Public Pension Funding and Valuation Methods Vary Globally

The researchers found the examined plans in France, Finland, the United Kingdom and Germany rank the highest in terms of net unfunded liability, with the French level reaching over 90% of GDP and the Finnish one over 75% of GDP. The net unfunded liabilities in Sweden, the Netherlands (ABP and PfZW together), and Canada (only public servants) are low due to the relatively high funding levels in the examined funded plans. The examined plans in the United States (all state and local plans) and Norway fall in the middle.  

The paper contends that prefunding can be justified on various grounds. First, it facilitates intergenerational tax smoothing, ensuring that each generation pays a more or less constant percentage of taxable income. Secondly, it can reap the benefits of diversification of pension fund investment, in particular into foreign markets. Thirdly, it can protect beneficiaries from the possibility of bankruptcy of the sponsoring governmental entity.  

At the same time, the researchers said, there are various possible justifications for underfunding such public pension commitments. First, to the extent that funding risks can be smoothed over time as they can be shared with future generations of tax payers, underfunding in market value terms may be an optimal strategy. Second, a funding surplus might also mobilize pressure to increase benefits which in turn leads in the longer term to higher funding costs and so underfunding. So for taxpayers it is rational to aim at underfunding rather than full funding or overfunding. Moreover, a funding surplus will enforce contribution cuts and once contributions are reduced, it is difficult to get them increased. Third, to the extent that prefunding leads to investment in domestic government bonds, a circularity in government funding may be created, with little added value relative to a PAYG system.  

Valuation Methods  

According to the working paper published by the National Bureau of Economic Research (NBER), the Netherlands has two public sector plans, APB for the sectors government and education, and PfZW for the health care sector. Like all other pension funds in the Netherlands, the public sector pension plans in the Netherlands have to report the fair value of their nominal liabilities. The nominal liabilities are the accrued pension rights without taking into account future indexation. The supervision prescribes that the discount rates for the various terms have to be derived from the nominal swap rates curve. End 2008 the swap rate corresponding with the duration of the liabilities for the two plans is 3.56%.  

The plans in the United States use the actuarial method as prescribed by the Government Accounting Standards Bounds (GASB). GASB 25 states that the discount rate should be based on “an estimated long-term yield for the plan, with consideration given to the nature and mix of current and planned investments…“ For most plans this expected yield turns out to be equal to 8% or close to 8%. 

The Australian plan also employs the actuarial method and applies a discount rate of 8%. The Australian PSS scheme for federal employees is partially funded, partially book-reserved, with assets at about 30% of liabilities.  

The Norwegian SPK plan for federal employees is accounted for using the Norwegian accounting standard NRS 6 which is similar to the pension accounting standard required by US GAAP for corporate plan sponsors. The SPK plan is partially funded, partially book-reserved with assets at about 60% of liabilities. As of year-end 2009, the market-based discount rate was 5.70%. 

The pension plan for federal employees of Sweden uses market-based discount rate that is net of future indexation. As of year-end 2008, this discount rate was 1.90%.  

The United Kingdom public sector pension plans are partly unfunded and partly funded in nature. Unfunded plans cover civil servants, national health sector and teachers. The 99 plans of the local communities all are based on funding. The reported value of liabilities is based on a discount rate of around 3% (= 6% denominator discount rate minus 3% inflation rate). Cash flows are projected with an expected rate of inflation/indexation of 3% (approached by taking the difference between the yield on long term gilts and the yield on inflation linked bonds). The denominator discount rate turns out to be equal to around 6%, determined as the sum of the long term gilt return plus assumed outperformance of assets over the gilt return, being 2% for assets relating to preretirement service and 1% for postretirement. On average this corresponds with a denominator discount rate equal to around 6%.  

Reforms  

Public pension reforms have been undertaken in many countries, according to the working paper published by the National Bureau of Economic Research (NBER).  

