Why Financial Strength Testing?
Current solvency relief solutions grant the same relief to all companies, whether the company is financially strong or on the brink of bankruptcy. Some jurisdictions are using letters of credit to manage this situation, but that’s not a solution for those who cannot secure a line of credit. The odds of getting any sort of relief certainly seem stacked against a lot of companies.
While it would be nice to have a simple one-size-fits-all solution, the reality is that DB pension plans and solvency funding are not simple. In the words of Albert Einstein “Everything should be made as simple as possible, but not one bit simpler.”
With this in mind, a regulatory framework that includes financial strength testing and a low, moderate, or high risk rating can help address some of that inherent complexity. It would support a more robust solvency relief solution, one that is based on current and company-specific information, helps meets the needs of the company, and protects plan members’ rights.
Low-risk company Companies in strong financial health, that is, with good cash flow and/or unencumbered assets on the balance sheet, can largely fix their own pension plan problems. Solvency relief could be achieved by legally assigning an unencumbered balance sheet asset to the pension fund. That asset would be subject to first charge on windup, and would not be considered part of the fund assets for ongoing valuations. Such low risk companies could also consider letters of credit, if they’re available to them.
The valuation credit would be the full market value of assets so pledged.
Medium-risk company These companies are financially healthy, except that periodic spikes in DB contributions can force unmanageable cash demands at times. Aside from this, there is little or no short-term risk of bankruptcy.
These companies would not have unencumbered balance sheet assets to assign to the pension plan. Solvency relief for them could be in the form of a simple extension of deficit run-off periods subject to ongoing monitoring to ensure the position of the company does not change significantly. Requiring quarterly sign off by the directors and the auditor, and an enforcement of the fiduciary responsibility, should be sufficient. Letters of credit can be considered. For additional security, restrictions on payments to shareholders should also be considered.
High-risk company These are companies that are more likely to go under than survive in the short-term even without considering any DB pension plan solvency funding contributions.
This is where an automatic extension of the deficit run-off period is worrisome. These companies are most at risk of bankruptcy – and their pension plans are also at risk of reduced benefits on a wind-up. This is when solvency standards are most useful, and we must be very careful not to implement change that weakens that level of protection.
Permanent solution for a High-risk company (All jurisdictions in Canada)
Proxy Pension Bankruptcy. Allow plan sponsors to amend plan rules to reduce accrued benefits on wind up to the level that can be afforded by the pension trust assets (and assigned assets) if the plan were to be wound up. This would be applied to companies likely to be declared insolvent in the current conditions. With members’ benefits subject to such a reduction, solvency funding has effectively been suspended.
In essence this is along the lines of U.S. Chapter 11 insolvency protection. To qualify for this relief, the following conditions are required:
• Employers must pass an insolvency test. The insolvency test is to confirm that there are no other options available to support the plan now.
• Unencumbered assets would have to be pledged to the plan and not used to prop up the company.
• There would be no return to shareholders (i.e. dividends or share buy-backs) until compliance with solvency funding is restored. Reasonable remuneration would be exempt from this condition.
• No accruals of DB benefits would be permitted during this period (but some level of defined contribution may be needed to ensure an ongoing workforce).
• Pension trust fund assets would be invested fully in bonds.
• The sponsor should also consider having assets allocated as individual defined contribution account balances.
