A quick note on pension plans and contract workers

Some random thoughts…

Often, companies seek to hire contractors or non-permanent staff.  This could be for a number of reasons, and by a number of means, such as “outsourcing work, hiring through temp agencies, [and] classifying employees as independent contractors”1. Many of these decisions are very tactical in nature—i.e. myopic in their scope—and companies do not consider the long term ramifications of their decisions.

I am thinking of this within the context of pensions, specifically, (long term) (defined benefit) pension obligations. A DB plan has a certain value of long term liabilities, defined by their pension obligation (i.e. the money that must be paid to individuals when they retire and start collecting their pension). However, this long term obligation is funded by the pension contributions of current workers. But, if you start outsourcing work, or otherwise taking corners to have “non-permanent staff”, then you cannot charge those employees for pension contributions.

Example: Fred and Carl work for ABC Co. Moreover, ABC Co. has exactly one pensioner, Paul. Fred is a full time permanent employee, and as such is entitled to a pension, and makes pension contributions. To cut costs, ABC Co. has classified (i.e. hired) Carl as an independent contractor. In the short term, this means that they may be able to pay Carl a lower wage than Fred, they do not have to pay for his benefits, etc. Now, if we look at the total number of working employees (Fred and Carl) to the total number of pensioners, (Paul), the ratio of workers to pensioners is 2:1. However, if we look at the ratio of pensionable workers to pensioners, the ratio is only 1:1. This means that, if there are any additional funding requirements for our single pensioner (say, for example, Paul lives longer than expected), then Fred must absorb the full burden.

But, Fred can only absorb so much of the pension obligation. If he has to pay more out of his paycheque to contribute to the collection of investments which supports Paul’s pension, he eventually will quit and go somewhere else; there is a finite amount that the current membership (i.e. people who are working) can put into a company (i.e. as a percentage of their own wages), to contribute to the money used for investments for the pensions of the pensioners. From an asset (income stream from pensionable workers) to liability (payouts to pensioners) perspective, if the liabilities are more than the assets (i.e. we are paying out more than we are bringing in), then a pension is underfunded. So, by cutting corners with Carl (i.e. positioning him as a contractor so as to pay him less and/or not pay him benefits), you are saving money in the short term, but taking the wide-view, ABC Co. now has no way to match its liability to Paul!

These are just random thoughts, and the above example is very simplistic, but they lead to a very real question: Is the drive for short-term gains vis-à-vis lower fully-loaded human capital costs worth it, when considering the long term pain of pension obligations?

-pmp

Notes
  1. Too many Ontario workers exploited; laws need quick overhaul, study urges. The Toronto Star, 2015/03/31
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A quick note on pension plans and contract workers