Yesterday the Globe and Mail had a story about how the wealth of Canadian households had rebounded last quarter, after declines for most of the last year. While this is seen as positive news in regards to our economic health, I believe there’s an important element the report leaves out – wealth of Canadian households by age-group. My hunch is that older Canadians got a fair bit wealthier during this time period, but younger Canadians – on aggregate – treaded water while lurching into ever-greater debt. And it is this group of Canadians that I’m concerned about.

The reason I started thinking about this was simple. The article presents two key facts:

1. The resulting increase in the value of household financial assets (including shares, mutual funds, and pension assets) was the principal factor behind the rise in household net worth.

2. The use of credit also rose more quickly in the quarter, with notable borrowing for mortgages as resale housing markets picked up.

Now the argument is that, on aggregate, the increase in #1 more than offset the increase in #2. But think about it in terms of age-groups. The increase in the value of household financial assets (shares, mutual funds, etc.) flows disproportionately to older Canadians. After all, on average they have far more invested than younger Canadians. In contrast, the increased use of credit (i.e. getting mortgages) is likely driven by younger Canadians – more likely to be buying their first home, upgrading, etc.

So while it’s all fine and good to say that, overall, household debt and a percentage of net worth decreased in the quarter (good news!), what I’d really like to see is this broken out by age group. My hunch is that household debt as a percentage of net worth for older Canadians declined by a fair bit, while the household debt as a percentage of net worth for younger Canadians might have even increased.

Why this matters is because debt as a percentage of net worth as a good indicator of the risk our economy is facing – particularly if interest rates start to rise (which Garth Turner, among others, believes is absolutely going to happen) again someday. If- and again I say if because it’s just a hunch – we’re in a situation where the younger Canadians are racking up huge piles of debt to buy houses and things, and in general they have very few other financial assets, this “rebound in wealth” might be a bit of an illusion. And if it is an illusion created by nothing other than the dramatic decline in interest rates, we have more than a few data points from recent history indicating that it will not end well.

Today yet another report came out saying that Canada is facing a long-term pension funding crisis – particularly for defined benefit pension plans. Much of the blame is being placed on the market downturn over the last year. But the reality of this problem is that it is much, much bigger than the recent market declines would imply.

In order to explain why, it is best to start at the top – the very best defined benefit pension plan in Canada. That would be the Ontario Teacher’s Pension Plan (OTPP), which has long been the best managed plan, while simultaneously earning the best investment returns. Any problems they might be having, other pension plans will be having in spades – there is simply no way around it.

The OTPP has been having a lot of problems. And while the plan itself has been remarkably open in reporting the problems that they do face, most people probably don’t realize how big they are, because there are certain groups of people that do a lot of work to bury the real story as much as possible.

What’s below is my first crack at getting to that real story – it takes a while to read, but I think it’s worth it. Short version: if you really believe the OTPP has a funding deficit of only $2.5 Billion right now, I’ve got a sub-prime mortgage investment to sell you for face value. The reality is about 10 x bigger, and getting worse. And as future posts will cover, the “real reality” for most other pension plans, including the CPP, is likely far worse than that, once you eliminate all the funding valuation gimmicks.

So if you go back to 2001, the OTPP was reporting that it was fully funded – more than enough assets to pay for all their future liabilities. If you look at the “2009 funding valuation”, the plan “officially” (more on this later) shows a $2.5 Billion shortfall, which they say is likely to grow. Now that might not look to bad – after all, $2.5 Billion isn’t THAT much in comparison to their $87 Billion in assets. However, where this becomes interesting, and where the scope of the problem starts becoming clearer, is when you open up the OTPP’s 2005 funding valuation report.

If someone told you the plan was fully funded in 2001, and had a $2.5 Billion shortfall in 2009, what would you guess the shortfall would have been in 2005? Something around $1 B would probably make sense to most people. But what was the actual number? Well that would be $21.8 Billion. Kind of stands out against the other two numbers, doesn’t it?

So how did this happen? How did the OTPP go from being fully funded, to a $21.8 billion deficit, and back to a $2.5 Billion deficit, in 8 years? And how is it that in 2005, in the midst of boom times in the market, the OTPP suddenly faced such a massive deficit, even while their portfolio returns were high? It all sounds kind of fishy, non?

Well let’s start with the latter question, which shows just how crazy these “pension funding” reports are. Historically, the OTPP had been using a real-return assumption (expected investment returns, after-inflation) of 4.1%. This is what they expected to earn every year, for about 75 years. In 2005, they lowered this to 2.5%. That change – from 4.1% to 2.5% – explains almost the entire deficit.

The reason they did it was because real interest rates had declined so much, and weren’t expected to pop back up. It’s too much detail to go into on this post, but lowering the return expectation made TOTAL sense. What followed did not.

Now I remember watching this closely when the report came out in 2005, and the way the Ontario Government and Ontario Teacher’s Federation (OTF) managed to sweep the problem under the rug involved using tactics that would make the most aggressive Ponzi Scheme Hedge Fund manager in the world blush a little. They unilaterally changed dates, increased expected returns to absurd levels, and did all kinds of other crazy things that had absolutely nothing to do with actually helping solve the problem. But I’ll also write about those details some other time.

