The 21st century has been one marked by low interest rates and even lower real interest rates. In response to the dot-com crisis of 2001 Western governments embarked on a policy of low interest rates in order to stimulate the economy. While those on Wall St. praised this move, which allowed them to lever up to new heights at reduced costs, others are suffering greatly from this policy that has now been adopted by central banks and governments worldwide.
Government interventions such as artificially-reduced interest rates upset the natural order of the marketplace. A market is a dynamic and complex system of human interactions that brings forth a structure of production manifested by voluntary interactions and the price discovery mechanism. Interference in this process only directs resources away from their most efficient uses towards politically-expedient ends, often resulting in future turmoil when unsustainable projects must finally be liquidated. There are always winners and losers in any market intervention because no new resources are created, they are only shifted to one party at the expense of another.
Low interest rates may benefit financial institutions such as banks and hedge funds, however insurance and defined-benefit pension funds suffer greatly. Such is the nature of these kinds of organizations, which must anticipate future expenses and set aside enough money in the present to be able to afford them.
How Pensions Work
Pension plans began as an incentive offered by companies looking for the best executives and were initially only granted to the top managers in an organization. This practice continues today under the name of Supplemental Executive Retirement Plans (SERPâ€™s). During the post-war period though, western companies and governments began offering everyone defined benefit (DB) pension plans and many employees happily accepted the promise of a guaranteed retirement income.
In order to provide these benefits, pension plans consult actuaries who calculate the present value of the liabilities these plans are assuming. Such liabilities consist of the obligation to provide future payments of cash, medical and dental services, survivors and death benefits and a host of other features that will all cost the Plan money. These future costs are translated to the present through a process called â€œdiscountingâ€, which relies on a rate of return in order for the calculation to take place. The lower the rate of return, the less of a difference there is between present and future money. Hence, low interest rates increase the present value of the costs these Plans have assumed. When Plan assets no longer outweigh the present value of their liabilities, the Plan is considered underfunded. At the same time, low interest rates reduce the rate of return on Plan assets and thus make it even harder for Plans to balance their assets and liabilities.
The Best Laid Schemes of Mice and Men
The Ontario Teachersâ€™ Pension Plan (OTPP) has its roots back in 1917 and has grown in to the second largest pension fund in Canada (after the CPP).Â It provides a particularly illustrative example of the difficulties faced by DB pension plans worldwide. It has over 180,000 active contributors and provides benefits to over 120,000 pensioners. In 1990, changes to the Plan resulted in significant asset diversification away for Ontario Provincial Bonds in to real estate, stocks and even commodities.Â This strategy appeared to work for a time, with the Plan reaching 100% funding by 1996.Â Since the year 2000 though, the financial health of the OTPP has rapidly deteriorated.
As you can see in the chart above, the OTPP is facing a severe funding problem. It is now over $45 billion behind in its funding requirements. To put the size of this deficit in to perspective, if the OTPP were a Province, it would be the third most indebted Province in the country (after Ontario and Quebec). New Plan members are assuming a $250,000 funding requirement in order to pay for current and soon-to-be pensioners. This is over and above their own personal funding requirements, which are quite significant as the table below indicates.
Such a huge deficit could be indicative of a failure of management to produce adequate investment returns; however this is not the case. The OTPP is actually one of the best performing pension funds in the country, averaging over 10% per year for the last 20 years.
Such nice returns donâ€™t come without a price tag though. Last year Jim Leech, CEO, received compensation totalling over $4.3 million. Neil Petroff, EVP Investments, received $3.5 million. While this is not out of line with compensation received by other fund managers of similar size, one must take note of the fact that the OTPP does not generally outperform the market. Furthermore, as we will soon see, the returns to plan participants are actually far lower. It would seem preferable to simply invest in a market index ETF due to their lower costs as well as the fact that you would enjoy the full benefit of all the funds you invested rather than receiving an annuity that may be worth far less than what you put in. Unfortunately for teachers, enrollment in the OTPP is mandatory.
Shifting demographics are also playing a large part in increasing Plan liabilities, as the image below indicates.
Increasingly, the burden to support pensioners is falling on the shoulders of a smaller and smaller group of working teachers. Current expectations are that this ratio will continue to decline from the present 1.5:1 to 1.3:1 by the year 2020. As class sizes have not grown significantly it cannot be argued that teachers are becoming more productive and thus able to support these more narrow ratios. The growth in the amount of pensioners has simply been outpacing the growth in the number of active teachers for some time. That may be due to the following factors.
As a result, benefits being paid out of the fund now greatly outpace contributions going in.
All of this indicates that the Plan is suffering from unrealistic assumptions about the amount of retirement benefits that can be sustained by the Plan. Furthermore, the assumptions used in calculating the actuarial liability may be too optimistic. For instance, it is assumed that the inflation rate will remain at 2.15% even though in the past a much higher 4% assumption was used. A higher rate of inflation further reduces the discount rate thus growing the liability all that much faster. In fact, in a sensitivity analysis, the OTPP calculates that a decrease in the discount rate of only 1% would add another $25 billion to their liabilities.
The OTPP is suffering from the same error many DB pension plans have made; promise more than they are able to deliver. As a result, too many teachers are now retiring too early and collecting benefits for much longer than initially anticipated. Without significant changes to when teachers can collect benefits and how much they will ultimately receive, the financial position of the OTPP will continue to deteriorate until it wonâ€™t be able to fund anyoneâ€™s retirement.
When making decisions between two or more alternatives itâ€™s instructive to perform a cost-benefit analysis to determine the best course of action. Fortunately when it comes to pensions itâ€™s rather easy to perform the necessary calculations. What we are comparing is the value of the Plan contributions vs. the value of benefits received. To do this we compare the future value of a teaching careerâ€™s worth of contributions, to the lump-sum value of that teacherâ€™s pension benefits as of the same date. What we find is rather alarming.
Teachers enrolling in the OTPP in the year 2011 will be trading in a retirement account potentially worth over $1.3 million for benefits worth about $425,000. Such is the cost of the illusion of safety in todayâ€™s precarious world of finance.
In ten years, the OTPP has gone from being a fully funded pension to over $45 billion in debt due to deteriorating market conditions, demographics, and a benefit plan that simply cannot be sustained. Teachers just beginning their careers are now being burdened with not only supporting their own retirements, but also filling in for the inadequate contributions of their predecessors. It is a great example of why many employers are now switching to defined contribution plans, which donâ€™t suffer from the same actuarial funding requirements. Unfortunately, these changes are being fought tooth and nail by unions who either donâ€™t understand the implications of these financial problems, or are simply too short-sighted to care about the financial welfare of their youngest members.