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The guarantees in federal public service defined-benefit pension plans are mis-priced—causing Ottawa to seriously underestimate their costs, says the C.D. Howe Institute.

This advantageous situation for members of the main Public Service Pension Plan exacerbates the growing compensation gap between federal public-sector employees and their private-sector counterparts, says pensions expert Malcolm Hamilton.

“Back in 2006, a government report acknowledged that federal public-sector salaries generally out-stripped those for comparable jobs in the private sector,” notes Hamilton. “Steady pay increases since then and rising pension costs mean that federal employees are probably significantly overpaid by now. And while salaries for senior-level mandarins may still lag those in the private sector, they have some extraordinary pension benefits.”

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The federal government appears to believe that pay in the federal public sector should be comparable to pay in the private sector on a total compensation basis, he says, noting that recent government reports are generally consistent with this view. However, to implement this principle pensions must be valued appropriately.

“Fair values are the best measure of a pension plan’s worth in a transaction where employees provide their labour in exchange for compensation that includes a valuable pension,” says Hamilton. However, the government appears not to apply fair value principles, preferring instead to use funding estimates developed in accordance with public-sector accounting standards.

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“It is undeniably more convenient for the federal government to continue to use the numbers it has been using. But it is also wrong,” says Hamilton. To do so is to collectively guarantee federal employees a 4.1% real rate of return on their retirement savings at a time when other Canadians must accept a 1% guarantee or they must bear significant investment risks in pursuit of a 4.1% real rate of return, he explains. “These guarantees are very advantageous yet public-sector accounting standards attach no value to them and the federal government appears to ignore them when assessing the reasonableness of employee compensation,” he adds.

The payroll for members of the federal Public Service Pension Plan was about $20 billion in 2012, with pension contributions totaling about $4 billion, says Hamilton. The fair value of these pensions was about $8 billion. As a consequence, the federal government underestimated the 2012 compensation of these members by $4 billion and reached a long list of erroneous conclusions about the cost of its pension plans and the compensation of its employees.

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How can this be? The culprits appear to be actuarial and accounting standards that are incompatible with market prices and designed for purposes other than compensation management. “In this sense, actuarial and accounting standards have become the enablers of bad financial practice even though the standard-setting bodies do not advocate or condone bad practice,” he says.

Hamilton does not advocate slashing salaries, setting absurdly high employee contribution rates or converting to defined-contribution pension plans. “The easiest fix is to eliminate the guarantee, transfering the investment risk to employees, as has become common in provincial public-sector plans and in Europe,” he says. “If Ottawa is to meet the goal of general parity with the private sector, it needs to stop tinkering with its pension plans and to start making some meaningful changes,” concludes Hamilton.

Originally published on Advisor.ca

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