New research commissioned by the Global Risk Institute in Financial Services demonstrates the effects of low interest rates on Canadian public pension systems using four scenarios following the financial crisis
The impact of the current extended period of low interest rates on the viability of public and private pension schemes is a matter of pressing concern not just for individuals, but for governments across the developed world.
Working with the Policy and Economic Analysis Program (PEAP) at the University of Toronto’s Rotman School of Management, the Global Risk Institute in Financial Services (GRI) has developed four macro-economic scenarios for the next fifteen years in Canada, as the world recovers from the major crisis experienced in 2007-2008.
This research aims to examine the health of Canada’s pension system – but observations from this study may be of benefit to other pension systems world-wide.
The four scenarios established using PEAP’s proprietary model were, briefly, as follows:
- Scenario 1 – interest rates remain low through 2014, but then rise significantly as global economic recovery finally takes hold in 2015 and successive years, with relatively strong economic growth and improving corporate and government balance sheets;
- Scenario 2 – as per Scenario 1, but with somewhat lower ultimate levels of interest rates than Scenario 1;
- Scenario 3 – low interest rates continue for an arbitrary five years longer, owing to relatively weak economic growth and demand, before rising to the relatively high levels seen in the first scenario;
- and Scenario 4, in which low rates for another five years eventually rise to the lower levels seen in Scenario 2.
In our view, the most likely outcome based on present data is Scenario 1, with the other Scenarios listed in descending order of probability.
The research considered the effect each scenario might have on the two elements of Canada’s public retirement provision – the Canada Pension Plan (CPP, and the accompanying Quebec Pension Plan (QPP)), and Old Age Security and the Guaranteed Income Supplement (GIS).
OAS/GIS functions as a minimum income level for those in retirement in Canada, rather like the state pension in the UK
OAS/GIS functions as a minimum income level for those in retirement in Canada, rather like the state pension in the UK, although qualification is not contingent on an individual’s work history – it is available to all Canadians on reaching retirement age. In the CPP/QPP scheme, contributions are automatically deducted from employee earnings each month, much like the UK’s SERPS (State Earnings-Related Pension Scheme).
According to the 25th actuarial report from CPP/QPP, these schemes assume a 4% p.a. return on investment for their models in the future; this research focused on how the four economic scenarios might affect this objective, and what the policy implications of this might be. Under Scenario 1, assets in CPP/QPP schemes would continue to rise in value until 2030, with the viability of the schemes remaining strong. We consider this to be the most likely outcome.
In Scenario 2, with interest rates climbing to a level some 100 basis points lower than in Scenario 1, there are no major impacts to these schemes, as the total value of assets continue to climb until 2025 before levelling off until 2030.
In Scenarios 3 and 4, however, in which economic growth remains low for another five years until 2019 before recovery begins, we find significant reductions in the balances of the CPP/QPP schemes and a turn into deficit before 2025.
In addition, it’s worth noting that low real interest rates on government bonds, and low equity risk premiums put the 4% return on investment target of these schemes at risk. As a result, under Scenarios 3 and 4, total asset values peak before 2025 then tail off to 2030.
Consistent with these findings, this study’s analysis of the Old Age Security (OAS/GIS) portion of Canada’s state pension provision found that balancing Canada’s federal and provincial budgets is key to the continued viability of these schemes. Under Scenarios 1 and 2, federal budgets would return to balance on a National Accounts basis by 2018 at the latest, with provincial budgets returning to balance by 2020, leaving room for the OAS/GIS schemes to be further supported by government if necessary.
In Scenarios 3 and 4, however, Canada’s federal budget remains in deficit until 2030 under current tax and spending settings, with considerable stress on provincial balance sheets and, as a result, less fiscal room to support the costs of OAS/GIS.
Across the entire exercise, two points of importance to government pension schemes become clear – balanced budgets and fostering economic growth.
The real threat of a continued period of low interest rates for a longer period of times comes not from the low rates themselves
The real threat of a continued period of low interest rates for a longer period of times comes not from the low rates themselves, which reduce the burden on public debt, but from a continuing period of low economic growth. Indeed, low economic growth implies lower levels of employment and wages and, as a result, lower contributions both to the CPP/QPP schemes directly and to the wider government finances via taxation.
Without reduced federal and provincial deficits, any support of the OAS/GIS portion of Canada’s pension scheme becomes less affordable – a further factor highlighting the importance for both national and regional governments to achieve sustainable public finances. Looking outside Canada, these comments could also apply to many other national pension schemes.
For more information about this research and the Global Risk Institute in Financial Services, please go to: www.globalriskinstitute.org
Michel Maila, President and CEO, the Global Risk Institute in Financial Services