Revisiting the DB Pension Plan Model Failure

Last week, I critically reviewed an op-ed in the Globe and Mail written by Brent Simmons, Senior Managing Director & Head, Defined Benefit Solutions at Sun Life on why the DB pension plan business model has failed.

Following that comment, I received some feedback from senior pension fund managers and Malcolm Hamilton, a retired actuary and one of the best actuaries in the country.

Before I get to this, I was also contacted by Arif Sayeed who was told by Colin Carlton to reach out to me. Colin is a senior consultant at CPPIB and one of the smartest people I've met in the investment industry (a real thinker which is refreshing and unfortunately, very rare).

Anyway, Arif shared this comment on why the corporate DB plan has failed:

The defined benefit (DB) pension model was created more than a century ago. During much of its early years the management and administration of these plans was in the hands of the insurance industry. Pension contributions by a company and its employees were used to purchase insurance policies – essentially deferred group annuity contracts. When an employee retired the insurance company would pay their pension out of the general assets of the company.

It was not until the mid-1960s that trust companies together with the money management industry came up with the idea of a pension plan sponsor establishing a trust, i.e. a “pension fund”, separate from the assets of the company. Pension contributions would go into the trust and be invested substantially in equities, as well as in bonds. Investment managers argued that by investing in equities, the pension fund would be able to earn a higher rate of return, which would then result in lower contributions and lead to increased earnings for the corporation. The idea caught on like wildfire. Today the assets of almost every DB plan – other than those which have been closed to new entrants – are invested substantially in equities.

In the early 1970s, economists took a look at the way pension funds were being invested, and they quickly came to the conclusion that it did not make a lot of sense from an economic or corporate finance perspective. It is reasonable, of course, to expect that equities, being riskier and more volatile than bonds, will on average over the long run provide a higher return than bonds, and that this should result in lower required pension contributions. But in the short to medium term a substantial investment of the pension fund in equities can also lead to substantial fluctuation in the funded status of the pension plan, requiring large, unanticipated increases in contributions and creating significant risk to the corporate cash flow and bottom line. The economists argued that not only would this not enhance shareholder value – because knowledgeable analysts and investors would simply apply a higher discount rate to the expected stream of higher but more volatile future earnings of the company – but rather it would actually decrease shareholder value. Why? Because the company would be taking on all of the risk of pension deficits, and be forced to make additional contributions, most likely in bad economic/market times, yet would enjoy only limited access to the rewards of pension surpluses in good times, by taking contribution holidays to the extent permitted. The company would not be able to withdraw surplus assets out of the fund to use for its own purposes.

What many companies, of course, have chosen to do is to fritter away those temporary “snapshot” picture of surpluses in good times to further enhance the benefits to plan members, leaving a subsequent generation of company management and shareholders to deal with the consequences of a richer and less affordable DB plan.

In other words, even if the strategy is successful – and I cannot stress this strongly enough – even if it results in lower pension contributions and higher corporate earnings in the long run, investing the assets of the pension fund in equities destroys shareholder value. In fact, if the company wanted to take the risk of investing in the equity market, it would be better off doing so by using its own corporate assets – taking out a bank loan or doing a bond issue, and investing the proceeds in equities. And if no company could or would see any justification for doing that, it should not see any justification for investing the assets of the pension fund in equities.

As far as economists are concerned, this is an issue that was settled a long time ago. All economists, across the ideological spectrum from liberal to conservative, agree that the assets of a DB fund should be invested in some combination of nominal and real return bonds in a way that maximizes, as far as possible, the matching of pension assets and liabilities and minimizes any fluctuation in the funded status of the plan.

The DB pension model has failed not because the model itself is inherently defective – in fact, it is a far better and cheaper way of providing employee pensions than the DC model – but because of the way in which the assets funding those DB obligations have been invested. Why is it that earlier in this century, DB pension plans went through two episodes of once-in-a-lifetime “perfect storms” within a decade, in which their funded status declined 30%-40% each time, whereas the insurance industry, with very similar long-term obligations in their annuity business, sailed through unscathed? Surely there is a lesson here for the pension industry.

