Andrew Coyne’s column in the National Post today is an unusually clear example of a mistake that people on the right always make when talking about public pensions. The headline in fact says it all: Turning the CPP into 18 million RRSPs. Here’s the basic problem with Coyne’s analysis. A public pension, like CPP, is providing an insurance product to Canadian citizens, in the same way that the health care system provides an insurance product to Canadians. Having insurance is not equivalent to having a pile of money in a savings account. And yet people on the right – merely because they don’t like government – are constantly suggesting that we abolish these insurance schemes, and replace them with individual savings – effectively forcing individuals to self-insure. So people like David Gratzer want to get rid of public health insurance, and replace it with individual savings accounts. And now Coyne wants to phase out public retirement insurance and replace it with individual savings accounts. Both of these proposals are non-starters, because of the enormous loss of welfare that would accompany abolition of the insurance scheme. There is, in other words, no economic or public policy case to be made for these proposals, it’s just pure anti-government ideology. Their line of reasoning winds up being something like the following: “if the private sector can’t deliver this kind of insurance, then no one should be able to have it.”
There is one key difference between the health care case and that of public pensions. Most proponents of health savings accounts recognize that they are recommending more than just privatization of a public good, they understand that they are also abolishing an insurance arrangement (and so they usually make some provision to provide a “back end” insurance scheme to support the savings accounts). In the case of pensions, however, proponents of “privatization” schemes such as the one Coyne is recommending often don’t realize that they are abolishing an insurance scheme, because they don’t realize that this is what public pensions are. (Actually, he recommends that only the expansion be diverted into individual funds, not the core system, so the headline is misleading. For simplicity I’ll ignore that quibble.)
The core insurance product being offered by the public pensions system is a life annuity. A life annuity is a slightly obscure product that can be purchased from an insurance company, which offers protection against the risk of outliving one’s retirement savings. The basic idea is simple: in return for a large upfront payment, the annuity then pays out a fixed monthly sum, from the age of retirement until death. This means that you cannot outlive your savings, and so you don’t have to worry about being 95 years old and running out of money. Anyone interested can go fiddle around with an annuity calculator, such as the one offered by RBC Insurance (here). A word of advice though – in the field where it asks you to provide your age, don’t put in a number less than 55. Why? Because they won’t sell annuities to anyone younger than 55. This is what we in the public policy business call a market failure – and an unusually clear instance of one at that. An entire category of consumers (individuals under age 55) are simply not being served by private markets.
The underlying business model is that insurance companies sell a lot of these annuities, some of which they make money on (because the person dies young) and some of which they lose money on (because the person lives for a long time), and the two balance each other out. Furthermore, if you sell a lot of them, then the law of large numbers allows you to calculate with considerable confidence exactly how much you need to have on hand, in order to make the monthly payments.
Why do people want this type of insurance? Because it generates a massive efficiency gain (those interested in more details can see sections 1 and 2 of this paper). Each of us has a non-zero chance of living to the age of 100. In principle, this means that each one of us should be saving enough to finance 35 years of retirement income. This is a giant sum of money, and none of us is actually going to do that. In practice, maybe 1% of us will actually make it to the age of 100. Lots of us will die younger. So what we should do is pool our retirement savings, so that instead of each of us saving enough to support each of us until 100, we collective save just enough for one of us to make it to 100. (Same with health insurance – instead of each of us saving enough to pay for kidney dialysis, because each of us has a non-zero chance of getting diabetes, we collectively save enough for kidney dialysis for the 2% of us who are likely to get diabetes.)
Anyhow, to make a long story short, life annuities are subject to market failure, largely because of adverse selection problems. As a result, they are often a better deal when purchased collectively. This is essentially what a defined benefit pension scheme is. I participate in one of those as a University of Toronto employee. Basically, I make an upfront payment every month, and in return, I get a fixed monthly payment from the age of retirement until death. Whenever the stock market goes up, there are always some doofuses (doofi?) in the faculty association here who want to convert to a defined contribution scheme (i.e. an individual savings account), so they can use some of their alpha to get those sweet, sweet returns. This is a transparently bad deal, since the two are simply not equivalent – and if you do the math, on how much it would cost to purchase private annuities versus how much it costs to get the defined benefit pension, the pension easily comes out ahead.
I know this because my wife is a surgeon, and so has to save for her own retirement. She’s always dragging me along to meetings with her fancy Bay St. investment advisers. Whenever they find out I have a defined benefit pension, reactions vary from “Oh my god, you’re so lucky!” to “Wow, that thing is gold” to “Okay then, you don’t need me.” Unfortunately, not everyone is so lucky. In fact, defined benefit pensions are now pretty much confined to the public sector, because historically they have been unfunded, or partially funded, which in the public sector is fine but in the private sector creates perverse incentives (namely, to run up pension obligations and then declare bankruptcy). So how do all those unfortunate people in the private sector get their life annuities? From the government… the CPP (QPP) is basically a defined benefit pension scheme, which means that it is essentially a publicly-provided life annuity.
So why might we want to expand the CPP? A typical retirement portfolio should contain a mixture of savings and insurance. Basically, you should have enough annuities to cover your basic needs – so that if you wind up spending 10 years in hospice care, lying on a hospital bed with Alzheimer’s, those bills will be covered. Savings should be used to supplement these annuities, to cover things like trips to Florida while you’re still young enough to travel and enjoy it. Yet if you look at the typical Canadian’s retirement portfolio, it doesn’t have nearly enough annuity income. Furthermore, the current working generation is facing very significant uncertainty about how long they will live – who knows what medical technology will do to extend life in the next few decades? Again, this pushes in the direction of expanding annuity income, which for the average Canadian, can only be achieved through CPP expansion.
Okay, so there’s a clear and cogent argument in favour of CPP expansion. What is Coyne’s argument against it? Other than confusion about what pensions are, he seems to be troubled by some vague suspicions about the CPP Investment Board. (As some have pointed out, the idea that individuals get better financial management on the funds in their private RRSPs is wishful thinking.) And he seems to be worried that the government will start using it like a sovereign wealth fund, and that this will impact returns. And he seems to be suspicious of the idea that we need to be accumulating funds at all, to meet the demographic challenge posed by the retirement of the baby boomers.
Alright, well if it’s the float that he doesn’t like, then there’s an easy solution to that – bring CPP back to pure PAYGO (for explanation of what that means, see section 3 of this paper). That will put the CPP Investment Board out of business overnight. Of course he’d never go for that. Why? Because it’s inefficient not having a funded scheme. Here’s my point: forcing people to self-insure is also inefficient. In order to make the case for his proposal, Coyne needs to show that no insurance is better than public insurance. This is a tough case to make, because public insurance has to be pretty badly managed before it becomes worse than no insurance (the same way pizza has to be really bad before it becomes worse than nothing.)
P.S. This point about pensions is one that I’ve made before, if anyone is interested in seeing a different version of the argument. My hope is that if I explain it enough times, enough different ways, eventually it will begin to seep in.