Book Review: Pension Ponzi

Did you ever wonder exactly how good some of those defined benefit pension plans are that most civil servants get?  Well I was a little curious to learn some more so when I heard about the book called Pension Ponzi: How Public Sector Unions are Bankrupting Canada’s Health Care, Eduction and Your Retirement by Bill Tufts and Lee Fairbanks I knew I had to read that book.

As you can likely tell from the title the authors aren’t that fond of unions so the entire book does have a right leaning political stance.  Yet in all fairness that still doesn’t detract from the mind blowing stats in the book about the benefits some defined pension plans pay out and how they won’t be able to be sustained.

For example, well how much does the federal government owe for these kinds of pensions?  Isn’t it included in the federal debt?  Umm, actually no it isn’t included in the net federal debt, which is estimated to be at close to $600 billion in 2011.  Now what happens when you add in an estimate for those pension costs, the total debt load jumps to $1.2 trillion.  Yep, it DOUBLES the debt.  To put that into more realistic terms that is about $35,000 per person in Canada.  So my family of four’s portion of the federal debt is $140,000 if you add in pension obligations. Yet it gets better, we still have two other levels of government that are in similar problems.

So its fair to say as a country we have a problem with pension related obligations and it isn’t small.  Yet, how can this happen?  It largely comes down to the promises made by defined benefit plans are completely unreasonable.  Let’s say we have a person, called Jane Doe, who makes $50,000 a year just prior to retirement.  She has worked for the government for about 35 years and has been promised 70% of her five highest earning years.  So that would be a $35,000 per year pension in retirement.  Reasonable right? Ah, no it isn’t.

You see defined contribution plans pay out based on your average salary over your working career.  So while you make $50,000 during your last five years, you spend the other 30 years making less than that.  So by having the obligation at the highest level you are basically guaranteeing a shortfall since it is extremely unlikely Jane Doe will be contributing enough between herself and her employer to make up the difference.  For example, to ensure a comfortable payout of $35,000 a year you would need at least $875,000 saved (assuming a safe withdrawal rate of 4%).  Yet Jane only contributes like 9% of her pay or $4500/year during her last five years.  So even if that is fully matched by the employer that only put in $45,000 during those last five years.  That is at her highest salary, so every other year has been at less than that.  Yet to save that total $875,000 total at 5% real return she would have had to save that $9000/year for her entire career and she would still be $25,000 short.

Basically the assumed payouts being linked to the highest earning years at that high replacement rate of 70% makes it impossible to for an employee and employer to a put enough money in during the life of the plan.  The only reason this has worked so far was the number of workers greatly out numbered the number of retired people in the plans for decades.  Yet this is coming to a crashing halt over the next two decades as that ratio plunges from 5 worker to 1 retiree to about 2 workers to 1 retiree.  Yep, defined benefit plans have largely been a very big ponzi scheme.  Yet who is going to cover that shortfall…you and me, the taxpayer.

So while the title of the book was a bit long, it overall is likely going to be correct without some serious reforms to these pension plans.  Which the book outlines in the final chapter.  Some of the more obvious ones is change the benefit formula from 70% down towards 50% and then shift to the average yearly salary rather than highest five years.

Overall the book is a good read to learn the ins and outs of pensions in Canada.  So be prepared to hear the words ‘pension reform’ a lot over the next few years, because collectively we need to have a talk about this issue.

11 thoughts on “Book Review: Pension Ponzi”

  1. I`m confused on your requirement for 875000? According to my calculations, assuming a 30 year life post retirement, you would only need 570000. If we assumed you lived forever you would need 875000. In the case of a death the 875000 would be left over to fund other pensioners.

    I see the perceived dilemma with using the best 5 year approach for determining the payout during retirement, however this is assuming that the majority of public servants become directors or get huge raises during the end of their careers. I would think that this is not the case since there are only so many “higher up” positions to go around.

    My last point RE: that the government will have to bail the pension plan out. Since tax payer money pays the contributions and essentially funds the pension plan isn’t the issue moot if the gov has to bail it out later? Pay now or later, it still comes from the tax payers.

    I don’t believe that the pension plan doubles the debt. Sounds like the job of a good accountant or someone throwing around numbers to sell a book…

    There is nothing wrong with reviewing whether or not this pension thing is worth funding, but at a macro level vice a micro.

  2. I’m not an actuary, but using the 9% contribution rates and 5% growth over inflation you’ve mentioned in your post, I did a spreadsheet workout for a hypothetical (and what I’d consider typical) employee born in January 1954 who starts working at the start of 1978 and retires at the end of 2012. In current value dollars, I start her out at $24,000 ($14,540 in 1978) when she’s 24 years old and have her finish up making $52,300 this year, before she turns 59. I increase her salary continuously to reflect her increased work experience and career progression from entry level to supervisor level over time (by 2.32%, just to make the numbers line up tidily). The average of the last five years is $50,000.