I thank Arif (and Colin) for sharing this perspective and I agree, insurance companies are much better at matching assets with liabilities but not because they invest largely in nominal and real return bonds, but because they invest across a broad basket of public and private investments, including other alternatives like hedge funds and private debt.

Let's face it, insurance companies are all about matching assets and liabilities, if they can't get it right, their whole existence is jeopardized.

Arif is right to point out many corporations squandered away their pension surpluses in good years (not surprising!) and many of them totally mismanaged their DB pensions much to the detriment of their shareholders.

He's also right to point out that from and economics/ finance perspective, they would have been better off issuing debt and buying back their own shares than investing large sums in equity markets.

But as I pointed out last week in my comment, there are exceptions to the rule -- CN Pension, Air Canada Pension, Kruger's pension were examples I cited -- companies that only maintained their defined benefit (DB) plan, they bolstered them. So what can we learn from their success?

However, I am a realist and realize the economic reality confronting most large corporations simply means they cannot afford a DB plan so they typically opt to shut down old DB plan and replace them with cheaper and much worse defined contribution (DC) plans.

This is why I believe large corporations shouldn't be in the DB plan business (apart from some exceptions I cited previously). They don't get it and are incapable of fulfilling the pension promise. Businesses should focus on their core business and let pensions to the experts.

Moreover, I fundamentally believe we can offer Canada's corporations real, long-term solutions to their workers' pension needs not by de-risking them and doing away with them, but by bolstering them and creating a national plan that covers all workers properly just like CPPIB covers all Canadians properly.

As I stated last week: "If we want to improve corporate DB plans, all we need to do is look at the success of Canada's large public DB plans and model something based on their governance and investment approach."

Now, following last week's comment on the failure of the DB pension plan business model, Wayne Kozun, a former SVP at OTPP who is now CIO of Forthlane Partners, shared this with me:

Sun Life also has a bias to push companies to DC plans as I am pretty sure that they offer services to DC pensions, including asset management, administration, etc.

The author mentions that $158B in contributions were made. But he doesn't mention the nature of these contributions. They could have been because returns were below expectations but they also likely included contributions required to fund future service earned beyond 1999 and also changes to mortality tables as people are living longer than actuaries assumed 20 years ago. That does not indicate a problem with DB pensions, it just means that this risk was socialized to all members in the plan rather than each member having to bear this risk on her/his own.

Unless we see that $158B broken down then I don't think we can actually say that this proves the failure of DB corporate pensions.

But I do agree with him that the premise of a DB plan is somewhat flawed as you can think of it as a swap where the short leg is pension payments (which is essentially a long bond) and the long leg is the asset portfolio which has primarily been equities plus bonds and the bonds in the asset portfolio defease part of the pension liability. To make a long story short, the company is essentially issuing debt to invest in the stock market. As a shareholder of that company is that something that you should encourage? Probably not, but I think that DB pension are good for society as a whole as we need to make them work.

Then retired actuary Malcolm Hamilton shared this with me:

Here are some points for your consideration.

• The failure of corporate DB plans is best measured by the disappearance of DB plans in the private sector. Why do private sector DB plans disappear? Because, properly priced, employees don't want them and, improperly priced, shareholders don't want them. There is no value proposition for either employees or shareholders with interest rates this low (average 30 year RRB rate during the last 10 years = 0.7%). This isn't a Canadian phenomenon. It's a private sector phenomenon, at least in the developed world.
• I agree with Wayne's observation that traditional DB plans are, from a financial perspective, like employers issuing debt to their employees and investing in the stock market (or, more generally, in risk assets). To understand the consequences you must first specify the interest rate at which the debt is issued.
• In the private sector the debt is issued at AA corporate bond rates - say 3%. The pensions are quite expensive. Shareholders are not unhappy to see the corporation borrowing money from employees at 3%. However employees don't want to see their retirement savings earning a 3% rate of of return. Employees want higher returns at low risk. Shareholders don't want to borrow at above-market interest rates. The obvious compromise - replace the DB plan with a DC plan where employees decide how much risk they are prepared to take in pursuit of higher returns, and live with the consequences. This is as it should be.
• Contrast this with public sector DB plans - your gold standard. In the public sector the debt is issued at a 6% rate, the rate of return that the pension fund expects to earn on a portfolio heavily invested in risk assets. This is a great deal for employees... in a world where safe investments earn a 3% return they are guaranteed a 6% return. It's not such a great deal for taxpayers, who question the wisdom of issuing debt to employees at 6% when the government could just as easily borrow from the public at 3%, or less. Of course, the substance of the transaction is never shared with taxpayers.
• Public Sector DB plans do a great job for members and a poor job for taxpayers whose interests are ignored by those who are supposed to represent them. There is no magic here... just bad accounting and poor governance.

