Canadian public pension plans need more regulation, particularly when it comes to setting a key calculation used to determine the assets they need to have on hand to meet future liabilities, because the high rates being used by many plans increases the probability that the plans will have “insufficient assets” to meet their obligations, according…
Many defined-benefit pension plan sponsors in Canada are using high discount rates — the interest rate used to calculate the present value of projected future benefits — because it keeps the contributions employers and workers must make to the pension lower, says the paper authored by Stuart Landon and Constance Smith, both professors emeritus in the University of Alberta’s economics department.
The report, published last week, recognizes that there is an incentive for this, but says their analysis shows that the choice to use a higher discount rate adds “considerable risk“ and “increases the probability that the plan will have insufficient assets to meet obligations.”
At the moment, the paper says, public-sector pension plans “receive little guidance on the choice of discount rate and, in practice, many such plans use a rate higher than our best performing rules.”
This, the authors conclude, “suggests the need for prudent regulation of pension plan discount rates.”
Landon said current trends, which include low interest rates and an aging population, are forcing pensions to invest in riskier assets to generate higher returns. A lower discount rate would reduce “the risk these investments will turn out badly,” he told the Financial Post. “You want to build in some insurance.”
The paper he co-authored notes that the prolonged period of low interest rates that followed the 2008 financial crisis — which put pressure on pensions and other long-term investors such as insurers with respect to meeting their future obligations — has already prompted reviews of discount rates by accounting standards boards and regulators in jurisdictions including Canada, the United States, and Europe.
Pension funds using high discount rates may be relying too heavily on boosting investment returns to satisfy their future obligations
Besides the concern that pension funds using high discount rates may be relying too heavily on boosting investment returns to satisfy their future obligations, the selection of the discount rate in a public sector defined-benefit pension plan is also an important factor in how the cost of the plan is allocated between current and future contributors. The higher the chosen rate, the higher the proportion of the cost burden falls on future contributors.
The C.D. Howe Institute paper did not analyze the discount rate used by specific pension plans. Instead, it analyzed a generic defined benefit pension plan in simulations using six different discount rate rules. But the analysis “is relevant for (all) defined benefit plans, such as the CPP (Canada Pension Plan) and the OTPP (Ontario Teachers Pension Plan),” said Smith, Landon’s co-author.
Landon noted that the Ontario Teachers’ Pension Plan uses a discount rate of around five per cent, which is very close to the level the paper found desirable. The rate used by the Canada Pension Plan is higher, he said, as is the closer to six per cent rate used by the Ontario Municipal Employees Retirement System (OMERS).
Thomas Klassen, a professor at York University’s School of Public Policy and Administration, agreed that there is risk associated with choosing a relatively high pension plan discount rate, as many defined benefit plans do.
However, he disagreed with the idea that these rates should be regulated.
“No one can foresee the future. Governments are no better, or worse, than pension plan sponsors in predicting future economic conditions,” he said.
Klassen noted that all pension plans carry risk, and said plan sponsors have made adjustments to contributions or benefits in the past when the discount rate has turned out to be too high or low in the past.
“That is how matters should work, and indeed how they having been working for many decades,” he said.
“A second worry is that should the government force discount rates lower, the attractiveness of defined-benefit (DB) pension plans decreases,” Klassen added.
There has been a steady migration away from defined-benefit pension plans, which guarantee a set payout to employees in retirement.
“No government would wish to intensify this trend,” Klassen said.
A second worry is that should the government force discount rates lower, the attractiveness of defined-benefit (DB) pension plans decreasesThomas Klassen, a professor at York University’s School of Public Policy and Administration
Keith Ambachtsheer, director emeritus of the Rotman International Centre for Pension Management, is not opposed to some regulation, but said he is of the view that the focus should rest not on the discount rate but on the details and transparency of underlying pension contracts.
“Regulation should require that the economic nature of the contract should be clearly spelled out, including its risks and how and by whom they are borne,” he said, referring to an article he published in December that looked at how employers and their workers would bear the costs in various scenarios if returns failed to materialize as anticipated from higher-risk investments.
Pension plans could also be required to obtain an arms-length “fairness certification” that would demonstrate when a plan was designed to ensure “no party to the contract is systemically advantaged at the expense of any other party,” Ambachtsheer suggested to the Financial Post.
“If all that is done, the choice of liability discount rate becomes self-evident,” he said.
Officials at large Canadian pension plan managers including the Ontario Teachers’ Pension Plan Board, The Public Sector Pension Investment Board (PSP), and the Caisse de dépôt et Placement du Québec, declined to comment on the C.D. Howe Institute paper. A spokesperson for the Canada Pension Plan Investment Board, which invests funds on behalf of the Canada Pension Plan, declined to comment because the discount rate for the national pension scheme is determined by the Chief Actuary of Canada.
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