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.