William Robson is president and CEO of the C.D. Howe Institute.
What returns can we earn on our saving? In planning for retirement, few questions matter more. Project prudently and all should be well; count on a bonanza that falls through – not so good. What is true for individuals is true for pension plans. Those that forecast conservatively and back their obligations well tend to pay what they promise; those assuming turbo-charged returns to fund rich benefits on the cheap might not. So far, the debate over a bigger Canada Pension Plan (CPP) and the Ontario Retirement Pension Plan (ORPP) has skirted this question.
The going assumption – explicit in the ORPP's numbers; implicit in conversations about "fully funded" CPP expansion – is that assets in these plans will earn 4 per cent annually in real (inflation-adjusted) returns over decades. Few people have noticed this. Some who have noticed can recall when interest rates were higher than that. Others know that the 1998 reforms that stabilized the CPP assumed 4-per-cent real returns, and that the CPP Investment Board, like many asset managers, has done better than that since then. So this assumption hasn't been an issue.
It should be. Any pension plan that bases benefits not solely on what money in the plan can cover, but on participants' earnings and work history, depends upon some minimum rate of return. Some, including the CPP and the proposed ORPP, can trim benefits if funding falls short. But the adjustments they contemplate are small and very gradual: Big setbacks will force contribution hikes, or unplanned benefit cuts. Such things have happened in Canada – not just in private-sector plans, but in the CPP's reforms. They are happening big-time in U.S. state and local plans, and in European social-security schemes. Canadians already have major bets on 4-per-cent real returns in the CPP. Doubling down with expansion or new plans on the same basis will magnify any mishaps.
Many people – including financially sophisticated people – dismiss this concern. Professors of finance and asset managers have asserted to me that they themselves can earn 4 per cent in real terms over the long horizons needed to pay pensions. Why? Because it's happened before. I suppose those people have read the warning in countless prospectuses that past returns do not guarantee future returns. They may repeat it to friends and clients. They know that, after giving investors double-digit returns for decades to 1990, the Japanese stock market stands at less than half its peak more than 25 years later. But when it comes to pensions, they sweep all such wisdom and experience aside.
They also ignore key facts about the world today. Real yields on high-quality securities were above 4 per cent in the late 1990s; they are now around zero or negative. That collapse in yields supported the capital gains that boosted asset managers' returns. Financial assets have become expensive. How much higher can they go? The yield on the federal government's real-return bond has averaged barely more than 1 per cent for a decade. With work-force growth flat-lining and the population aging, we will be lucky to achieve real economic growth of 2 per cent. How do we get sustained investment returns of 4 per cent from that?
To anyone still convinced that 4-per-cent real returns are there for the taking, I say: Why limit your ambitions? Bargain-priced retirement is only a start. You can solve all Canada's fiscal problems.
Take the Ontario government's $5-billion deficit. The province can issue long bonds paying interest at 2 per cent in real terms. If the ORPP can reliably earn 4-per-cent real, let's lever the two-percentage point difference: Borrow $250-billion, invest it with the ORPP and the profit will balance the budget. Better yet, borrow $500-billion, invest with the ORPP, and – presto – a $5-billion surplus!
The federal government can do even better. The real yield on their long bonds is zero. If the Canada Pension Plan Investment Board (CPPIB) can reliably earn 4-per-cent real, Ottawa can borrow, say, $500-billion, invest with the CPPIB, and boost their bottom line by $20-billion. Free money! What could go wrong?
Well, nothing – if 4-per-cent real, year-in year-out, is really a slam-dunk. But in reality, plenty. In fact, many U.S. state and local plans, including the Detroit plan that went bust in 2013, tried this trick – so beguiled by assumed high returns that they forgot their duty to make actual payments. It is one thing for individuals to shoot for the moon – gamble their own money and retirement. It is something else to do it on others' behalf – especially millions of others, with failure meaning not just individual but societal hurt.
The question of returns on investment in the ORPP or a bigger CPP needs more attention. The 4-per-cent real returns underlying these proposals are aspirations. The "new normal" of low yields on high-quality investments suitable for backing pension promises is a reality. When someone talks about rich returns not yet earned as if it's money already in the bank, we should call them on it. Four-per-cent real is a hope, not a guarantee.