Hard Lessons

The financial results of 2008 are hitting pension fund balance sheets, and they aren’t pretty. The most serious challenges arise when the plan sponsor is insolvent, but there are other difficulties that the pension industry can learn from.

Most severely affected by the crisis are those plans that entered 2008 with weak balance sheets. Not only do they have to deal with the financial collapse, they also began the year with deficiencies. Here are two valuable lessons learned.

Lesson No. 1: In good times, funding rules should require the funding of margins for adverse deviation to cushion against inevitable adversities. Pension reform panels across Canada have recommended the adoption of mandatory provisions for adverse deviation. The current crisis underlines the importance of having a positive margin.

Pension plans with heavy equity allocations are also suffering. Many plans maintain significant equity exposures to maximize returns. However, research has shown that equities can be risky for protracted periods of time.

Lesson No. 2: Asset allocation is about both return and risk. Those making risk/return decisions must be able to bear their consequences and not simply shift them to others. This is a tough lesson, and its implications will be manifold and difficult to accept.

When the sponsor of an underfunded plan becomes insolvent, the results of the underfunding must be addressed. However, since the sponsor cannot bear the consequences, the risk of loss shifts to plan members and retirees. In principle, this outcome can be avoided by constraining the risks that plan sponsors take, “insuring” the risk of sponsor insolvency or sharing the risk-taking decision with those members who may ultimately bear the consequences.

With these lessons in mind, how do we deal with the widespread funding difficulties today?

While the current crisis has affected all defined benefit pension plans, not all of them require the same degree of relief. Indeed, it would be a mistake to restrict the response to this crisis to a one-size-fits-all set of provisions.

In the most severe cases, pension funding reforms—which require multi-stakeholder discussions and a custom response—are developed in the context of a court-supervised or out-of-court insolvency proceeding. In the cases of Air Canada and Stelco, for example, special regulatory provisions were adopted for pension relief but, at the same time, significant concessions were made by other stakeholders to create a viable post-restructuring business entity. In these situations, pension funding is a significant issue for the plan sponsor, but not the only one.

It is difficult to apply a generalized pension funding solution to these cases. Rather, the worst cases of plan sponsor insolvency require a process solution—one in which pension stakeholders, pension regulators and governments participate along with other corporate stakeholders, all of which recognize that they cannot solve a corporate insolvency problem simply with pension relief.

In between the least and most serious cases, there will be a number of plan sponsors requiring some measure of pension funding relief. One solution is to create a permissive regime, as the federal and Ontario governments have proposed, that would provide for member consent to funding relief (i.e., 10-year solvency amortization). Through the mechanism of consent, members would have a say in the additional risk they’re being asked to assume and would also have an ability to consider the degree of relief that is necessary.

These aren’t easy measures, but these aren’t easy times. The private pension system is under tremendous stress, and the current round of reforms may well determine whether or not it survives. If private pensions cannot deliver secure benefits for working Canadians, then plan sponsors and members will expect the industry to move on and look at more far-reaching reforms.

Murray Gold is a partner with Koskie Minsky LLP in Toronto.
mgold@kmlaw.ca

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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the July 2009 edition of BENEFITS CANADA magazine.