Public sector pension bubble; Is your retirement chained to your home?

Pension tension

The CD Howe institute released an interesting report today in which they suggested that there is a bubble in federal public sector pensions.  The report calculated that the government’s federal pension unfunded liabilities are some $208 billion, which is $65 billion more than the government had calculated.  The implication is that Canada’s deficits and total debt have been understated for many years.

From the report:

“Government employee pensions are rapidly emerging as a major fiscal problem.”

“The government’s net pension obligation under the fair-value approach thus stands at almost $208 billion – some $65 billion larger than reported in the Public Accounts. This raises the net public debt by an equivalent amount. And, because the gap between reported and fair-value pension obligations has grown over time, these adjustments
also change the annual budget balances.”

“The fair-value approach to pensions, by contrast, shows a cumulative deficit over that period (2001-present -ed.) of $72 billion. In 2009/10 alone, the annual deficit would have been not the $55 billion reported, but $63 billion.”

In a previous post I noted that,  “pensions will be in serious trouble.  Large public pensions will face serious underfunding issues.  Most will switch to defined contribution.” In the current interest rate environment, it is exceptionally difficult for pension plans to achieve their estimated returns, which are usually calculated at 7-9%.  This partly explains the increasing size of the unfunded liabilities.

Perhaps the more significant issue is that defined benefit pension plans are inherently Ponzi-like in that they need an ever-expanding contribution base to maintain payouts at the top.  Demographics and life expectancy being what they are here in Canada, this is highly unlikely.  This is not just a federal issue, but is true of provincial pensions as well.

The solution(s)

There are four solutions that I see to the growing pension issue:  1)  Switch to defined contribution; 2) Increase contributions by employees;  3)  Increase contributions by taxpayers; 4)  Change retirement age of pension benefits.

You can guess which one I like least.  With taxpayers already contributing over two thirds to the federal pension plans, there is absolutely no reason for them to be on the hook for one extra penny.

I believe that all defined benefit pensions will at some point be switched to defined contribution.  This involves an enormous up-front cost, but will provide tremendous savings over the long run.  You can imagine what the public sector unions will think of any proposal to alter these over-generous and unsustainable pensions.

Another solution is to increase contribution from the employees.  Yet the report suggests that contribution rates would need to double, up to nearly 40% of income.  This would be about as popular as a fart in an elevator.

Finally, a change in entitlement promises is another option for plugging this hole.  I think a combination of increased contributions and decreased total benefits will likely be the temporary solution.  As I said above, I do think that the age of the defined benefit plan is behind up and these pension plans will be very lucky to survive beyond the next decade in their present form.  It’s really quite simple:  By definition, something that is unsustainable will not be sustained over the long term.

I’ll leave you with one final quote from the report.  Take particular note of the final sentence:

“Taxpayers face two types of risks. One is obvious: responsibility to back-fill the funding hole will fall to them. The other risk is more speculative: as debt levels rise, fears of sovereign defaults will likely drive up the cost of borrowing – for all governments, but particularly for those with opaque balance sheets and big exposure to public employee pensions.

Certainly there is a danger to letting federal debt obligations swell.  While we may not be a Greece, Ireland, or Portugal when it comed to federal debt, as Jonathan Tonge noted, we’re not materially different when it comes to aggregate debt levels in our societies.


Let’s not completely ignore the harsh rebuke the bond market has recently given many countries.

 

Is your retirement chained to your home?

After three posts about the CAAMP report, I figured I should leave it alone for a while.  But then I read this great piece in the Financial Post and figured I should pass it along.  Here are some key quotes:

“Statistics released this week show 42% of mortgages originating in the last year went for an amortization period of more than 25 years.

It’s a huge jump when you consider that just five years ago, you couldn’t even get an insured mortgage backed by the government that was amortized above that period. Now the government limits insured mortgages to 35 years.”

The article explains that home owners debtors with amortization terms longer than 25 years don’t believe that carrying that debt burden for up to 10 years longer than their peers will materially affect their retirement plans.

But perhaps these people are actually going to take advantage of lower monthly payments to make larger lump sum payments.  The CAAMP report indicates that a significant proportion of these homeowners are planning on making those extra payments.  Are they?

“Vince Gaetano, a principal broker and owner at Monster Mortgage, agrees people who choose the longer amortization and the lower payment rarely take advantage of that extra cash flow to make additional payments later on. “It’s a very small group of people who do that,” he says.”

The article makes the following conclusion:

“There is no getting around the fact the people who take a longer amortization will take longer to repay their loan. The CAAMP study found consumers going longer than 25 years, were done with their mortgage at age 53 on average, compared with an average of 47 years for those going for the less than 25 years.

If you are going for a longer amortization, you better hope your home goes up in value because you are going to have fewer mortgage-free years in which to save. It’s hard to believe that won’t affect retirement plans.

Hard to argue with that!

-Ben

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4 Responses to Public sector pension bubble; Is your retirement chained to your home?

  1. breezer1 says:

    what is unsustainable will not be sustained.

  2. pricedoutfornow says:

    I agree. It is not sustainable for someone to work for 30 years, retire at age 55 then collect a nice pension for another 20-30 years. Maybe in prior years this was the case but not now. I see the Conservative government is about to make trips around the country, asking people what services they want to keep and what should be scrapped. I think “austerity” measures will be coming soon to our country. Unfortunately, I know several people who are in their late-40s or early 50s and are counting the days until they retire at age 55 with that lovely pension. Oh, and most of their wealth is in real estate. Can you say..Yikes???

  3. Pingback: Changing social trends in the news… | Financial Insights

  4. Pingback: BMO weighs in on troubling RSP trends and public sector unions | Financial Insights

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