    In her first year, she contributes $2160, as does the employer. Assuming the invested money grows at a rate of 5% over inflation (maybe it does, maybe it doesn’t), at the end of 2012, she’s contributed a total of $114,634, matched by the employer, and the growth is $300,035, for a total of $529,303.

    Now the plan is going to give her $35,000 a year until she dies. Actually, for my defined benefit plan it’s less than that, since the amount paid drops by an amount roughly equivalent to CPP once I turn 65. Factoring that formula in, I calculate that the $529K would fall below zero… on her 151st birthday! =D

    By reducing the returns to 4.5% over inflation and the contribution rates to 7.5%, I can bring that down to a more actuarially sane 81 years old. I see some risk, but on average I wouldn’t call this a ponzi scheme. From 1978 to 1991 the low-end contribution rate was only 5.5%, which initially looked shocking to me until I saw that it only took an adjustment of the returns to a non-unheard-of 5.75% over inflation to make the money last to 83. Subtle changes to these numbers can create big swings, of course, which is what the actuaries are meant to stay on top of.

  3. Just following up…. My first rough calculations had some basic errors and I wasn’t comfortable with the “average rate of return” concept, since it doesn’t really exist — the market goes up and down. My latest version of the model for this hypothetical worker uses historic S&P 500 returns, actual year-by-year inflation, and actual contribution rates used by the OMERS plan in Ontario over the period — including the lamentable contribution holidays when the plan ran too large a surplus. I’m now starting her at $6797 in 1978 and increasing her salary over and above inflation by 2.45% to get to $50K at age 59.

    Over that period I calculate only $50K in contributions matched by the employer, but $478K in market gains. Indexing the pension at 2% starting now, and assuming returns of 1.8% above inflation, this safely takes her to age 83.

    What’s really interesting looking at the historical results is the wild swings in the total value of invested assets. In 2000-2002 the value drops by over $170K and in 2008 it drops by $200K. There are no similar swings in the 1978-1999 period, which may explain why people are now suddenly thinking of these plans as unsustainable (and why contribution rates are high at the moment).

  4. Pa,

    Your numbers make sense and I think that we can all agree that there is someone out there working on the pension plan, doing those calculations. I would be interested in reading the book to see their calculations. There is obviously risk through the process, inflation, investing returns, retirement age, but I would imagine there are people who deal with those issues accordingly.

    Assuming there are 500,000 active contributing members of the public service and the gov matches the 9% contribution (assuming 50,000 average salary), we have a 2.25 billion/year of tax payer money going to funding the pensions. Of course, depending on how you look at it, the other 9% is also coming from the tax payers. so 4.5 billion/year is funding this program. There must be some kind of accounting thing to segregate the two contributions. I don’t understand why the gov doesn’t pay the whole 18% and lower the wages, or just increase the wages and make the employee contribute more? Maybe this has tax implications not accounted for within the pension adjustment on the t4?

    I would be interested in how much it actually costs to employ a public servant. Medical/Dental benefits, pension contributions, professional training, holidays… I know that contractors doing the same job typically get paid around double the salary but get none of the above perks.

    Thoughts?

  5. Just cut to the chase and agree that these well described ‘gold plated pension plans are unaffordable, taxpayers should not be on the hook like that.

  6. Canuckguy,

    I don’t agree. As demonstrated by Pa’s calculations, the pension plan is self-sustainable and funded reasonably. Whether or not there should be a public service pension plan is moot. The more important question is how much does a public servant cost to employ. Whether or not the perk is a pension plan or free strippers or an extra 9% wage increase I don’t care. Any corporation could cut salaries by 9% + do another 9% deduction per paycheck and have the same benefit.

    If the gov wants to save money they could reduce public servant salary and have the same effect as removing the pension plan. So the question remains: what is the cost to fund a public servant and is it too high compared to private industry. If it is, there are many options to reduce the cost, but focusing only on the pension plan is for those who do not see the big picture.

  7. @ Money Matters:
    I still stand by my comments. I don’t think most civil servants are overpaid, though the governments, both provincial and federal, have too many of them. The pensions plans really do need addressing. I have been retired 6 years and my pension is the same as the day I started getting it. I adjust for the reduction of my buying power and I certainly welcomed the CPP when I started collecting it a year ago at 62. It was enough to replace my loss of buying power. Then later the OAS will kick in and I will again recoup my buying power. Then that’s it. Continuous belt tightening from then on. Retire government workers don’t have to worry about inflation. It is due to take off like in the 80’s and then non government retirees will really feel the pain but not the happy receiptants of indexed pensions

  8. Canuckguy,

    Pa’s calculation included inflation from 78 to the present. So yes inflation may affect short term cash on hand within the pension plan, however investments within the pension plan go up too. So long term, indexing is reasonable.

  9. @Money Matters
    The bottom line is that the taxpayer money has to prop up the civil servants gold plated pensions. Not right and not affordable

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