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Canadian Pacific Railway's Submission in Response to Finance Canada's Regulatory Framework for Federally Regulated Defined Benefit Pension Plans consultation:

Canadian Pacific Railway

Submission to the Department of Finance Canada

In Response to its May 2005 Defined Benefit Pension Plan Consultation Paper

September 2005


Table of Contents

1. Introduction

2. Background

3. CPR's Concerns with Current Legislative and Regulatory Framework for DB Pension Plans

4. CPR's Proposals for Changes in Legislative and Regulatory Framework for DB Pension Plans

5. Summary

Appendices:

A. Summary of CPR's Views on those Issues for which Finance is Seeking Canadians' Views

B. Government of Canada Long-Term Bond Yield History

C  Extract from Association of Canadian Pension Management's August 2005 Report Entitled "Back from the Brink: Securing the Future of Defined Benefit Pension Plans" – Proposal for Use of Letters of Credit to Meet Solvency Deficit Contribution Requirements for Registered Pension Plans


1. INTRODUCTION

Canadian Pacific Railway welcomes the opportunity to make this submission to the Department of Finance Canada in response to the Department's May 2005 consultation paper entitled "Strengthening the Legislative and Regulatory Framework for Defined Benefit Pension Plans Registered under the Pension Benefits Standards Act, 1985".

CPR supports the Department's initiative to seek the views of Canadians on key pension issues, specifically on how to ensure the viability of defined benefit (DB) pension plans. In addition, we recognize the need to balance the interests and incentives of plan sponsors and plan members in ensuring the viability of DB plans while having regard to benefit security.

CPR believes that the current legislative and regulatory framework for defined benefit pension plans jeopardizes the viability of DB pension plans. Specifically:

  • the onerous and volatile cash contributions associated with 5-year solvency funding, particularly in a low interest rate environment; and
  • the risk/reward asymmetry in the current DB pension system.

CPR has been involved in dialogue with the federal and provincial governments on the need for change to the legislative and regulatory framework for DB pension plans. We believe that there are practical changes to the existing framework that would better ensure the viability of the DB pension system without adversely impacting benefit security.

We are also sharing our views on the need for change with the various unions that represent our employees, and are providing our unions with a copy of this submission.

The body of this submission addresses the current DB pension system from CPR's perspective, and our recommendations for change. Appendix A sets out, in tabular form, CPR's views on each of the questions raised in Finance's consultation paper.

CPR looks forward to the opportunity to continue our dialogue with Finance.

2. BACKGROUND

A. About Canadian Pacific Railway

Canadian Pacific Railway is a transcontinental carrier operating in Canada and the U.S. We have been in continuous operation since 1885 and have been one of Canada's largest employers during our history. Our 14,000-mile rail network serves the principal centres of Canada, from Montreal to Vancouver, and the U.S. Northeast and Midwest regions. CPR feeds directly into America's heartland from the East and West coasts. Alliances with other carriers extend our market reach throughout the U.S. and into Mexico.

CPR's business is very capital-intensive. We annually spend approximately $750 million to sustain our network and provide for our base business needs – these investments equate to about 16% of our annual revenues. In addition, CPR is investing an incremental $160 million in 2005 in a major expansion of the track network in our western corridor, representing the first phase of a capacity expansion program that, if fully implemented, will have total projected incremental investment costs of approximately $500 million over the next four to five years.

B. About CPR's Pension Plans for Canadian Employees

CPR has a single defined benefit pension plan that both covers over 90% of our 14,000 Canadian employees and provides pensions to 23,000 retired employees and their survivors. All of our Canadian unionized employees participate in this plan, while non-union employees have a choice to participate in either the defined benefit plan or a defined contribution plan (with about two-thirds of the non-union employees in the DB plan).

Our DB pension plan is one of the largest corporate plans in Canada, with assets in excess of $6 billion.

As per our DB plan's most recent actuarial valuation, as of January 1, 2005, the plan has a going-concern surplus, while it is approximately 95% funded on a solvency basis.

