There was a time when job security and good benefits were the hallmarks of public sector employment. Employees reasoned that while they may be able to make more money in the private sector, a lower-paying job in the public sector meant a job for life and a good pension at retirement. While the job security aspect of public sector employment has fallen to the wayside, the desirable pension benefits are still very much part of the picture.

Defined benefit(DB)plans dominate the public sector while the private sector is increasingly moving towards defined contribution(DC)plans. In the not-too-distant future, Canada will have a two-tiered pension system whereby the private sector is dominated by DC plans and the public sector is dominated by DB plans.

It’s possible that the public sector will turn out retirees who can afford to retire early with comfortable pensions while private sector employees with DC plans will be forced to work as long as they’re able. “We definitely have a two-tier pension system in Canada,” says Bill Solomon, a consulting actuary in Richmond Hill, Ont.

A recent survey by SEI Investments of 302 North American public and private executives responsible for managing DB plans found that decisions being made by parent companies are impacting Canadian plan sponsors. Almost one-fifth (18%)of Canadian respondents to the survey said decisions by parent companies is a reason their organization is considering or did make a change to its DB plan.

“Because we have a lot of companies in Canada that are subsidiaries of U.S. companies, the Canadian companies are feeling the same kinds of pressures as the U.S. parent companies,” says Mazen Shakeel, a principal with Hewitt Associates in Toronto.

The SEI survey also found that the trend towards closing and freezing pension plans appears more prevalent in the U.S., with 40% of those executives polled having plans that are either closed, frozen, or terminated. Only 30% of Canadian executives polled, meanwhile, have plans that are either closed, frozen, or terminated.

The wave of DB plan conversions seems an unstoppable force in countries such as the U.K. and the U.S. and it’s likely that private plan sponsors in Canada will follow suit. But there are very few, if any, public sector employers considering a move to DC plans.

There is also a growing disparity between private sector DB coverage and public sector DB coverage in Canada. “The growing disparity is pretty alarming,” says Scott Perkin, president of the Association of Canadian Pension Management in Toronto.

In a report released last year called Back from the Brink: Securing the Future of Defined Benefit Pension Plans, the ACPM says that between 1992 and 2003, DB coverage in Canada declined from 44% to 34% of the workforce. In the public sector, coverage dropped from 91% to 79%. In the private sector, DB coverage dropped from 28% to 20%. “The decline is getting worse in the private sector,” notes Perkin.

About 10 years ago, the drive towards DC was largely employee-driven. Technology markets were booming and employees saw great opportunities to earn high investment returns.

“From the employer’s perspective at that time, the balance sheets for these pension plans were very healthy so they could actually recognize positive accounting implications by making the switch to DC,” says Shakeel.

Today, however, it’s mostly financial and administrative pressures that are driving plan sponsors to switch from DB to DC. And the way plan sponsors are approaching conversions has changed too. “In the past, companies would often give employees the option to convert their pension into an account balance in a defined contribution plan,” says Shakeel. “Now if they do that, there will likely be significant negative accounting implications so more often than not, companies aren’t giving employees that option.”

As well, he says, plan sponsors are moving away from giving existing plan members the choice of moving to the new DC plan or staying in the DB plan almost indefinitely. “Nowadays, companies want a more definite timeline for wrapping up their defined benefit plan.”

New international accounting rules, coupled with funding and solvency rules, have increased the pressure on private sector DB plans in recent years.

While new accounting standards have not yet come into effect in Canada, it’s expected that they will in the next year or two. The changes mean that if a DB plan has a deficit, that deficit must be recognized on the balance sheet, as opposed to spreading that deficit over a number of years into the future. “It’s potentially a large, one-time hit to their balance sheet,” says Shakeel.

And even though public sector plans have their own accounting rules designed to mimic those in the private sector, they are not widely applied, says Serge Charbonneau, partner with Morneau Sobeco in Montreal. “With accounting rules gradually moving to a mark-to-market approach, it’s really going to hurt the bottom line,” he says. “And even though there are accounting rules that apply to the public sector and they’re intended to be similar to those in the private sector, they are not widely applied.”

Solvency rules also appear to favour large public sector DB plans.

“You’ll find that, within the provincial pension legislation, public plans are often able to get exemptions from the solvency funding rules or extensions on the amortization periods,” says Rosalind Gilbert, senior consultant with Aon Consulting in Vancouver.

Economies of scale also help DB plans. “The most visible public sector plans, like the Ontario Teachers’ Pension Plan, are managed for very large groups and so, typically, the assets under management are very significant,” says Bruce MacDonald, partner, Integra Capital in Oakville, Ont. “When you’re managing $50- or $75-billion in assets, you can afford to have a very sophisticated and very significant staff.”

Private sector DB plans seem to be less well-funded than their public sector counterparts. When private sector companies have to report to shareholders, they are obviously sensitive to the amount of money they put into pension plans, however, public sector plans are essentially funded through tax dollars.

