The Price of Benefit Security

Presumably you would want to make sure that these individuals’ benefits are well covered by the assets of their DB plan. All other things being equal, you might want legislation to be written in such a way as to virtually guarantee a high level of benefit security. For example, you might want to have a government-run pension benefits guarantee fund, like Ontario’s Pension Benefits Guarantee Fund (PBGF). However, you would probably then get caught up in a dilemma as to whether the funding for that guarantee fund should be derived solely from all employers who sponsor a DB plan, or also perhaps from taxpayers if necessary.

Let’s step back from this member perspective and look at it from the perspective of a private sector plan sponsor. Naturally, the more sponsors have to contribute into their DB pension funds, the greater the amounts they are diverting from investing in other elements of their business, or, looked at another way, the more they might have to divert from other elements of the total compensation offering for their current employees.

Herein lies a problem—many of these plan sponsors are saying that they see a risk of some of that extra funding becoming “trapped capital” —money that is locked into the pension fund and can only be accessed by the employer over a long period of time, instead of being invested as new capital into their business.

If that private sector employer has the freedom to be able to change its DB plan—by reducing the benefits in some way, or moving to a cheaper defined contribution (DC) plan, or even winding up the DB plan—the employer may exercise that freedom. We have been seeing increasing numbers of employers make that decision over the course of many years.

Put simply, if you had the ability to resolve this dilemma once and for all, it may come down to a choice. You could increase benefit security for accrued pensions, and thereby run the risk of benefit accruals changing or being reduced in the future. Or you could maximize the chance of adequate benefit accruals being granted in future years, but at the risk of reduced benefit security for accrued pensions.

Here is the big question: is there any hope today of enhancing the adequacy of future DB accruals, or have we come to a point where in reality there is little hope? If there is indeed some hope, then how can we make that hope a reality, while still managing the critical issue of benefit security for accrued pensions going forward?

Quebec has created one solution to enhance benefit security, though a mandatory provision for adverse deviations (PfAD), whereby the funding of DB plans registered in that province will gradually be increased through various means such that a plan’s solvency funded ratio is equal to 100% plus the PfAD. Part or all of that PfAD may be covered by a letter of credit, which can be prohibitively expensive if the bank regards the plan sponsor as a moderate or significant credit risk—in fact, many plan sponsors cannot obtain one, in which case they have to find other ways to increase plan assets to that funding level.

Suppose you are in favour of a mandatory PfAD. How much should it be? It may well be related to how the plan’s asset mix matches the plan’s liabilities—the bigger the mismatch, the larger the PfAD. That actually will be Quebec’s approach. The trouble with that approach is that in reality the benefit security for plan members depends not only on the degree of the plan’s mismatch, but also on the financial strength of the employer, since even a poorly funded DB plan will still pay the promised benefits if the employer stays in business forever. Yet it is hard to conceive of a pension funding regime that depends on some measure of an employer’s financial strength.

However, PfADs have a distinct lack of appeal to many of those employers who have expressed concern about “trapped capital”. So what other ways exist to shore up the protection of accrued pensions that perhaps might be more palatable to private sector employers who want to continue accruing future DB pensions for their active plan members? There are several examples of potential solutions, each of which have pros and cons, and differing degrees of benefit security:

• As mentioned above, allow letters of credit instead of requiring actual contributions (Quebec, Alberta and the federal government have all accommodated this solution within their pension legislation).
• Prohibit benefit improvements if a pension plan has a solvency funded ratio below a certain level, as exists in some jurisdictions.
• Change the priorities by which the plan assets, upon wind up, are applied to different plan members (e.g., pensioners get the first tranche so that their full pensions are covered, and active members get whatever is left)—this was a more common approach in the distant past.
• Improve the priority given to pension deficits in the event of employer bankruptcy, via changes to the bankruptcy laws—recognizing, however, that banks and bondholders have expressed concerns about this idea, and it could increase the cost of credit for many businesses that sponsor a DB plan.
• Enhance Ontario’s PBGF, or in other jurisdictions introduce a guarantee fund—a number of employer groups have rejected this option, stating that (for example) it would mean that better funded plans would end up bearing the financial burden of deficits of poorly funded plans that are sponsored by employers who become bankrupt.
• Require more frequent actuarial valuations when solvency funded ratios are below a certain level, as is in place in some jurisdictions.

A more indirect way to address the issue is to improve the disclosure of a plan’s funded status to plan members, by disclosing more financial information in their annual pension statements to plan members and perhaps requiring for the first time that plan sponsors should publish their funding policy.

A more dramatic way might be to follow Quebec’s example and give plan members more say in the governance of their pension plan, as espoused by a number of unions and pensioner groups. However, if this means giving these plan members fiduciary responsibilities, that creates the challenge of requiring them to gain sufficient investment knowledge to be able to make critical decisions in the operation of the plan.

It can be seen that the best way forward is not at all obvious. Being one of the “expert advisors” to the Ontario Expert Commission on Pensions, I am not in a position to endorse any particular solution at this stage. Clearly, however, it is a question of finding the right balance.

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