Wednesday, 3 March 2010

Montreal Economic Institute Attacks Québec Public Sector Pensions

The Montreal Economic Institute, which describes itself as "an independent, non-partisan, not-for-profit research and education organization", has just published a brief 4-pager Are public sector plans too generous? Its answer is yes, they are. They are not the first ones to point out the fact that they are generous (e.g. Sherry Cooper shows the same in her book, The New Retirement, reviewed here), though the MEI's overtly political aim of influencing negotiations with public sector unions to reduce their generosity is perhaps not shared by everyone, especially public servants.

The interesting bit in this paper is the assertion that the main advantage for the public sector pension stems from the greater job stability and security in the public service combined with the defined benefit rule that the pension amount is based upon the salary of the five best years of service. They calculate that a hypothetical private sector worker who changes companies and pension plans three times in a career will, at the point of retirement, have fully 41% less value in his/her retirement plan. This is even assuming the presence of am identical private sector defined benefit plan (which most private sector workers no longer have of course) with the same final five best year rule and the same salary throughout a career!! As they explain:
"The job security that many public sector employees enjoy makes all the difference. The five best years providing the basis for the pension are those late in their careers, when their salaries are at their peak. In contrast, the salaries for the five best years in the three different jobs held by the private sector worker are necessarily lower. This reality means that public sector employees are able to get the full benefit of their defined benefit pension plan, which is not the case for private sector workers employees, even with an identical plan."
Wow! Who'd have thunk, huh? Merely switching jobs in an upward career path at different organizations could royally mess up your retirement.

In a strict sense the public sector DB plan isn't necessarily special or unique. Any such DB plan and career path, private or public, would give the same result. Portable years of service credits and the continuation of the five year rule are the key. Of course, there is a crucial practical difference in that almost all public sector jobs are covered by DB plans so portability agreements which preserve accumulated work year credits ensure that the huge payoff of the "five-best-years" rule is preserved. Transferring accumulated pension savings from a DB plan into a DC plan cuts off the magic of a pension that is calculated on the basis that you earned your highest salary during your whole working career.

The five-best-years rule both catches up for past inflation and captures real salary increases. My guess based on personal observation is that it is also pretty rare for public employees' salaries ever to actually go down - when someone achieves their Peter Principle level, they get shunted aside where they can do less harm and stay at the same "red-circled" salary level.

With the disappearance of DB plans in the private sector, the practical result is that very many private sector workers, even those earning more than public sector employees, and / or who save just as much, will never be able to achieve the same pension.

The effect of the five-best-years rule is akin to the oft-repeated example of the long term benefits of compounding that putting aside a small amount left to grow easily beats saving much larger amounts later.

It is clear that public sector workers' pensions are far ahead of those in the private sector. The debate about whether to redress the fact of the inequality of private vs public sector pensions by reducing the pensions of public servants, or increasing the pensions of private sector workers and the equity or fairness of any solution, will be hotly contested and is not properly addressed in this short paper. However, at least it reveals one of the key practical differences.

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