Watson Wyatt Special Memoranda - English

 

On October 27, 2009 , Federal Minister of Finance Jim Flaherty released a plan for the reform of the legislative and regulatory framework governing federal private pension plans (Framework).

The Framework contains a range of proposals aimed at:

• Enhancing protection for members of defined benefit (DB) plans;
• Reducing volatility for DB plan sponsors;
• Assisting troubled pension plans;
• Providing a clearer framework for defined contribution (DC) plans and negotiated-cost DB plans; and
• Making technical amendments to the federal investment rules, the Income Tax Act (ITA) and the Pension Benefits Standards Act (PBSA).

While the majority of the proposals only affect federally regulated pension plans, the Framework’s content will undoubtedly attract attention from provincial governments as well. Alberta, British Columbia, Nova Scotia and Ontario are all in the process of looking at long-term pension reform, while Québec’s long-term reform measures are already coming into effect. In addition, some governments are developing proposals for a universal retirement savings plan, as well as programs to improve financial literacy.

The Framework was formulated following extensive consultations with stakeholders. In January 2009, Finance released a Discussion Paper, Strengthening the Legislative and Regulatory Framework for Private Pension Plans Subject to the Pension Benefits Standards Act, 1985, for review and comment. Following the release of the Discussion Paper, Ted Menzies (Parliamentary Secretary to the Minister of Finance) conducted a series of public and private consultations across Canada to obtain input on changes to the system regulating federal pension plans.

In formulating the Framework, the Federal government has attempted to consider the divergent demands of various stakeholders. While DB sponsors called for relaxation of the current funding rules, pensioners and unions sought measures to increase benefit security, and opposed many suggested changes to funding rules. The Framework represents an attempt to balance these competing interests; we evaluate below how successful the measures are at achieving this balance.

Measures to Increase Benefit Security

The Framework contains the following measures designed to increase benefit security for members of federally-regulated DB plans.

Institution of Full Funding on Wind-up

An employer will be required to fully fund any deficit that exists upon plan wind-up through amortization payments made to the plan over a maximum of five years.

The deficit will be considered an unsecured debt of the plan sponsor. This change addresses a risk of which many plan members may have been unaware: the PBSA is currently one of only two Canadian pension statutes (the other is Saskatchewan) that allow a financially healthy plan sponsor to terminate its DB pension plan and walk away from any deficit after making all payments that had come due as of the termination date (except where required otherwise by collective agreement or the plan terms).

The proposed introduction of full funding on wind-up will bring the PBSA into line with all pension jurisdictions except Saskatchewan, while providing some comfort to members of federally regulated plans. Many employers have regarded any requirement to fully fund benefits on wind-up as a quid pro quo for a relaxation of funding requirements such as moving to 10-year amortization of solvency deficits.

As this proposed change will apply retroactively (i.e., to benefits already earned by plan members), it is perhaps the most fundamental element of the Framework. With the move to full funding on wind-up, plan sponsors will now be committed to ensuring that the promised benefit will be paid, as opposed to their commitment under the current PBSA, which is merely to fund the benefit while the plan continues.

Enhanced Disclosure

The information provided in annual statements will be expanded to include items such as the plan’s total assets and liabilities and the total employer contributions made for the reporting year. In addition, disclosure requirements will be expanded to include other items such as an annual statement to former members and retirees with relevant information. Québec is the only other Canadian jurisdiction that currently requires this disclosure to inactive members of a plan. Electronic provision of disclosure requirements will also be permitted where the member has agreed to receive information through this medium. Note that all of the new annual disclosure items are already available to members and beneficiaries on request. It will be up to plan administrators to turn this statistical data into information that is meaningful to plan members.

Prohibition of Enhancements where Plan Falls Below Prescribed Solvency Standard

An amendment that increases liabilities will be considered void if it results in a solvency ratio below 0.85, unless the employer contributes up front to ensure that the amendment does not lower the solvency ratio. This change will have the greatest impact on a flat-rate defined benefit plan in which increases are negotiated with each collective bargaining agreement and, typically, funding then follows after the negotiated improvements are granted. This limitation may not be of great consequence at this time, since benefit improvements are not currently a top priority in most workplaces.

