The US should look to Canada to reform its public pension system

The US should look to Canada to reform its public pension system
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Observers of the diverse and often challenged American public pension system look north to Canada with a certain degree of admiration. Canadian public pension plans tend to be fully funded — some even have healthy surpluses. Most U.S. plans are in deficit, and several are unlikely to be sustainable. So what makes the Canadian system better? The inevitable response has to do with better governance. But it goes a lot deeper. It is the legal structure of Canadian public pension plans that enables strong governance.

Based on a new, comprehensive study of the largest Canadian and U.S. public pension systems – their design and performance – we found one feature of the Canadian model to be fundamental. If adopted in the U.S., it could reorient the relationship between employers and pension beneficiaries in the public sector, and even renew interest in defined benefit pensions for a significant group of private-sector employees. 

Canadian public pension plans underwent a series of reforms starting in the late 1980s. Until then, many of them were not in good shape. In some cases, there was an unhealthy relationship between government pension sponsors and plan members. Sponsors were willing to grant benefit enhancements but did not match them with increases in pension contributions. So, both employers and employees became concerned about system solvency. Employers worried that they had made promises that would be difficult to honor. Employees worried that what seemed to be too good to be true actually was. Unions fretted that pension promises might be reneged when future governments realized they were simply not affordable.

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Federal and provincial political leaders, for whom pension reform might have been fairly low on the priority list, were forced to reckon with design flaws in the pension system. Kicking the can down the road increasingly looked like a mug’s game.

First in Ontario and then in other provinces, negotiations between government and unions reached a compromise, whereby public pension plans would be restructured under so-called “joint sponsorship.” Rather than being unilateral promises from government employers to their employees, pensions would instead come under the joint control of both governments and unions.

Fundamentally, this was a shift from a paternalistic model to one in which employee representatives got a seat at the table alongside employers. Benefit and contribution levels would no longer be determined in a separate and distinct way. Unions cut back on unreasonable demands knowing they would be jointly on the hook for ensuring plan solvency if benefits were not matched by corresponding future increases in contributions. 

In Canada, the joint sponsorship model was key to ensuring greater public pension sustainability. How is it relevant to the U.S.? 

In both countries, there are few legal precedents for what happens when a public pension plan is unable to pay contractual pension benefits. By establishing a pension trust under joint sponsorship – independent of government – the responsibility for future funding is insulated from public finance. Market forces in public employment will help ensure that governments do not promise benefits they will be unable to pay, and that unions do not demand benefits future workers will be unlikely to receive. 

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There are many other features of the Canadian model of sustainable public pensions that bear consideration, but joint sponsorship is at the heart of the model. The governance advantage that pervades the Canadian system emanates from this feature, as each pension constituency selects trustees to represent its interests.

Potentially, the basic features of joint sponsorship could also be used to benefit certain private sector pensions. In the United States, ERISA was enacted in 1974 primarily to protect private sector workers from egregious corporate activities such as raiding of pension funds. But it had the unintended consequence of encouraging companies to discontinue defined-benefit pension plans because the obligation to cover pension liability gaps became extremely costly. If pensions were established as trusts – independent of the sponsor – benefit and contribution levels may well move in tandem, with employee unions assuming joint responsibility for adequate pension funding. 

Retirement planning is complex for everyone. Defined-benefit plans have received bad press for decades, but if structured carefully they provide numerous benefits relative to self-directed savings. These include risk pooling, professional investment management, lower expenses and a more sensible approach to withdrawing pension assets during retirement (decumulation). The joint sponsorship model is worth considering in the public sector and perhaps even in the private sector as well.

Ingo Walter is a professor emeritus of finance at NYU Stern School of Business. Clive Lipshitz is managing partner of Tradewind Interstate Advisors. They are the authors most recently of “Public Pension Reform and the 49th Parallel: Lessons from Canada for the U.S.”