The plan's solvency deficit at the present time is the result of the decline in long-term interest rates to their lowest levels in almost half a century, as illustrated in Appendix B. If, on the other hand, long-term interest rates today were to increase by just 1% above their January 1, 2005 levels, we would expect the plan to return to a solvency surplus without any additional solvency contributions.

CPR is taking a very responsible approach to funding its solvency deficit, as evidenced by the following:

  • CPR contributed $355 million to the plan in 2003, including a $300 million prepayment of solvency contributions projected for future years.
  • CPR contributed $157 million to the plan in 2004, including almost $100 million towards the plan's solvency deficit.

CPR expects to make significant solvency contributions to its pension plan in 2005 and future years, despite the fact that the plan has a going-concern surplus as at January 1, 2005.

3. CPR'S CONCERNS WITH CURRENT LEGISLATIVE AND REGULATORY FRAMEWORK FOR DB PENSION PLANS

A. Solvency deficit amortization period

The current 5-year solvency deficit amortization period:

  • Imposes onerous and volatile cash demands on companies
  • Drives available cash flow to pension funding rather than to plant, property or equipment investments that would make companies healthier and improve their ability to support pension plans
  • May lead to compensation cost cutting in other areas to support increased pension funding costs
  • May lead to accelerated movement from DB to DC plans, leaving DB plans vulnerable

For CPR, the decline in long-term interest rates has led to significant cash demands for pension funding, owing to the sensitivity of our pension plan's solvency funded position to changes in long-term interest rates. For example, a 1% decrease in long-term interest rates increases the plan's solvency deficit by approximately $500 million – this amount must be funded over 5 years under the current regulations. Further deterioration in long-term interest rates may have detrimental effects on our investments in our core business.

The current and potential demands on CPR's cash flow for pension funding has the following implications to CPR:

  • May reduce infrastructure investment plans to increase the capacity of our network to meet Canada's growing demand for transportation of goods.
  • Will have an effect on our maintaining a competitive position within the North American rail and truck transportation sector as such demands on our cash flow have a significant impact on our cost structure.
  • May constrain a potential improvement in CPR's credit rating, with the result that our borrowing costs remain at a higher level than necessary. This is evidenced by the following excerpts from recent Standard & Poor's reports:

"In other cases, required pension funding has acted as a constraint on potential credit improvement. Canadian Pacific Railway Co. (CPR) has had to materially increase its pension contribution over the past two years – potentially preventing this cash from being used for other uses, such as debt repayment. CPR's continuing pension deficit and unfunded benefit obligations continue to act as a constraint to the ratings on the company, which has offset its good operating performance through the past couple of years."

[1]

"Weaknesses: Large pension obligations sensitive to interest rates and asset returns"

[2]

"Outlook: The outlook is stable. Standard & Poor's Ratings Services expects that CPR's consistent earnings will provide the foundation to maintain the current ratings, despite lingering concerns about its unfunded postretirement obligations. Materially improved margins could lead to a positive outlook, provided there is no significant. growth in unfunded postretirement obligations."

[2]

Longer solvency amortization periods would partially address contribution requirement concerns under the current DB pension system.

B. Risk/reward asymmetry in current DB pension system

With plan sponsors obligated to fully fund over a 5-year period the solvency deficits that have arisen in this low interest rate environment, we project that many DB plans will have significant surpluses in a few years' time, if long-term interest rates return to more normal historical levels. Surpluses may also arise if future equity markets are more favourable. Any such surpluses will prove previous solvency contributions to have been unnecessary to secure members' pension benefits.

Under the current legislative/regulatory environment, surpluses can be used for employer current service costs, but any excess is largely trapped. CPR believes that this risk/reward asymmetry is detrimental to the long-term viability of DB pension plans in the Canadian private sector.

As context for CPR, if long bond yields were to increase by 1% after we have fully funded our solvency deficit, the result would be to increase our plan's solvency surplus by about $500 million – or about nine times CPR's annual current service cost.