Limits on Contribution Holidays

The Framework proposes that a contribution holiday will only be available to the extent that plan assets exceed 105 percent of solvency liabilities. For mature pension plans where solvency liabilities exceed going concern liabilities, this new restriction on contribution holidays will make it more difficult to avoid overfunding while a DB plan continues in full operation. Plan administrators will need to review their investment strategies, and consider more closely aligning their evolving asset allocation with their solvency liabilities (a technique that falls under the umbrella of “liability-driven investing”) or taking advantage of the letter of credit (LOC) funding alternative discussed below to minimize the risk of overfunding.

Annual Valuations

Plan sponsors will be required to file a funding valuation report annually, even if the plan is in surplus. The result of this proposal will be that contributions or contribution holidays will be determined on a more up-to-date basis than under the current PBSA regime. The new annual valuation requirement is intended to address the situation where the funded status of the plan has deteriorated, and yet the contributions (if any) are still being determined based on information that is up to three years out of date. This will be welcome news to plan members.

Elimination of Sponsor-declared Partial Wind-ups

The Framework eliminates the ability of a plan sponsor to declare the partial termination of a federally regulated pension plan. This elimination could be seen as an improvement to benefit security for members under the current PBSA rules which permit an employer to cease funding for a partial wind-up group following a partial termination, even though employers have rarely exercised this right. Employers will now be required to fully fund a deficit on a full or partial wind-up, so this concern no longer seems valid. Further, partial wind-ups will not be eliminated entirely, as the Superintendent will retain the right to declare partial wind-ups. It is unclear why the Framework does not entirely eliminate the concept of partial wind-ups.

Adoption of Immediate Vesting

The current two-year vesting rules will be eliminated and replaced with immediate vesting. The requirement for locking-in vested pensions would remain at two years of plan membership. With this proposal, the federal government will join Québec in providing for immediate vesting. A plan sponsor with high turnover rates for short-service employees may decide to revisit eligibility requirements, and impose a waiting period before its employees can join the pension plan.

The implementation of immediate vesting has often been cited as a reasonable trade-off in exchange for the complete elimination of partial wind-ups. However, as mentioned above, the Framework leaves the Superintendent with the power to order a partial wind-up.

Missing Proposals

There are a number of items absent from the Framework, which could have helped improve benefit security had they been included - either by encouraging the employer to contribute more to the plan or by improving the priority on bankruptcy.

Priority on Bankruptcy

The Framework contained no proposed changes to the priority scheme in either the Bankruptcy and Insolvency Act (BIA) or the Companies’ Creditors Arrangements Act (CCAA) to the benefit of plan members of underfunded plans, who currently rank as unsecured creditors. While Minister Flaherty has indicated a willingness to examine this issue, any change to the BIA or CCAA would likely be extremely unpopular with secured creditors as it would reduce the amount of money they can recover following the bankruptcy of an employer with a pension plan in deficit. Not only would this make secured credit either more expensive or unavailable for sponsors of large DB plans in the future, but it would be tantamount to a retroactive change to the quality of covenants that are already in place.

The federal New Democratic Party is attempting to address this issue through the recent introduction of a Private Member’s Bill (Bill C-476) that proposes to amend the BIA and CCAA to make the liabilities of unfunded pension plans secure debts in the event of bankruptcy proceedings. Bill C-476 also proposes amending the Canada Business Corporations Act to provide a procedure through which former employees of a bankrupt corporation can proceed with claims against the corporation’s directors for amounts owed to them.

Pension Security Funds

The use of a pension security fund (PSF), recommended in the report of the Alberta-British Columbia Joint Expert Panel on Pension Standards (JEPPS Report), would provide another tool to an employer that wants to contain the possibility of a surplus that would be trapped in the pension fund. A PSF is a tax-sheltered, creditor-protected fund that an employer could establish separate from the regular pension fund, to hold solvency contributions that exceed going concern contributions – if no longer required for funding the DB promise in later years, the sponsor could remove monies from the PSF without impediment, and include the refund in its taxable income. A PSF would be an option in situations where an LOC is not feasible.