“In bad times, private organizations are much less able to find the money. If the pension plan is in a bad situation, they don’t have the ability to raise taxes to generate revenue. That money has to come from somewhere else in the budget,” says Gilbert. “When you combine that with the really big balance sheet liability that came from the accounting rules on the pension side, that has a major impact on a private sector plan sponsor.”

The insecurity of underfunding between the two sectors is like night and day, says Charbonneau.

“In terms of security in the public “In terms of security in the public sector, it doesn’t matter so much if the plan is underfunded because employees know very well the employer is always going to be around to make up the promise.” sector, it doesn’t matter so much if the plan is underfunded because employees know very well the employer is always going to be around to make up the promise,” says Charbonneau. “If you’re in a similarly funded pension plan in the private sector, even though you think your employer is secure today, who knows how secure they’ll be five years from now?”

“Ultimately it’s the corporation that’s the back stop for the pension plan in the private sector,” says David Service, principal with Towers Perrin in Toronto. “In the public sector, it’s the taxpayer who’s the back stop for the pension plan.”

The lack of symmetry between risk and reward in private sector plans is also a contributing factor to the growing gap between private and public pension plans. Large public sector plans are mostly risk-shared, contributory plans whereas the majority of private sector DB plans are non-contributory. In general with risk-shared plans, the member contribution and employer contribution are tied together by a formula. If the employer contribution is increased or decreased, then the employee contribution also increases or decreases. Plans in the private sector, meanwhile, tend not to be jointly trusteed.

As a result, public sector plans tend not to change their contribution levels very much. “Their goal is to keep contributions as stable as possible,” says Service. “When they develop a bit of a surplus, they keep contributing. They don’t want to increase contributions if they can avoid it. So they tend to build more of a buffer.”

In the buoyant markets of the 1990s, public sector plans did not exercise the option of taking contribution holidays to the extent that private sector plans did. That has put the public sector plans in a better financial situation today.

And because of legal decisions in cases such as Monsanto, which awarded plan members the right to share in the surplus in the event of a partial plan wind-up, private sector employers are increasingly reluctant to build up any kind of surplus in their DB plans.

“It has tended to drive plan sponsors to a position of ‘why should I put in anything more than the minimum I’m required to put in? If I put it in and it proves to be too much money, I basically lose control of it,’” says Service. “It’s not that they’re consciously trying to shortchange the pension plan or jeopardize the beneficiaries’ benefits. They’re mindful of that. What they’re trying to do is minimize the possibility of a significant surplus.”

Because there isn’t a lot of risk-sharing in the private sector, plan sponsors are increasingly looking to DC plans as a way to transfer that risk away from themselves and on to plan members.

Gilbert maintains that with retirement income from DC plans being less predictable than income from a DB pension, retirees in DC plans may come to rely more and more on the Canada Pension Plan(CPP)and Old Age Security.

With the general decline in private sector DB plans, there may be a corresponding increase in the appreciation of the CPP, which provides benefits fully indexed to inflation. CPP benefits are financed by a contribution formula that shares risk and returns fairly between current and future generations of contributors.

Federal and provincial politicians recognized in 1997 that the CPP lacked sufficient financial resources to meet its long-term obligations. Thus, the CPP Investment Board was created to invest CPP contributions in capital markets.

Private sector pensions, meanwhile, have languished. DB plans are too expensive and risky for private sector employers to maintain, while there are real concerns about the ability of DC plans to meet the retirement needs of Canadians.

“If a DC plan member thinks that by putting 5% or 6% of pay in their plan over the course of their career, that they’ll have enough at the end of the day, they’re in for a rude awakening,” says Charbonneau. “We’ll end up having generations of public workers who can afford to take early retirement and have pretty secure income for the rest of their lives whereas in the private sector, we’ll have people who hang on as long as their health allows them and, even then, they’ll have an uncertain retirement.”

But he maintains that there are effectively two classes of retirees in Canada already, given that indexing provisions in the public sector are often more attractive than in the private sector.

“I think employees are going to wake up at some point and figure out that government employees are covered quite nicely thank you very much but why aren’t they covered as well in the private sector,” says Perkin. “A lot of it stems from the government’s reluctance or unwillingness to deal with some of these difficult pension issues.”

In the public sector, DB plans are more entrenched as a part of the total compensation package. Unions, in particular, favour DB plans and a greater proportion of the membership in public plans is unionized.

And while it may appear that public sector plan sponsors and employees have it made in the shade with regards to their DB plans, no one is getting a free ride. “Public sector employees very often pay very substantial contributions themselves and if it’s being bargained, in theory, it’s part of their overall compensation,” says Charbonneau. “That protection and security is worth a lot of money.”

Andrea Davis is a freelance writer in Guelph, Ont.

For a PDF version of this article, click here.