Published in The Globe and Mail.
On Nov. 25, the federal government announced that the Public Service Pension Plan (PSPP) – the plan for federal public-service employees – has an “excess surplus.” By the government’s accounting, the plan’s assets exceed its liabilities by 26.3 per cent, surpassing the 25-per-cent limit permitted by the Income Tax Act. The government plans to transfer the “excess” of approximately $2-billion into its regular budget. This transfer would reduce the federal deficit for the 2023-24 fiscal year, which is likely to exceed the $40-billion target set by the Minister of Finance in the 2023 federal budget.
However, this “excess surplus” is an illusion. The calculations use an artificially high number to discount the PSPP’s liabilities – shrinking them by about $80-billion. Rather than pretending the plan has an excess surplus – or any surplus at all – the government should reveal that taxpayers are on the hook for billions in underfunded pensions, and set about reforming the plan to prevent the problem getting worse.
Actuaries discount pension liabilities because a dollar today is worth more than a dollar in the future. The choice of the discount rate is crucial. A higher discount rate lowers the present value of the plan’s liabilities and reduces required contributions.
Years ago, failures of single-employer defined-benefit pension plans in Canada and elsewhere highlighted the dangers of allowing plans to choose their own discount rates when assessing their ability to pay future benefits. Plans typically discounted their liabilities at rates they assumed they could earn on investments. The flaw in that approach is that it encouraged backing certain obligations with risky assets. More speculative investments justified higher discount rates, making the plan’s financial position appear better and avoiding necessary higher contributions to secure pension promises – hence the painful failures.
The private sector no longer assumes that the cost of pensions with guarantees like those of the PSPP depends on expected returns from risky investments. Instead, companies treat pension promises as debt guaranteed by them, valuing obligations using the yields on long-term corporate bonds.
Promising to pay a pension is like promising to repay a loan: the obligation is fixed. It does not change based on investment performance or whether investments exist. Federal pensions are particularly valuable because they are fully guaranteed by taxpayers, no matter how investments perform. So their future pension payments should be valued like long-term debt, at fair-market bond yields.
International public-sector accounting standards align with this approach, stating that the discount rate should reflect “market yields on government bonds, high-quality corporate bonds, or another financial instrument.” Although Canadian Public Sector Accounting Standards align with international standards in most respects, Canada’s Public Sector Accounting Board has rejected this approach as inappropriate based on the “Canadian public interest.” The Chief Actuary’s report on the PSPP that prompted the government’s announcement uses a discount rate for benefits earned after the PSPP became partially funded in April, 2000, based on expected future returns from investments managed by the Public Sector Pension Investment Board.
A fair-market valuation for the PSPP, and all federal employee pensions, would use the interest rate the government pays on its real-return bonds as the discount rate. Those bonds resemble the pension promises: they are unconditional and indexed to inflation. As of March 31, 2024, RRBs yielded 1.5 per cent – 2.5 percentage points lower than the assumption used in the PSPP Actuarial Report. This fair-value discount rate would make the liabilities about $80-billion higher.
The government also reports an artificially smoothed value for its assets, creating a small offset, since the fair-market value for the plan’s assets would have been $8-billion higher. In total, a fair-market valuation would have turned the reported $39-billion surplus into a $33-billion deficit. A fair-value calculation reveals that the PSPP is not 26.3 per cent overfunded – it is 14.5 per cent underfunded.
Not surprisingly, the government’s proposed removal of the “excess surplus” in the PSPP is controversial. PSPP members would prefer lower employee contributions, richer benefits, or a pay increase. The Auditor-General may object to the timing, if not the substance, of the government’s desired approach. Yet, taxpayers are responsible for the PSPP’s obligations. If a surplus exists, they should benefit.
Sadly, however, no economically meaningful surplus – excess or otherwise – exists. Acting as if one does is misguided. Ottawa should dispel this illusion by aligning its pension reporting practices with international public-sector accounting standards. That would set the stage to transitioning federal employee pensions to a shared-risk, jointly-governed arrangement, like those that have proved so successful elsewhere in Canada’s public sector. This approach would offer a better deal for Canadians than a battle over a non-existent “excess surplus.”
Alex Laurin is vice-president and director of research at the C.D. Howe Institute, where Bill Robson serves as president and chief executive officer.