Ring-Fencing

The matter of pension surplus ownership is often a very contentious one, with case law evolving in a way that many plan sponsors did not expect or contemplate. One reason for underfunding of pension plans is the unwillingness on the part of many plan sponsors to make more than the minimum contribution when there is a material risk that extra funding margins cannot be returned to them once it is established that they were unnecessary (i.e., once they become surplus).

It would be helpful to plan sponsors if the federal government would provide mechanisms such as the “ring-fencing” proposals contained in the JEPPS Report as a way to contain the surplus that would be subject to the current rules and allow for a clear statement of ownership regarding future surplus within existing pension plans. Ring-fencing offers a method of addressing plans where an employer’s entitlement to surplus is unclear, and allows an employer to freeze an existing plan and establish a new plan to wrap around the frozen plan. The two plans are treated as a package for purposes of the benefits payable to the members, but the new plan will give the sponsor clear entitlement to surplus that arises in that plan.

Risk-Sharing

Recent discussions of pension reform have highlighted the need for a middle ground between pure DB pension plans and pure savings plans, whereby investment and other risks are shared amongst plan members, between generations of plan members, and between employers and employees. While the Framework proposes to clarify rules for negotiated-cost plans (as outlined later in this article), they will only apply to negotiated plans subject to collectively bargained agreements. There is no mention of allowing innovative designs that contemplate different ways of distributing risks and governance amongst stakeholders. An example would be a negotiated-cost plan in a non-bargained setting (otherwise known as a target benefit plan), whereby the expected pension benefit is expressed as a DB formula, but the employer’s obligation to contribute is specified like a DC plan, and the accrued DB pensions in an ongoing plan may, or in some circumstances must, be reduced if a deficit is emerging. This is a glaring omission from the Framework.

Measures to Reduce Volatility for DB Plan Sponsors

The current federal funding rules require the amortization of solvency deficiencies over a five-year period. On more than one occasion in the past decade, we have seen this requirement impose almost crippling cash flow restrictions on plan sponsors. Federally regulated plans were provided with temporary funding relief in 2006 and again in 2009. Each of these federal relief packages allows an employer to move from a five-year to a 10-year amortization schedule if they obtain either a letter of credit or member consent to support the increased amortization period.

In an attempt to permanently reduce contribution volatility going forward, the Framework proposes a number of changes:

• Increase the ITA surplus threshold: The surplus threshold (the level where an employer must stop contributing to the plan) will be increased from 10 percent to 25 percent of going concern liabilities. This change will apply in respect of employer contributions relating to current service costs for 2010 and subsequent years. Considering the overall regulatory regime that will be in place after all these reforms are approved, it is unlikely that most sponsors of single employer DB plans will be looking to contribute up to this higher surplus threshold. Nevertheless, the existing 10 percent threshold has proven to be an impediment to benefit security. This change will apply to all plans registered across Canada, not just those registered federally, and will also include designated plans for senior executives and shareholders. In addition, the change will replace the 2007 dispensation for jointly funded DB plans, which had allowed a graduated threshold up to 25 percent of liabilities.
• Letters Of Credit (LOCs) to cover solvency special payments: Sponsors can use “properly structured” LOCs to satisfy solvency payments up to 15 percent of plan assets. The Framework does not provide any details about the rules that will govern the use of LOCs, which will presumably be addressed in forthcoming legislation and/or regulations. In order to enable the use of LOCs to guarantee solvency contributions for a pension fund without placing either an undue burden on plan sponsors or posing undue risk to plan members, upcoming rules should contain a number of requirements. For example, the rules should take account of existing LOC amounts for the purpose of determining the need for further special payments; and the employer should also be allowed to reduce or eliminate the amount of the LOC to the extent that additional contributions are made to the pension fund.
• New solvency funding rules: The federal government is proposing a new funding standard that will establish minimum funding requirements based on the average of solvency ratios over three years, using the market value of plan assets. Special payments due in a year will be established based on a five-year amortization period, but a fresh start will be allowed each year. This “rolling five year fresh start” amortization, combined with the ability to use LOCs, has definite attractions to plan sponsors, as discussed below. However, the ultimate effect, and appeal, of this proposal will depend on the details and the transition rules that will be required to move from the current regime over the coming three or four years. These details, some of which are discussed below, can make all the difference between a package that is regarded by sponsors as reasonably balanced and one that leads them to move away from DB plan sponsorship.