P.S. - I know that the story is a little more complicated for jointly sponsored plans but it comes down to the same thing. The plans succeed because taxpayers involuntarily subsidize members but in JSPPs, the subsidies are smaller.

And Michael Wissell, Senior Vice President, Portfolio Construction and Risk at HOOPP also shared this with me after reading this comment:

This is an important debate. Quantifying risk I think is at the cornerstone of this conversation. The assertion that pension plans are invested in “risk” assets is routed in the concept of the near term and shorter term implications but I would humbly submit that it is the outcome of pooling across time that greatly reduces risk that is so simple and yet so misunderstood. Risk assets over 30 years will pay you a return with near certainty, even in Japan you would have done fine if well managed and risk balanced, I just don’t know which of the thirty years will be good and which will be poor therefore if I retire at the wrong time as an individual I might be in real trouble so why take that very real risk.

Secondly how much I need (how long will I live) is much easier to manage as a group than as an individual. It is the incredible and certain risk reduction (together we have much greater certainty) that pensions offer that underpins their use in our society (you would have to believe that risk assets of all sorts everywhere will no longer over decades pay a return for this not to be true and this has not been the case for all of human history). Putting these concepts together as a pooled saver you will with certainty earn a return over time and you can target your correct risk level as you know how much you actually need. The pension good or bad debate viewed through the lens of the short term is confusing, however viewed through the certainty of returns over the long term and in my view it is only the partisan that would not want to benefit by being a part of a well managed pooled saving strategy.

I thanked them all for sharing their insights but clearly stated that as I explained here, I don't agree with Malcolm Hamilton on the true cost of public DB plans to taxpayers (think he is wrong to discount to federal government bond yields) and I still stick with my proposal to create a well-governed federal public pension fund to properly manage these corporate DB plans.

Malcolm Hamilton came back to me privately after and stated this:

Just between you and I, do you have a reason for believing that pensions guaranteed by the federal government should be valued by discounting at something other than government bond interest rates, or do you just like the answer you get when you use higher rates?

FYI:

• If the federal government promises to pay someone $100 in 30 years and does not fund it, the government values the obligation by discounting at the government bond interest rate.
• If the federal government promises to pay someone $100 in 30 years and funds it with a 30 year zero-coupon bond, the government values the obligation by discounting at the government bond interest rate.
• If the federal government issues a 30 year zero-coupon bond at par, it values the obligation at the par value of the bond plus accrued interest, which equals the present value of the principal and interest payments at the government bond interest rate.
• If an employee leaves the federal government and elects to transfer the lump sum value of their pension to a personal RRSP, the lump sum is calculated by discounting the vested deferred pension at the government bond interest rate (plus about 1% according to the relevant standards/regulations).
• BUT, if the federal government promises to pay a public servant $100 in 30 years and funds it with a portfolio of risky assets that someone believes might earn a 6% return, then the government values the obligation using 6%, thereby cutting the reported value of the obligation in half even though the obligation itself - to pay $100 in 30 years - is unaffected by the government's funding and investment decisions. The obligation is, and remains, the responsibility of the federal government.

It's fine to say that you believe that federal employee pensions should be discounted at rates much higher than government bond rates, but what is the justification? Which, if any, of the five obligations described above should be valued at government bond interest rates? Which should be valued using a different interest rate... and why?

I replied:

This is a big discussion and gets into MMT theory. My thinking is simple, a federal public pension plan isn't a corporation and therefore shouldn't be required to discount at the sovereign risk-free rate or the AA corporate bond rate.