What matters more now is what they actually did. The OTPP represents many teachers in or nearing retirement, and a whole bunch of young ones. So in order to “solve” the problem, what they decided was that young teachers would have to pay more into the plan (with the government matching, of course – your tax dollars at work!), and that young teachers would give up half of their inflation indexing for future service. They then used some convoluted logic to determine this meant future return estimates could be higher.

But regardless of this latter point, you will notice that the key word in both of those “solutions” was “young”. Older teachers, and retired ones (i.e. the ones pulling money out of the plan), basically gave up nothing. The entire shortfall is being funded out of the pockets of younger ones, tied to future service. In short, younger teachers will pay in more, and get less. That was the negotiation.

Doesn’t really sound fair, does it? Well, it gets much worse. If you read the 2008 valuation report, there are some very, very funny sounding little tidbits in there. Here is my favorite:

The projection includes the cost of pensions for current members, but does not include the cost of benefits for teachers who are expected to be hired in the future.

How interesting. Might one jump to the conclusion from this that teachers hired in the future might not be included in the pension plan someday soon? It’s enough to make you want to jump over and read the other details behind the 2008 report. It’s got some other interesting stuff that jumps off the page. Such as the fact that the OTPP actually projected a $12.7 Billion shortfall at the start of 2008, not $2.5 Billion.

So how did they get from $12.7 Billion to $2.5 Billion? Well just like in 2005, people decided to play with the return assumption. The OTPP leadership thought that “real interest rate + 1%” made sense. For the valuation, this was increased to “real interest rate + 1.5%”. That 0.5% makes up the majority of the difference, allowing them to “eliminate” most of the deficit.

Why did they do this, and what’s their plan for return assumptions going forward you might ask? Well let me quote the report:

The funding valuation now uses an assumption based on the real interest rate plus a premium of either 0.5% or 1.4%. The Funding Management Policy calls for the lower basis (0.5%) when the plan is in a strong financial position, and has the effect of enabling the plan to build up an asset cushion in good times. The policy calls for the higher basis (1.4%) when the plan’s finances are weaker, and has the effect of enabling the plan to keep contributions and benefits stable in less favourable times. Previously, the assumption was based on the real interest rate plus either 0.5% or 1.0%.

How nice. So “before”, the assumption was real interest rate + 0.5% or + 1%. You use the lower one when times are good – theoretically of course, because when times were good they used a MUCH higher one. But if the plan finds itself in a weak financial position, you just increase the return expectation to +1.4%, and problem solved! As long as things are bad, returns must keep getting better, right? RIGHT? Assuming bigger returns from the start of 2008 on is just prudent!

Well, as we all now know, WRONG. We’ve had a wee bit of a market crash. In 2008, the OTPP lost 18% – versus a loss of 9.6% for the composite benchmark. Why does this matter? Well, let’s quote the site again:

If we had recognized all of our 2008 losses immediately, our projected funding shortfall would be about $22 billion as of Jan. 1, 2009.

So… here we are. As of January 2009, if you actually look at what the OTPP has, the funding shortfall is actually $22 Billion. Not $2.5 Billion as widely reported, or even the $12.5 Billion you can find in the funding valuation report, or any of the other fictitious numbers floating around out there. And it’s $22 billion even though they already decided to ramp up contributions for working teachers again. And the only way they closed the funding shortfall in 2008 was through the conditional inflation indexing, which allowed them to increase expected returns… right before they took a massive loss.

Kind of sounds like a house of cards, doesn’t it? Well, it likely is. At the end of the day, the OTPP continues to effectively hide funding shortfalls, while asking young teachers to pay in more, and agree to take back less, while never actually scaling back anything for older and retired teachers, which, of course, are the ones taking money out of the fund. That’s not solving a problem, it’s delaying a problem – and making it worse. Someday, those younger teachers are going to figure out that, if this continues, there isn’t going to be much left for them. But older teachers will be already retired, with a government promise that their benefits are protected. Taxpayers, already making a startling high matching contribution for the plan, might have a problem paying in ever-more. Then, things might get ugly.

It’s quite simple really – the real funding shortfall in 2005 was about $22 Billion. They increased contribution rates, and implemented conditional inflation indexing for future service, to deal with it. The real shortfall in 2009 is… about $22 Billion. In both cases, this was openly reported in the funding valuation. In both cases, some fancy looking stuff made the “official” report much smaller. See a pattern here?

So fine you might say- I’m not a teacher, I don’t care. But let’s go  back to my original point – the OTPP has long been the BEST run, best managed, best everything pension plan in Canada. If I had to bet, I’d say it still is. If they’re facing all of these issues, how do you think the other defined benefit pension plans are ACTUALLY doing – such as the CPP? You know, the real grand daddy of all the defined benefit pension plans, and the one that every working Canadian is supposed to be able to count on?

When I looked at them in 2005, the games they were playing with their funding valuation reports were even more aggressive than what the Ontario Government and OTF was doing with the OTPP. And they haven’t even with through the mirage of making people pay in more (again), etc., and pretending that fixes things. Maybe it’s time to take another look at them, because something doesn’t smell right…