In general terms, given a particular solvency deficit at the inception of the new rules, the “rolling five year fresh start” amortization initially results in less onerous contribution requirements than the current rules which amortize deficiencies with five equal payments, but more onerous contribution requirements in the early years than the 10-year amortization requested by many employers. This is illustrated in Figure 1 below:

Figure 1: Comparing straight line amortization to the proposed rolling fresh start

   

In this example, there is a solvency deficit of $1,000 as of December 31, 2009 , and we assume no future gains or losses. The annual special payments under the current rules would be $225 per year for five years, as illustrated by the blue bars. If all else were the same, the “rolling fresh start” concept in the Framework would result in the same payment for 2010 as under the current rules, but the remaining payments would be successively reduced, as illustrated by the yellow bars. That is, the deficit is amortized on a “declining balance” schedule rather than a “straight line” schedule. By 2013, the special payments under the proposed solvency funding rules would be lower than those based on the requested 10-year amortization, as illustrated by the maroon bars in Figure 1.

When this “rolling fresh start” is combined with a three-year averaging of the solvency ratios, the result, in most circumstances, will be a reduction in contribution volatility over the long term, compared to the current rules with five-year asset smoothing. For plan sponsors who have chosen investment strategies that link asset returns to solvency liabilities, smoothing solvency ratios can be much more effective than smoothing asset values in isolation.

The results of any comparison of projected contribution requirements in the short and medium term under the Framework against those under the current regime will depend on the final transition rules – the attractiveness of the proposed solvency funding rules to plan sponsors could vary significantly depending on how these rules unfold. Plan sponsors will need to model various alternatives and scenarios before they can judge the future regime.

If all contributions are made in cash, the current rules and the Framework proposals lead to comparable long-term funding levels, as well as a similar likelihood of surpluses becoming too large to be absorbed through contribution holidays alone. This risk of “runaway surplus” is reduced by the proposed declining balance amortization, but exacerbated by the inability to take contribution holidays until the solvency ratio reaches 105 percent. In addition, due to the averaging of solvency ratios, an employer may still have to contribute even if the most recent valuation showed a solvency surplus, depending on the details of the final regulations.

The ability to use LOCs to cover some or all of the solvency special payments will provide additional flexibility under the new rules for those plan sponsors who can obtain (and can afford) such coverage. When solvency contributions are covered through LOCs rather than cash, the likelihood of mature plans facing runaway surpluses can be contained.

Measures to Assist Troubled Plans

The Framework also states that the federal government will develop a scheme to assist sponsors of federally regulated plans that are unable to meet their near-term funding requirements. Under the scheme, sponsors, plan members and retirees of a distressed plan will be able to negotiate special funding arrangements to facilitate a plan restructuring. The government hopes this scheme will be used in “very limited circumstances.”

In order to apply for the scheme, a sponsor’s Board of Directors must issue a declaration that the sponsor does not anticipate being able to meet its upcoming special payment. Once it falls under the scheme, a plan sponsor will be eligible for a short moratorium on special payments, with representation provided for plan members, deferred vested members and retirees. Where a workplace is unionized, the bargaining agent would provide representation, while in non-unionized environments, and for retirees and other beneficiaries, the PBSA would provide for the appointment of a group representative. Member and retiree consent would also be required. The negotiated workout arrangement would also be subject to Ministerial approval.

