Guaranteeing pension plans is a bad idea (Guest commentary)

Legislation, regulation and litigation have brought DB pensions to the edge of a cliff

Pension policy in Canada needs a fresh look. Defined benefit (DB) pensions are in trouble — many are underfunded and exposed to the financial stresses of their sponsors. But some proposed fixes could make matters worse.

NDP leader Jack Layton has talked about pension protection as a condition for working with the Liberals. While we do not know what he has in mind, a federal pension-benefit guarantee agency — a deeper-pocketed version of Ontario’s Pension Benefits Guarantee Fund — is likely.

Such an agency, like counterparts in the United States and the United Kingdom, would backstop pension plans when sponsors go bankrupt. The agency would levy premiums on the plans and pay all or part of their benefits if a sponsor failed.

Especially for current, or soon-to-be beneficiaries of troubled plans, the idea has obvious appeal. But pension policy is a poster-child for the notorious law of unintended consequences. Desire to improve the lot of plan participants has motivated decades of decisions by legislators, regulators and judges. The result? Many DB plans have huge deficits, next to none are starting, and the number of workers they cover is in decline. A federal pension guarantee would either expose taxpayers to ill-defined and possibly huge liabilities or push DB pensions one step closer to extinction.

DB pensions are strong recruitment tools, especially at a time when firms want to keep older, scarcer staff. So why is policy undermining them? A central problem arises from one of their core features: because their managers do not have the same risk and liquidity concerns that individuals saving for retirement do, they can invest in assets whose value does not move identically with their liabilities. This mismatch means that their net worth fluctuates. Sometimes, combinations of poor returns on assets and low interest rates, used in discounting future payments, mean they have deficits. At other times, good returns on assets and high discount rates for future payments mean they have surpluses.

Since sponsors must cover deficits, logic suggests they should have access to surpluses. But policy makers and the courts have eroded that access. Consequently, sponsors shrink from funding plans as well as they should. Moreover, the Income Tax Act forbids contributions to most DB plans if their surpluses are larger than 10 per cent of liabilities, but provides no offsetting subsidy when plans have large deficits. Since normal fluctuations can create either surpluses or deficits larger than 10 per cent, this asymmetry promotes underfunding.

When, as now, plans have deficits, and regulators impose penalties and mandate larger contributions, a vicious circle arises. Current practice lets managers who invest in riskier assets that generated higher returns in the past project those returns into the future. Those projections improve the look of plan balance sheets. Pressure from regulators, therefore, can encourage riskier bets. Spectacular smashes in the car, airline and steel industries show how bad pension plan bets damage a company with healthy operations, and finish a sick firm off.

Hence the attraction of a federal backstop for underfunded pensions — and the danger. The moral hazards government guarantees create are on lurid display south of the border, where the unfunded liability of the U.S. Pension Benefit Guaranty Corporation is $26 billion US and mounting. As the U.S. Comptroller General testified to Congress, this backstop encourages managers who cannot afford higher compensation to offer higher pensions instead of wages, and encourages firms to shirk funding pensions the government will have to pick up.

If he had been rude enough to cite examples, the Comptroller General might have pointed to United Airlines, which hiked the promises of a badly underfunded pension plan in 2002, and dropped a US$6.6 billion obligation on the Guaranty Corporation when it declared bankruptcy nine months later. A government backstop allows firms that slough their pension obligations to get a leg up on competitors that honour theirs.

In principle, a pension guarantee agency could address moral hazard by gearing premiums to sponsors’ risk. Three difficulties make it unlikely in practice. First, politics. The federal EI program should penalize industries that lay more workers off. It doesn’t — in fact, it subsidizes them at the expense of those that lay off fewer. Second, assessments of risk tend to be backward-looking. Risk-adjusted premiums therefore fall more heavily on plans already in trouble. Third, the risk-based premiums currently charged by pension-insurance agencies ignore mismatches between plan assets and liabilities, and encourage riskier investments, amplifying swings in plan fortunes and the damage when those bets do not pay off.

The moral hazard of guarantees, moreover, can sweep away pre-set limits. The Pension Benefits Guarantee Fund in Ontario, the only province to travel this dangerous road, covers pensions only up to $1,000 per month, and has used partially risk-based premiums for years. Yet depletion of the fund by the Algoma Steel bailout necessitated an interest-free loan from the province last year.

Now, fears that the $1.3-billion deficit in Stelco’s pension plan might swell the fund’s $100-million-plus deficit have inspired Ontario’s offer to extend Stelco a $100-million loan. The terms could make the province a shareholder in the bankrupt company. So a pension backstop can be a backdoor to nationalization of declining industries.

Many avenues toward healthier DB pensions exist, such as balancing sponsors’ risks with regard to surpluses and deficits, ending penalties for “over contributions,” and closer attention to asset-liability mismatches. A federal pension guarantee, however, illustrates the truth of the adage that when a deal looks too good to be true, it almost certainly is. Legislation, regulation and litigation have brought DB pensions to the edge of a cliff. Reacting with a pension guarantee could help push them over.

William Robson is senior VP and director of research at the C.D. Howe Institute. For more information contact (416) 865-1904, [email protected] or

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