-ended but is legally capped at 10%.”

But it’s grim across the United States, as Capitol Hill legislators whisper about modified insolvency models for the states – which are not permitted to go bankrupt – at least partially in order to renegotiate the pension promise for underfunded plans, according to the New York Times:

“Unlike cities, the states are barred from seeking protection in federal bankruptcy court. Any effort to change that status would have to clear high constitutional hurdles because the states are considered sovereign.

“But proponents say some states are so burdened that the only feasible way out may be bankruptcy, giving Illinois, for example, the opportunity to do what General Motors did with the federal government’s aid.

“Beyond their short-term budget gaps, some states have deep structural problems, like insolvent pension funds, that are diverting money from essential public services like education and health care. Some members of Congress fear that it is just a matter of time before a state seeks a bailout, say bankruptcy lawyers who have been consulted by Congressional aides.”

Of course, that will wreak havoc on states’ abilities to go to the capital markets. But with talk of sovereign defaults in Europe no longer improbable, former World Bank chief economist (and Nobel Prize winner) Joseph Stiglitz suggests there is life after sovereign debt restructurings. But for whom?

DC, DB, PRPP, RRSP, as the saying goes, there’s no free lunch. Market returns are no substitute for inadequate contributions.

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