In the wake of the pandemic-related market volatility that battered already challenged public sector defined benefit plans in the U.S., a recent paper by New York University’s Stern School of Business is arguing that Canadian-style reforms could help secure these plans for the long term.
“The COVID-19 pandemic introduced new fissures in state and local government finances, heightening the need to bolster long-term public pension fund robustness,” wrote the co-authors, Clive Lipshitz, managing partner at Tradewind Interstate Advisors, and Ingo Walter, a professor of finance, corporate governance and ethics at Stern. “Long-term pension sustainability, once politically prioritized, must be built on equity and discipline in plan design, funding and amortization of existing deficits.”
The Canadian pension model offers several lessons for the U.S., wrote the authors, noting that Canada’s success traces back to concentrated efforts on reform in the 1980s and 1990s.
Before the enhancements, rising debt levels at both federal and provincial levels began to highlight design flaws in Canada’s public pension funds. These had several commonalities: benefit enhancements were untethered from contribution rates; contributions were co-mingled with general government funds instead of segregated in separate accounts; portfolio management was lacking; and plans were encapsulated in statute, with contribution rates determined by political processes that required legislative changes.
The paper traces the efforts made in Alberta, Ontario and within the Canada Pension Plan to address these issues. “While the particulars differ from province to province and between pension plans, certain common features came to epitomize the so-called Canadian model,” said the paper. “These include joint sponsorship — which gives labour a seat at the table — and independent, well-governed professionally managed investment organizations to invest pension reserves.”
In comparison, it noted, a U.S. commission during President Jimmy Carter’s administration in the 1970s highlighted the need to study potential pension reforms, which ultimately never materialized. “There was resistance to doing that, I think, partly because it would have meant more federal control over this topic,” says Lipshitz. “It’s unfortunate, obviously, because when you’re looking at things now 40 years later, we’re in a situation where we have meaningful underfunding at many of the very large plans.”
The paper also pointed to Canada’s joint-sponsorship model, noting it could greatly benefit U.S. plans by giving members the opportunity to provide input on plan design and making them partially responsible for the plan’s solvency.
It also highlighted the need to determine benefits and contributions holistically, rather than independently of each other, as it currently stands. In Canada, contributions cover about 80 per cent of pension benefits, whereas it’s roughly around 50 per cent in the U.S. The result is that U.S. public pensions are faced with underfunding and must take much more investment risk than Canadian plans.
U.S. plans could also benefit from insourcing their investment management like Canadian public plans have done, particularly in the area of private market investing, noted the paper. “This is predicated on strong governance and a willingness to establish investment teams of sufficient size compensated with market-rate remuneration.”
The consortium model, such as the Alberta Investment Management Corp., the British Columbia Investment Management Corp. and the Investment Management Corp. of Ontario could also be useful for smaller U.S. pension plans that don’t have the ability or scale to do that work in-house.
The report also suggested lowering the discount rate used by U.S. plans to evaluate their liabilities, which are quite high compared to the rates used by Canadian plans. “It lets people think the plans are better funded than they are. . . ,” says Lipshitz. “If you were to apply more realistic discount rates using the numbers Canadian plans use, the funded statuses would be very serious in the U.S.”
While the impact of the coronavirus on state and local government finances could present the opportunity for forward-thinking elected officials to use more realistic discount rates, he adds, the implications would be quite complicated.
On the legislative side, the report said governments should strongly consider implementing solvency funding that requires plan sponsors to fund the full amount of their actuarially determined contributions.
Beyond that, says Lipshitz, there’s much to learn from the Canadian decision-makers who implemented reforms. “They took political risk by forcing through changes but they were forward-thinking. What was also important was the fact that they were supported by a very strong cohort of civil servants in the various provinces who were able to do the math and figure out solutions.”