Public Pensions: Steady as they Go?

So far, this reserve has not been used to pay pension benefits, which were entirely covered by employer/employee contributions representing 9.9% of salary, explains Alexandre Laurin, director of research at the C.D. Howe Institute. However, “benefits should surpass contributions in 2022 and then we will start cashing out assets. Still, with returns and contributions combined, the reserve should continue to grow.” The fund should reach $3 trillion (or $1.6 T after inflation adjustment) by 2050, predicts the CPPIB’s 2020 annual report.

Is it Enough?
Not quite, notes the Parliamentary Budget Officer (PBO) in its November 2020 Fiscal Sustainability Report: Update, which asserts that the CPP is not sustainable over the long term. “Under the current structure, projected contributions and benefits are not sufficient to ensure that, over the long term, the net asset-to-GDP position returns to its pre-pandemic level. Increased contributions, or reduced benefits, amounting to 0.1% of GDP ($1.3 billion in current dollars, growing in line with GDP thereafter) would be required to achieve sustainability.” 

The PBO also finds a similar deficit in the Quebec Pension Plan (QPP) amounting to 0.1% of Quebec’s GDP, or $0.3 billion. Assets of the QPP, which stood at $73 billion at the end of 2018, are projected to rise to $548 billion in 50 years, and keeping the present contribution rate of 10.8% on salaries is expected to maintain sustainability of the plan.

The Old Age Security program (OAS) is a different beast. It has no capital reserve and is entirely paid from current government revenues. In 2020, total expenditures amounted to $55.7 billion ($42.7 billion for OAS and $13 billion for Guaranteed Income Supplement payments), which corresponds to a hefty portion of 16.7% of total government revenues of $334 billion.

In its most recent Actuarial Report of the Old Age Security Program, the Office of the Superintendent of Financial Institutions (OSFI) projects that expenses will grow to $123 billion in 2035, then to $243 billion in 2060. Unexpectedly, OSFI compares that not to projected government revenues, but to GDP, stating that the ratio of old age expenses to GDP will evolve from 2.77% in 2020 to a peak of 3.1% around 2035, then gradually fall back to 2.63% in 2060, a level comparable to its historic level of the early 1990s.

Comparing Programs
Comparing 39 pension programs across the world, the Mercer CFA Institute Global Pension Index is arguably the most extensive and in-depth of its kind. Based on three criteria – adequacy, sustainability and integrity – the index ranks Canada’s programs in 9^th position with an overall grade of 69.3%, or B+, behind the top programs of the Netherlands, Denmark, and Australia, but ahead of Germany, the U.K., the U.S. and France. 

On the sustainability sub-index that accounts for 35% of the country score, a key question focuses on the total level of pensions assets as a percentage of GDP each country holds. On that count, Canada and Demark alone score a perfect 10. However, for the whole sustainability sub-index, which takes into consideration features like life expectancy, labour force participation rate, recent GDP growth, Canada comes in with a 64.4% score, or a C+ note.

Canada 2070
The sustainability of Canada’s public pension programs hinges on many underlying hypotheses which are expected to hold steadfast for 50 to 60 years. A case in point, in its projections for the OAS programs, OSFI calculates that the expected slide back to 2.63% of GDP depends on a lower growth of inflation compared to the growth of salaries and GDP. Really? For the CPP and QPP, projections take into account levels of immigration, of unemployment, of life expectancies. If any one of these projections varies even slightly, it could significantly change results 50 years down the road – negatively as well as positively. 

For example, a key variable is average real annual rates of return (after inflation), which the Canada’s chief actuary sets at 3.95% for the CPP and Retraite Québec at 3.6 % for the QPP. Those are very reasonable assumptions. If ever the CPPIB continues generating a real rate of return close to 8.1% as it did over the last 10 years, then sustainability will cease to be an issue. But not if returns fall below their expected thresholds.

COVID Again?
One factor of immediate concern relates to the pandemic’s impact on the pension programs. At the end of 2021, total federal debt is forecast to rise to $1.2 trillion, or 55% of GDP, compared to $721 B and 31.3% of GDP at the end of 2020. That could potentially have major effects on future federal expenditures and the sustainability of the OAS programs. Unexpectedly, an Analysis of Federal Debt: 2020-21 by the PBO establishes that, thanks to historically low interest rates, debt service will also stand at historical lows. “Despite the record increase in federal debt, we project that the Government’s debt service ratio (public debt charges relative to tax revenues) will reach 7.0% in 2023-24, its lowest recorded level.” (The highest point since 1970 reached 48% in 1990). If rates in that period rise by 100 basis points, the ratio would crank up to 11.6%, while a 200 basis points increase would translate into a debt service ratio of 15%.  

Nevertheless, the long term trends of publicly funded healthcare and education programs will put the federal budget under pressure, the C.D. Howe calculated in a 2017 study. The Institute projects that these expense items will come to represent an unfunded liability of $4.5 trillion over the next 50 years and, to cover that liability, taxes will need to be increased by 25% over that period. If not, pension benefits could eventually suffer. To offset some of that potential pain, the Institute advises to increase the retirement age to 67 and, ideally, to 69. Pushing it up to 69 would help reduce the liability to $3.3 trillion. Still, something will have to give; either benefits will drop, contributions will increase or taxes will shoot up – or all three.

The C.D. Howe Institute’s recommendation to governments certainly holds for individual investors, argues David Blanchett, head of retirement research at Morningstar Investment Management, who calls delaying retirement “a silver bullet”  Each additional year of presence in the workforce allows one to grow one’s nest egg and increase CPP revenues while at the same time reducing one’s dependency on them.

And though it might seem obvious, it is worth mentioning a reminder by Ian Tam, Director of Investment Research for Morningstar Canada: “Although the CPP’s viability is strong, it is highly likely that you will need to supplement the benefit with another source of income in retirement. It is absolutely worthwhile to take advantage of RRSPs and TFSAs to grow your nest egg in a tax-efficient manner and maintain a good standard of living in retirement.”