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Tax and Spend is a new series that examines the intricacies and oddities of taxation and government spending.

There was a very large asterisk hanging in the air when the federal government revealed in mid-December that the deficit would be billions higher than expected.

In his spring budget, Finance Minister Bill Morneau had forecast a deficit of $19.8-billion for fiscal 2019-20. But by the time he delivered his post-election fiscal update in December, the gap had mushroomed to $26.6-billion. Similarly, the deficit projections were higher for the next three fiscal years, with the added red ink for all four years totalling $20.8-billion.

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Then came the asterisk: the soaring deficit was “largely attributable” to the annual reassessment of the government’s liability for the pensions and other future benefits of public sector employees. As part of that reassessment, the Finance Department revised downward its forecast for interest rates, triggering a reduction in the discount rate used for measuring pension liabilities. (The lower the discount rate used, the greater the present value of a future obligation; in essence, it’s a compound-interest calculation in reverse.)

The downward pressure on the outlook for interest rates has since intensified, after the Bank of Canada cut its overnight rate by 50 basis points earlier this week.

Faced with this volatility, Finance has floated the idea of creating a second deficit figure that would exclude pension liability adjustments from the government’s “operating balance,” essentially setting them aside. The two approaches result in very different deficit pictures.

In the current accounting (shown by the red bars), the federal deficit balloons to $28.1-billion in the next fiscal year, 2020-21. If those actuarial losses are excluded, the deficit is a much more modest $18.2-billion, as the smaller purple bars indicate.

Why such a difference? It’s the combination of the ubiquity of generous defined-benefit pension plans for federal government employees, Ottawa’s failure to set aside cash for its pension obligations until 2000, and a two-year-old change to the government’s accounting rules that resulted in a reduction in the discount rates it used.

The $20.8-billion downdraft in December is a big number, but it could be just a small part of a much larger pension bill. Pension experts say there could be even bigger liabilities hidden in Ottawa’s pension obligations. That’s a consequence of the government’s policy of guaranteeing pension payments and aggressive assumptions that would not be allowed in the private sector – a combination that could end up costing taxpayers billions more if investment returns don’t match projections.

“The taxpayers are subsidizing compensation, and it’s not showing up anywhere,” says Alexandre Laurin, director of research at the C.D. Howe Institute.

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Gold-plated pension, defined

Federal employees are in the fortunate position of receiving defined-benefit pensions, which guarantee pension payments no matter the performance of the underlying investment pool. That’s true of much of the public sector and in stark contrast to the private sector, which has veered away from, scrapped or converted such plans to less financially onerous (for employers) defined-contribution plans. Those plans, as the name implies, limit the employers’ obligation to initial contributions. If the underlying fund underperforms, employees lose out. The employer’s obligations do not increase, and there is no liability that lands on its financial statements.

The pension gap between the public and private sectors was always large, but as the graph below shows, it grew to enormous proportions by 2017: nearly eight in 10 public sector employees had a defined-benefit plan, according to Statistics Canada, while in the private sector, fewer than one in 10 workers had such a plan.

If all types of pensions are considered, the gap does shrink somewhat: nearly nine in 10 public sector workers had either a defined-benefit, defined-contribution or hybrid pension plan in 2017. For the private sector, that proportion is just over two in 10.

But for the federal government, the gap with the private sector is much wider. All full-time federal civil servants, and part-time employees working more than 12.5 hours a week, are part of the government’s defined-benefit pension plan.

Historically, the federal pension plan has been generous in another way: the ratio of employee contributions to employer ones. As recently as 2005, employees’ payments accounted for just over 28 cents of each dollar of total pension contributions, with the federal government making up the remainder. The contribution ratio has shifted over time, as the chart below shows, rising to 50 per cent (or just under that for employees who entered the plan before 2013) by 2017. Both groups are now at the upper end of the legally allowable limit for the ratio of employee contributions to employer contributions.

But the relatively smaller contributions of earlier years means the cumulative balance is still in employees’ favour. Even more significant is the fact that the government guarantees it will make pension payments, no matter what happens with invested pension funds. That kind of ironclad guarantee is extremely rare – and extremely valuable. Mr. Laurin of the C.D. Howe Institute says that, by contrast, most provincial plans place at least half of the burden of a shortfall on employees, and in some cases, all of it. Some analyses have concluded that the implicit cost of the guarantee for paying federal public service pensions exceeds the cost of the pensions themselves.

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Arcane calculations aside, there is a practical reality that the guarantee creates: taxpayers are on the hook for any unexpected shortfalls in invested pension funds for the federal civil service, since Ottawa is obliged by statute to pay out public service pensions.