Also, this whole debate that the members get all the rewards and bear none of the risk is misconstrued as society gets rewarded too when more people retire with certainty of income.

But it's a much wider discussion, your points are valid but IMHO, misconstrued.

Malcolm responded:

Basically you are saying that corporations should be required to behave with integrity while governments invent any pension numbers they want. Discount at 3% or 6% or 9% or 12%...just pick the answer you want and let that dictate your discount rate!

It is true that society benefits when retired people have certainty of income but certainty of income is expensive. Why should society pay for the certainty of income enjoyed by federal public servants if the benefits flow primarily to federal public servants with only some small residual trickling down to the general population?

The government could guarantee all Canadians a 6% return on their retirement savings by offering to sell special non transferable bonds yielding 6% to those who wish to buy them with their RRSPs. The proceeds could then be turned over to the PSPIB, or some similar government agency, to work its magic. Then all Canadians, not just public servants, could have a risk free 6% return on their retirement savings. Why doesn't this happen? First, because it is ridiculous, but no more ridiculous than the federal government's employee pensions. Second, because the public service is quite prepared to have the public guarantee public service pensions, heroically volunteering to accept guaranteed incomes for the good of the Canadian economy. However the public service has no interest in picking up the public's investment risk or guaranteeing the public's pensions. If you don't believe me, look at the CPP. The federal government provides no guarantee and takes no risk. All the money comes from contributors and all the risk is borne by contributors or beneficiaries. That's not how pension plans covering government employees work.

I replied:

I’m saying corporations are not governments, they’re private entities that cannot emit their currency to cover expenses so it’s ridiculous to treat governments like corporations or households. It has nothing to do with integrity!

You write: “The government could guarantee all Canadians a 6% return on their retirement savings by offering to sell special non transferrable bonds yielding 6% to those who wish to buy them with their RRSPs. The proceeds could then be turned over to the PSPIB, or some similar government agency, to work its magic.”

This argues in favour of my proposal to create a federally backed pension to properly manage corporate DB pensions using the governance model and investment strategy that Canada’s large public DB plans have adopted (as well as their shared risk model).

To my knowledge, CPP isn’t contingent on investment returns of CPPIB. I’m all for enhancing the CPP even if it’s not the best idea for the poorest Canadians.

I’d like to revisit this debate next week and take it public.

I shared Malcolm's initial feedback with some pension experts I know as I don't pretend to have a monopoly of wisdom on these issues.

Bernard Dussault, Canada's former Chief Actuary, shared this with me:

I fully agree with you and Wayne Kozun. Large DB pension plan funds invested on a long term basis in a properly diversified portfolio should not hesitate using 6% as the assumed average long term yield. Low interest rates normally play a very small role in such diversified funds.

Jim Keohane, the President and CEO of the Healthcare of Ontario Pension Plan, shred this with me:

This is a very academic argument and is a bit like comparing apples and oranges.

The first three examples are unfunded future liabilities of the federal government, so discounting them at the government borrowing rate is appropriate.

The third point about how lump sum transfers are calculated it another whole debate because the methodology creates a windfall for people leaving the plan. The logic behind this which was developed by the Canadian Institute of Actuaries (of which Malcolm was a senior member at the time) is that the amount calculated is based on what it would cost that person leaving to buy an annuity which would replicate their pension payment. This is ridiculous methodology because people pay into the plan based on the going concern discount rate and then when they leave the plan the money gets withdrawn at a much lower rate which results in them taking out much more money than they put in. And the money doesn’t come out of thin air, it comes from other plan members. If all members did this virtually every plan would run out of money. The point is, this is not a comparable situation at all.

It would only be appropriate to discount the future pension obligation if it were an unfunded liability of the federal government.

The difference with a pension plan is that the future obligation is funded through regular contributions from the employees and the employer. The question you are trying to answer is “how much money do we need to set aside to meet the obligation given a reasonable set of assumptions?” If you use any discount rate other than the best estimate of future returns on the portfolio you are going to overfund or underfund the obligation which brings up a whole series of intergenerational fairness issues.