These reforms have been oriented at bringing remuneration practices in the public sector more in line with those found in the private sector. Such reforms have generally involved lowering the generosity of public-sector pension schemes (e.g. Finland, France, Germany, Italy, Portugal, and Sweden). In some countries public sector workers have been transferred to the main public pension system (e.g. Austria, Chile, Czech Republic, Greece, Hungary, Mexico, Poland, Spain, and the United States), which in some cases include a fully-funded, defined contribution component (e.g. Chile, Denmark, Hungary, Mexico, and Poland).  

In addition, initiatives have been taken in a number of countries to introduce some degree of prefunding of public sector pensions via the establishment of reserve funds (e.g. Australia, Belgium, Finland, Germany, Ireland, and Sweden). Sometimes, however, fiscal pressures have overwhelmed the drive to prefunding as in 2003 when the Belgian government transferred the assets and liabilities of Belgacom, the former state-owned telephone monopoly, to the state system.   

The Portuguese government recently announced a similar planned assumption of the assets and liabilities of Portugal Telecom. Such moves, though worrisome if they lead to a depletion of the pension reserves, have also been justified as a way to unify pension arrangements between public and private sector workers. 

Plan Types  

Most OECD governments, with few exceptions, offer special DB arrangements for public sector workers, which in most instances are complementary to the general social security system. These special DB plans create a pension liability for governments beyond that already reported in social security arrangements. Unfunded (pay-as-you-go) schemes are the most common, followed closely by the number of funded schemes. At the local government level, funded schemes are more popular than unfunded (pay-as-you-go schemes). Some schemes at the federal and local government level are book-reserved, whereas a small number of schemes target partial funding.  

The researchers found that information regarding public expenditure on government workers’ pensions is readily available for most OECD countries. However, international comparability is problematic because of the way the information is reported. The OECD’s SOCX database, for example, reports pensions paid to former civil servants through autonomous funds as a private spending item (Australia (partially), Canada, Denmark, the Netherlands, Sweden and the United Kingdom). All social benefits not provided by general government are considered ‘private’.   

The individual pension schemes examined by the researchers are mainly DB. The plans in France, Germany and Norway are final pay DB schemes. Canada’s OTP plan is final average pay, whereas Canada’s plan for federal government workers is a highest average pay scheme. The schemes examined in Finland and the Netherlands are career average schemes. The UK scheme for civil servants is career average, whereas the other examined UK schemes are final average pay schemes, although the government is considering replacing them by career-average plans.   

The plans examined in Australia, and Sweden are a combination of DB and DC. There are three Hong Kong, China scheme for federal employees: Those members that joined after 1 June 2000 are covered by a DC scheme, whereas members who joined before then are covered by highest pay DB schemes.  

Members of the French pension schemes for public sector employees are not eligible for the state social security pension scheme, so the public sector pension scheme must therefore cover any resulting shortfall. Most German civil servants are also covered by schemes that replace the general social security system. The pension schemes examined in Canada, Finland, and Norway are integrated with the state social security pension scheme. The pension schemes examined in Hong Kong, China, the Netherlands, Sweden and the United Kingdom are distinct and complementary to the state social security pension scheme, although in the United Kingdom, some public sector pension schemes are contracted out of the state pension system and must make up the benefit shortfall.  

In Australia, Canada, France, Germany, Hong Kong - China, Netherlands, and the United Kingdom, the schemes examined offer more generous pension benefits than what is typical practice in the private sector. In Finland, the schemes give similar benefits to those found in the private sector. In Norway, the level of benefits is similar to that typically offered by large and mid-size employers. Small Norwegian employers, however, tend to offer significantly less generous DC schemes due to the government-mandated minimum pension level that was introduced in 2006. In Sweden, the schemes examined give slightly less generous DB benefits than the scheme that covers most private white-collar workers; although the public sector schemes are more generous than the DC scheme offered to most private sector blue collar workers and younger white collar workers who also receive DC benefits.