If there were a protracted run of such losses, the putative 50-50 split between employees and the employer could tilt against the public pocketbook as the government was forced to cover any shortfall. “The money has to come from somewhere,” says Rick Robertson, professor emeritus of accounting and finance at Western University’s Ivey Business School.

A history of liability

The prevalence of defined-benefit plans in the public sector would be challenge enough for the federal government. But the size of the problem is magnified by government policy before fiscal 2000-01. Until that year, Ottawa didn’t contribute any actual cash for federal pensions. It simply assumed the resulting liability and rolled employee contributions into general revenue, in effect writing IOUs each year. That changed in 2000, part of aggressive efforts by the federal Liberals to shore up public finances. Since then, government and employee pension contributions have flowed into an investment fund. But the gap for pre-2000 has never been closed, leaving $168-billion in unfunded liabilities as of fiscal 2018-19.

Those unfunded liabilities were behind the sudden inflation of the deficit in December, when Finance reduced its discount-rate assumptions. If those pension obligations were offset by funds amassed from contributions, the impact of a change in discount rates would be much reduced. To illustrate: if you want $1,000 in your investment account a decade from now, you can a) hope for high annual gains from your investments or b) simply invest more money to start with.

Or, if you’re the federal government, you have the option of c) pay the bill later.

Growing volatility

Before fiscal 2017-18, the government had used a relatively generous rule for determining its discount rate, a forecast of Ottawa’s long-term bond rates over the next 20 years. But three years ago, the Finance Department adopted a more conservative approach and began using its cost of borrowing as a discount rate, saying it did so in light of “industry practices and emerging changes in accounting standards.” (The move also followed several years of urging by the Auditor-General.)

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The change was significant. In 2016-17, the discount rate for unfunded pension obligations was 4.7 per cent, but in 2017-18, under the new rules, the discount rate dropped to 2.2 per cent (and to 1.9 per cent in 2018-19). Put another way, the change in the rate forced Ottawa to retroactively add $20.5-billion to its total pension obligation in 2017-18, an 11-per-cent increase.

A drop of just a couple of percentage points might seem minor, but compounded over decades, the cost of more conservative assumptions adds up. “A small change today can have a big impact 20 or 30 years from now,” says Constance Smith, professor emeritus at the University of Alberta’s economics department.

That added debt pales in comparison to what would happen if Ottawa used the same conservative assumptions for its funded pension liabilities. Currently, the government uses a discount rate based on the expected return on its investments (and so far, its actual returns in recent years have beaten expectations). Private sector plans aren’t allowed to use such aggressive assumptions for pension planning – the worry being that a nasty surprise in the markets would lead to funding shortfalls. Instead, they generally use a much lower rate based on the yields on high-grade corporate bonds, notes Michel St-Germain, president-elect of the Canadian Institute of Actuaries. (Of course, unlike the government, there is always the possibility that a company can go out of business and imperil pension funding.)

According to the most recent public information, Ottawa used a discount rate of 5.8 per cent in 2018-19 for its funded pension obligations, more than twice as high as that used for the unfunded obligations. If the government were to take a similarly conservative approach in accounting for its funded pension obligations, liabilities would skyrocket by $107-billion, according to sensitivity figures in Ottawa’s annual pension reports.

Even a more modest retrenchment would carry a big price tag. The Ontario Teachers’ Pension Plan, another public service defined-benefit pension with a large asset pool, uses a discount rate of 4.8 per cent. If Ottawa were to match that rate, its pension liabilities would jump by $27.5-billion – more than the increase added on to several years of deficits in December.

The government has given no indication it would take such a step, but those numbers do illustrate the fiscal risk lurking on Ottawa’s balance sheet. The Finance Department’s response has been to propose a change that would shift pension liabilities to one side, essentially making the case that such potential costs are less relevant than a core deficit figure.

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Mr. Laurin questions the merit of separating pension liabilities from deficit calculations, saying it could open the door for other costs to be hived off to create a more favourable fiscal picture. “What else will be broken out?” he asks.

Rather than creating new definitions of the deficit, he suggests Ottawa take steps to reduce taxpayer risk, namely by transferring some pension risk to employees and adopting more conservative actuarial assumptions. Those steps might not necessarily reduce the weight of pension obligations on Ottawa’s bottom line or the size of the deficit – but they would at least provide a clearer picture of what those obligations will be in coming decades.

Editor’s note: An earlier version incorrectly identified Ivey Business School professor Rick Robertson as Rick Roberts

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