Also, when we do valuations of companies we invest in, we don’t discount future cash flows using government bond yields, we us an estimate of the entire cost of capital. This is a standard market convention. If you applied a risk free rate – the government bond yield, you would massively overvalue the company. In the same way, if you used the risk free rate to discount the liabilities you massively overstate their value.

I would also say that this whole argument misses the point which is “what is the most efficient way to accumulate savings to fund retirements?” The answer is clearly DB plans. Pooling creates significant synergies that allow well run pension plans to produce a better outcome for the same cost or the same outcome at a lower cost.

I completely agree with Jim's points, he nails it here and it's important you all read more from HOOPP on the value of a good pension.

In my opinion, we should treat pensions the exact same way we treat healthcare and education, making sure every citizen retires in dignity and security and finding the best possible structure to pool resources and minimize the cost.

Wayne Kozun also came back to me, sharing this:

For some reason Malcolm has had a "hate" on for DB pensions for a long time, which is strange since they fed him for many years.

I don't necessarily disagree with him about using government bond rates to discount pensions. It does seem silly that you can increase the discount rate used, and thereby decrease the pension liability, by changing your asset mix to a more aggressive mix.

But I don't think this is a huge issue in Canada as the pension plans tend to be rather conservative in their discount rates. This data is a couple of years old but I collected data on plans and here is what they were using for discount rates - OTPP 4.8%, HOOPP 5.5%, OMERS 6%, OP Trust 5.6%, CAAT 5.6%, OPB 5.95%, U of T 5.75%

The real issue is in the US. Remember how in Dec 2016 CalPERS voted to lower their discount rate from 7.5% to 7% over three years. 7% is still WAY too high, but this caused a huge outcry from California city governments, etc, as it increased their pension contributions. Using this discount rate CalPERS is about 70% funded - which is a very deep hole. Change their discount rate to something more realistic, say 5%, and the funded status would likely be 50%. (If you assume that assets are 70 and liabilities are 100 and if the discount rate drops by 2% with a liability duration of 20 then liabilities go up to 140 - hence 50% funded.) There is no way that you get from 50% funded to fully funded unless you have 10%+ returns for a decade or more, lots of inflation (and no indexing on liabilities) or you break the pension promise.

I replied:

Thanks Wayne, I agree, the real issue is the US where chronically underfunded plans are one crisis away from insolvency. I do take issue with Malcolm’s insistence on using the government bond yield to discount liabilities, I think it’s silly to treat federally or provincially backed pensions and treat them like private corporations. Anyway, as you state, Canadian plans use very conservative discount rates.

Wayne's responded:

But then how do you come up with a discount rate? Even for a provincial government plan? Should you use the Ontario Provincial bond rate as your discount rate for OTPP, HOOPP, OMERS, OPB, etc? If so then maybe the province should try to sewer its credit rating as increasing the spread over Canadas would really help the funded status of provincial plans. Leo de Bever and I used to joke that we should move OTPP to Newfoundland and we would move the plan to a huge surplus as the discount rate would increase!

Speaking of Leo de Bever, he also chimed in this debate, sharing this:

If the shortfall risk is shared I would agree. The other practical issue is how long one has from a regulation respective to accumulate surpluses and and work out deficiencies.

Having flexibility to suspend indexation helps to smooth out the bumps. Given all of that, I would think that something like 4% makes more sense.

In discussing these things we make the assumption that the investment and economic environment and their associated risks will stay the same.

I am concerned that a more oligopolistic economic environment and the resulting concentration of profit and wealth will eventually result in a backlash that goes beyond fixing the real issues, which could reduce return on listed equity for a while, never mind a cyclical reset.

I would agree with Leo, conditional inflation protection is a must and 4% makes more sense given the economic environment. I also agree with his observation on a more oligopolistic economic environment will result in a serious backlash which we are not prepared for.

You all need to read Jonathan Tepper's book (written with Denise Hearn), The Myth of Capitalism: Monopolies and the Death of Competition, to gain a full appreciation of how oligopolies are destroying competition and exacerbating income inequality (of course, my friends on the Left are less enamored by this book but I still implore you to read it).

