So, in 1987, the Pension Benefits Act of Ontario was amended to require the funding of solvency deficits. This change was followed, with minor differences, by the other provincial pension jurisdictions. While different detailed rules applied to the determination of the assets and liabilities for purposes of understanding the solvency deficit, there was one common conceptual approach. Solvency deficits were settled by comparing the pension fund’s assets with the liabilities of the plan as if it were wound up on the date of the valuation. Any deficiency of assets below liabilities must be amortized over no more than five years.
Given that the mandates for the pension supervisory authorities included ensuring the security of earned pension benefits, it made some sense to make sure that plans were funded sufficiently well in order to provide for their liabilities if they were wound up. But it was not anticipated that the solvency calculation would become the driving force in determining minimum pension contributions, except possibly in the situation of negotiated flat dollar plans with significant early retirement subsidies.
VOLATILITY
Discount rates for solvency valuations have been in a downward trend since the solvency valuation was introduced. At the same time, discount rates for going-concern valuations (which are set as a conservative estimate of the expected pension fund return over a long time frame)have only dropped a little. As a result, virtually all plans have their minimum contribution determined using the solvency valuation. Because this valuation is based on changing market yields and any deficit needs to be paid off over a short period of time, minimum contributions can vary significantly from year to year. And, in the post-Monsanto environment where sponsors are concerned about over-contributing and thus creating surplus that would then need to be shared in the event of a partial plan windup, most sponsors contribute at minimum levels. The result is that pension contributions are very volatile.
It is legitimate to ask whether this volatility will cause or be a contributing factor in driving pension sponsors into bankruptcy, which would result in plan participants receiving less than their full pension promise. While there may be isolated circumstances of sponsor insolvencies, widespread insolvencies are unlikely. In looking at the 2005 financial statements of the 100 largest companies on the Toronto Stock Exchange, pension contributions(including defined contribution contributions)for half of those companies amounted to less than 5% of the cash that they generated from their operations. For three-quarters of those companies, pension contributions amounted to less than 13% of cash generated from their operations. So, for the vast majority of companies, pension contributions should not pose a problem. On the other hand, for 10% of the companies, pension contributions ate up more than 42% of the cash that they generated from their operations. These are the companies that the pension regulators are monitoring closely.
It is, of course, entirely appropriate to expect sponsors to pay for the pensions they promise to their employees. However, if the volatility of required contributions causes a financial health risk to plan sponsors(ironically, caused by the very system put in place to assure solvency), are there any actions that can be taken to bring relief?
SOLUTIONS
Three jurisdictions have proposed or implemented some form of relief through the use of Letters of Credit. Quebec and the federal government provided for temporary relief. Alberta proposed permanent relief, but has not yet passed enabling regulation. While the details differ, these measures allow for a Letter of Credit to be deposited into a pension fund instead of part or all of the contribution required to eliminate the solvency deficit. The advantage of using a Letter of Credit happens when the solvency deficit is eliminated as a result of good plan experience without needing to make additional cash contributions. In this situation, the Letter of Credit does not need to be renewed. If actual cash contributions had been made instead, surplus assets would exist in the pension fund. Letters of Credit are not a perfect solution. They still use up part of the available credit of the sponsor. Also, there is a cost to establish the letter of credit that varies with the credit-worthiness of the sponsor, but is generally in the range of 0.5% to 2% of the face value of the letter of credit each year.
From the broader perspective of the long-term economic health of plan sponsors, a better and more permanent solution would be to eliminate the requirement to distribute surplus in the event of a partial plan windup. The Monsanto case established this requirement for pension plans in Ontario, and several other jurisdictions have similarly worded legislation. In such a situation, the sponsor would be less averse to contributing more than the minimum requirement in order to achieve a smoother pattern of pension contributions. There would still be the potential issue of a large surplus being built up in a pension plan unable to be used in the short term. And there is also a question as to whether sponsors would actually make use of this approach to smoothing the pattern of pension contributions.
There may be another alternative. For example, is it possible to amend the legislation to have solvency contributions paid to a fund that is separate from the pension trust fund? That separate fund would need to be separate and apart from the employer in order to provide benefit security. Robust governance protocols would need to be developed, separate and different to some of the traditional trust law requirements that have formed the basis for many recent court decisions relating to Registered Pension Plans. Finally, if the separate fund ended up with more than enough money to provide for the solvency liability, the excess should be able to be withdrawn by the sponsor.
Is this a practical solution? Are there insurmountable barriers to amending legislation to accommodate this solution? These are unanswered questions at this point, but healthy debate is a precursor to implementing change. It looks like healthy debate will happen. The Ontario government has established the Expert Commission, and the federal government has appointed a cabinet minister responsible for retirement income. All stakeholders need to participate fully in both the debate and in moving forward to implement solutions appropriate for Canadians—including Canadian plan sponsors—in the market and workplace conditions of the 21st century.
Steve Bonnar is a principal with Towers Perrin in Toronto. steve.bonnar@towersperrin.com
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