Clarifying the Framework for DC and Negotiated-cost DB Plans

For DC plans, the Framework proposes revising the PBSA and Regulations to “provide clarity” regarding the responsibilities and accountabilities of affected parties. When making these clarifications, the Joint Forum of Financial Market Regulators’ Guidelines for Capital Accumulation Plans will be considered best practice. DC plans will also be exempted from the current requirement to adopt a Statement of Investment Policies and Practices. Finally, the Framework proposes permitting DC members (at the plan’s option) to receive LIF-style retirement benefits drawn directly from the member’s account.

The Framework also proposes formally articulating the rules governing negotiated-cost DB plans, particularly the fact that employer contributions are limited to the level set out in the applicable collective agreement. The rules will also set out the composition of the Board of Trustees (Board) to ensure the representation of all plan stakeholders. In addition, they will state that the Board has the authority to reduce accrued benefits, with the approval of the Superintendent, regardless of plan terms.

Technical Amendments

The Framework also proposes a number of technical amendments to the federal investment rules, the ITA and the PBSA. In terms of the investment rules, the Framework proposes:

• Removing the quantitative limits for resource and real property investments;
• Prohibiting direct self-investment; and
• Amending the 10 percent concentration limit to measure it against 10 percent of the market value of the fund’s assets, rather than the book value, in any one entity (note that an exception to this rule will be made for pooled investments where the employer does not exercise direct control).

The Framework contains a range of other proposed amendments to the PBSA. These include allowing the transfer of benefits due to members who cannot be located on plan termination to a central repository and expanding the powers of the Superintendent to intervene where “there are concerns about the work of a plan’s actuary.” Proposed technical amendments include:

• Restricting annuity purchases for an ongoing plan if it is underfunded to be consistent with the treatment of lump-sum benefit transfers;
• Removing the requirement for plans to report to the Superintendent on inflation adjustments made to pension benefits;
• Amending the definition of “former member” to ensure that members who have transferred to a new plan do not have a say in future surplus distributions from the original plan; and
• Requiring that pension plan contributions be remitted monthly rather than quarterly. 

Unanswered Questions

The actual impact of the Framework’s proposals may vary considerably depending on the circumstances of a particular pension plan. In determining the impact, there are questions about the Framework’s proposals, particularly those relating to the funding rules, which need to be addressed. These include:

• How will the three-year average solvency ratio be calculated in the first two years after the new rules have been implemented, particularly for those plans that have not been doing or filing annual valuations?
• How will previous special payments, plan improvements and LOC amounts be taken into account when determining the three-year average solvency ratio?
• Are special payments still required if the current year’s solvency ratio (on a market value basis) is greater than 100 percent but the average ratio is less than 100 percent?
• Will the existing special payment streams that resulted from the 2006 and 2009 temporary solvency relief measures, which have more than five years remaining in their amortization period, be grandfathered?
• With respect to the proposal that a contribution holiday will only be available where plan assets exceed 105 percent of solvency liabilities, how will LOC amounts be factored into the calculation of this 5% solvency margin?

Also, while it has yet to be confirmed, we expect that the goal is to have the new funding rules, once enacted, apply to valuations conducted on and after December 31, 2009. Regardless of the effective date, sponsors of federally regulated plans will require more details about the operation of the Framework’s proposals before determining their exact impact.

Conclusions

While the Framework’s proposed solvency rules seem likely to smooth out some of the volatility in employer contributions, the benefits may not be as immediate as many employers would have hoped. Sponsors might expect to incur more costs in complying with the additional disclosure requirements, immediate vesting and the requirement for annual valuations. There is also the potential for the proposed rules to force employers to continue solvency contributions in cases where the plan is fully solvent, though this might be mitigated by the use of LOCs.

Will the new rules be enough to stop employers from their gradual movement away from DB pension plans? The positive aspects of DB pension plans in terms of attraction, retention and workforce management may not be enough to counter-balance the perceived costs and risks imposed by DB pension plans even with the changes proposed by the Framework. While the new rules may slow the movement, they will likely not tip the scales. We expect that most sponsors will delay any decisions on future plan design changes until the rules are finalized. The ultimate impact of the Framework’s recommendations will likely depend on the content of the upcoming implementation details and rules.