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Underfunded Pensions: Canada’s Growing Problem

The US isn’t the only nation that is facing underfunded pensions problems.

Canada (among other nations) is also facing a looming pensions crisis, although the nation is better prepared than many others.

Canada’s pension problem

According to a report published by credit ratings agency Moody’s, Between 2006-16, the average active-to-retired ratio of the largest six Canadian pension plan fell to 2.0 times from 2.3. While better than average, this ratio is deteriorating rapidly. The Ontario Teachers’ Pension plan has the worst profile. The average active-to-retired ratio has declined from 1.5 in 2006 to 1.3 for 2016 — the worst of all the nation’s largest plans.

However, broadly speaking the Canadian pensions system is in better shape than that of say, the US for example. According to Moody’s over the past five years, through a combination of investment returns and member contributions, pension funds have substantially increased their scale. The combined gross assets of the six largest Canadian pension managers have nearly doubled in size; reaching almost CAD$1.4 trillion at the end of 2016 up from CAD$850 billion at the end of 2012.

Underfunded Pensions Underfunded Pensions

The bulk of this performance has come from investment income. CAD$400 billion in investment income has been received during the past five years. Leverage has been a key aspect of funds’ investment mandate. Since 2009, the aggregated average leverage of the largest six funds have increased to 24% from 19% helping returns but at what cost? Funds have been investing in Canada’s buoyant housing market and borrowing to do so, with concerns about the state of the market growing, there’s a chance the decision to lever up could come back to haunt these managers.

Like other pension funds around the world, Canadian funds have been turning to illiquid assets to boost returns. The funds’ average annual return target is 4% according to Moody’s (interestingly around half of the 6% to 8% annual returns targets of most US pension funds), around double the average sovereign bond yield. So-called level 3 assets (require non-observable assumptions such as future interest rates or expectations of future cash flows to determine periodic performance) have grown in popularity in recent years; rising to 34% of aggregate pension fund assets in 2016 from 32% in 2010.

Pension Woes – A trillion here, A Trillion There. Published: Oct 10, 2017 @ 10:12

So far, this series on underfunded pensions has concentrated on the obligations of US states and cities. And while non-federal budgets are showing a fair amount of strain from underfunded liabilities, these funding gaps are nothing compared to the federal deficit.

Social Security and Medicare are two ticking timebombs for the US government. The provision of pensions and medical care for those over a certain age is universal in universal in most developed nations, and most nations are paying for it.

However, the annual cost to the US government for these programmes appears to be completely unsustainable.

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Underfunded pensions: A trillion here, a trillion there

Since the turn of the century, US government debt has roughly doubled as a percentage of GDP total public debt is $20.2 trillion, that's excluding state-level debt of $3 trillion and counting. Added together, these two figures indicate a debt to GDP ratio of close to 120% putting the country in the top-ten most indebted nations in the world (rapidly closing in on Greece at 180%).

underfunded pensions

When it comes to underfunded retirement and healthcare obligations, the situation is even worse.

According to the Treasury's FY 2016 annual report, the net present value of the US government’s 75-year future liability for Social Security and Medicare at the end of the fiscal year was $46.7 trillion -- equal to 250% of GDP.

Unfortunately, for both taxpayers and benefit recipients, it looks as if this liability is only going to get bigger. For fiscal 2015 the figure was $41.5 trillion.

Even this might end up being a conservative figure. In 2014 economists estimated the real deficit to be around $210 trillion, a figure that's surely grown by several tens of trillions during the last three years.

Not alone

The US is not alone. Currently, the world’s leading economies are dealing with a $70 trillion pensions funding deficit according to the World Economic Forum and this could increase to $224 trillion by 2050.nAccording to OECD measures the UK’s shortfall is higher than £6.2 trillion, set to increase by 4% per year. This will be over £25 trillion in 2050. That's an enormous figure for a country with a GDP of less than $3 trillion and it means that the island nation boasts the world's second largest pensions deficit.

Our series on underfunded pensions continues below with: When underfunded pensions become debt. Updated, Oct 9, 2017

With concerns about the sustainability of states' underfunded pensions growing, and with "$70 billion in US municipal bonds across our asset management business" analysts at JP Morgan have set out to try and determine the riskiest states to invest in.

The findings of this analysis were published in a report last week, which ranked the 20 most risky cities and eight most risky counties by credit profile. On average, while a few states have very large debts relative to their revenues, many are in decent shape.

However, in general, US cities and counties have substantially more debt relative to their revenues than US states. While most have several years to undertake remediation measures, some "very difficult choices will be required in order for them to meet all of their future obligations."

What's of more concern to investors is the fact that, according to JP Morgan, when rare municipal bankruptcies do occur, bondholders have "usually received lower recoveries than pensioners."

When underfunded pensions become debt

JP Morgan's analysts point out in the report that cities' debt is not just limited to interest-paying bonds. Debt also includes unfunded obligations related to "pensions and retiree healthcare along with bonds, leases and other obligations supported by each municipality’s general account."

Interestingly, when all of these factors are added in, bonds and leases only represent around one-third of the total debt of US cities and counties.

Underfunded Pensions Below is the chart compiled by JP Morgan's analysts showing the “IPOD” ratio for US states, cities and counties. The measure represents the percentage of a municipality’s revenues that would be needed to pay interest on direct debt, and fully amortize unfunded pension and retiree healthcare obligations over 30 years. A conservative 6% return is used to calculate the return on pension plan assets over the period.

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