Unfunded liabilities - Part 1
Canada faces a huge unfunded liabilities problem, one that has already started to cause major concerns on the healthcare front. This article is the first in a series that will explain what unfunded liabilities are, how they came to be, how pervasive they are and possible solutions.
Before addressing the unfunded component of the issue, let’s first understand what a liability is.
A liability is a future debt or performance obligation that one party owes to another at some future date in time. It is commonly settled through a payment or performance of a service. An example of debt is a mortgage. The homeowner borrows money from the bank and settles the liability by repaying the amount borrowed, with interest, over several years. An example of a performance obligation is the government promising to deliver healthcare to its citizens when they need it.
Now, an unfunded liability is used to describe any liability where future revenues together with savings and future investment income on those savings will be insufficient to pay for future costs. It can be calculated by determining the difference, at any point in time, by which future payment obligations exceed the expected future stream of funding.
Let me give a simplified example taken from the life insurance industry where I spend my entire career. As you probably know, many life insurance products have level premiums payable for the duration of the contract even though the probably of dying increases every year. The imbalance between premiums and claims looks like this:
In the early years, premiums received exceed the claims paid, while later the opposite happens when claims exceed the premiums paid. In the insurance world, actuaries calculate the amount that needs to be set aside during the early years such that it, together with future investment returns that it will generate, will be sufficient to make up future deficits. It would be completely inappropriate for insurance companies to spend the early positive cashflows since doing so would render them unable to pay future claims in full unless they started to use the premiums paid by future policyholders to pay for the claims of the existing ones. But by law, insurance companies cannot have unfunded liabilities and are forbidden from acting that way. As we will see, this last statement is key as governments operate outside this constraint reserving themselves the right to kick the can down the road for as long as possible.
The technical definition of a Ponzi scheme is that it is a fraudulent investing scam which generates returns for earlier investors with money taken from later investors. While government programs such as healthcare, CPP, OAS and GIS are not investing schemes, they are nonetheless run like Ponzi schemes because earlier recipients are in part funded by later taxpayers. As we will see in later articles, this is the root cause of many of the problems we are starting to face.