By the way, for those of you wondering, Leo de Bever is doing well and shared this with me:

Have been busier than in any of my 8 formal job incarnations. In my 9th incarnation I am working to help along (as an advisor/investor/ board member) a number of innovative ideas that I see as desirable and profitable:

1. Nauticol, a methanol/fertilizer company with low emissions, water use and capital intensity.
2. Sulvaris, which makes slow-release fertilizer, and could lead the way to much more efficient sewage treatment.
3. Northern Nations, a first Nation co-operative in BC that is trying to forge JVs with non-indigenous nations to create employment and make life in the North more economically viable
4. Sustainable Development Technology Corporation, a Federal program to fund innovation
5. Vertical farming, and greenhouse agriculture production using waste heat through various channels.

Canada has a lot of people with great ideas. We have trouble quickly turning the viable ideas into products. There are lots of reasons for that, including lack of funding and resistance from the status quo.

So, life is good. I describe what I am doing as 'working with 70-year-olds to convince 30-year-olds not to behave like the typical 70-year-old.'

Canada needs to change fast, to stay internationally competitive. We are reasonably comfortable, but we cannot take that as a given. It does not help that polarized policy by soundbite is too simplistic to address real issues.

I have found 'kindred spirits', whom I have come to respect, because they believe that doing well and doing good can be profitable.

Must say that I am concerned that the Canadian pension funds are not as active in pursuing truly long-term innovative strategies as I wished they were. Lots of reasons for that too, not the least of which that benchmarks that judge long-term strategies by short-term outcomes can be dangerous to your career. Fear of failure is understandable, but as Gretsky said: I missed 100% of shots I never took. If you never failed at anything, you probably did not try much that was meaningful.

Leo de Bever is another great thinker who has a lot to say on pensions and the economy. He should really sit down and write a great book sharing all his knowledge, it would serve society well.

That reminds me, I have to get back to him on greenhouse agriculture production and put him in touch with my cousins in Crete who are running Plastika Kritis, one of the most successful private plastics company in Europe specializing in agricultural film.

Lastly, Samantha Gould of NOW:Pensions wrote a great comment on LinkedIn on what pension awareness week means for her. I left her my thoughts:

I’m glad to see young people in the UK jumping on the pension bandwagon. I’ve been harping on pension poverty for over a decade. Importantly, and the author nails it here, pension poverty disproportionately and ruthlessly strikes more women than men, so it does discriminate based on gender: “It is astounding that a woman that retires today will have a pension pot that is 1/3 the size of a man. This is mostly due to the numerous breaks in employment that a woman might ‘enjoy’ through child-rearing and caring for elderly relatives, typically later in their career. This is exacerbated by the gender pay gap which still exists across a lot of sectors.”

I'm happy to hear there are self-proclaimed pension geeks all over the world who are raising awareness on the importance of pensions. As I stated above, we need to treat pensions the same way we treat other important policy issues around healthcare, education, and even climate change.

In a well functioning democracy, we need to treat all these issues with the utmost importance.

Below, Michael Sabia, President and CEO of CDPQ, appeared on CNBC stating monetary policy will not get the world where it needs to be. Instead, investment is needed to expand the growth potential of economies, he says.

Sabia has been calling for a new paradigm on growth, one based on governments investing alongsdie large institutional investors to get infrastructure projects and other investments up and running.

And he's not the only one who thinks we are overly reliant on monetary policy. Pimco's John Studzinski also says economies need to rely on other vehicles such as capital investment and job creation as there's been too much reliance on monetary policy.

Studzinski, who is vice chairman at Pimco, also discussed Fed policy, the effectiveness of monetary policy, future rate cuts, negative yielding bonds, where he’s finding opportunity and the slowdown in China on “Bloomberg Markets: Asia” from the sidelines of the Milken Institute Asia Summit in Singapore.

In all honesty, even though I agree we need a new paradigm for growth, I'm not sure we have tested the limits of monetary policy and I'm bracing for QE Infinity.

Let me end by recommending another great book written by Binyamin Applebaum, The Economists' Hour: False Prophets, Free Markets, and the Fracture of Society. It provides a great history of the main ideas that economists have grappled with since Keynes and Friedman and he raises many serious policy concerns (see an earlier CNBC interview below).