4. CPR'S PROPOSALS FOR CHANGES IN LEGISLATIVE AND REGULATORY FRAMEWORK FOR DB PENSION PLANS

CPR recommends that the Department of Finance Canada proceed with the following key changes to the regulations to the Pension Benefits Standards Act:

  • Extend the solvency amortization period for investment-grade companies to a minimum of 10 years, with such extension applying to both existing and future solvency deficits.
  • Permit plan sponsors to utilize letters of credit in lieu of some or all of their required solvency contributions. The letters of credit must remain in effect as long as the contributions remain unpaid or, if earlier, until the pension plan has a solvency surplus1.

CPR's proposed terms governing the use of letters of credit are as set out in Attachment 1 of the Association of Canadian Pension Management's August 2005 report entitled "Back from the Brink: Securing the Future of Defined Benefit Pension Plans". Appendix C of this submission contains this attachment to the ACPM report.

The proposed extension of the solvency amortization period for investment-grade companies will both:

  • address the large solvency contribution requirements that have arisen as long-term interest rates have reached record lows; and
  • reduce the volatility of solvency contribution requirements in future.

The use of letters of credit with the proposed terms has the following advantages:

  • The rate at which pension benefits are secured would be no different than if cash were contributed to the pension plan. It is a secure option for plan sponsors to deal with both the high level of solvency contributions in the current low interest rate environment and the volatility of solvency contributions.
  • By permitting the non-renewal of the letters of credit if the pension plan has a solvency surplus, this proposal may reduce the growth of excessive surplus in the future. It is a significant consideration in the current asymmetrical environment.

5. SUMMARY

CPR believes that the current legislative and regulatory framework for DB pension plans jeopardizes the viability of DB pension plans. We have set out in our submission some practical solutions that will go a long way towards ensuring the viability of the DB pension system without adversely impacting plan members' benefit security.

CPR believes that all pension plan stakeholders – plan sponsors, members, unions and governments – must work together for solutions that will improve the long-term health of the DB pension system while ensuring members' benefits are secure. We have welcomed the opportunity to make this submission to the Department of Finance Canada, and we look forward to continuing our dialogue with Finance and other pension plan stakeholders on this important matter.


Appendix A

SUMMARY OF CPR'S VIEWS ON THOSE ISSUES FOR WHICH FINANCE IS SEEKING CANADIANS' VIEWS


ISSUES IDENTIFIED IN FINANCE'S CONSULTATION PAPER CPR'S VIEWS

A. Surplus 
Disincentives/obstacles preventing plan sponsors from adequately funding their plans and building up a funding cushion, including:  
10% excess surplus limit No issues with the current limit.
Surplus ownership asymmetry: negotiated and non-negotiated plans It is inappropriate for plan sponsors to bear the current solvency contribution risks in an environment where such contributions may subsequently become "trapped capital". In addition, in the current environment, plan sponsors are, and will continue to be, reluctant to contribute more than the minimum required to the pension fund.
Partial termination surplus entitlements The prospect of having to distribute a portion of the plan's surplus to those members who are included in a partial plan termination (if the plan has a solvency surplus at that time) is a further disincentive to contributing more than the minimum required.
Current dispute settlement mechanism for surplus distribution The current mechanism is not equitable to plan sponsors. This mechanism does not appropriately address the asymmetry in the current system.
Whether there should be partial plan terminations and, if so, whether there should be a requirement to distribute surplus at time of partial termination Surplus should not be distributed at time of partial plan termination to those members included in the partial termination.

Giving partial plan termination members a contingent right to any surplus distribution on full plan termination leads to unacceptable administrative issues (i.e., identification of who is and is not included in such category, and tracking for an indefinite period those such members who elect lump sum settlements).


B. Funding 
Whether alternative financial vehicles, such as letters of credit, should be allowed to provide greater funding flexibility, together with applicable conditions to minimize risk to benefit security Sponsors should be allowed to utilize letters of credit in lieu of some or all of their solvency contributions. Unless other measures are introduced that adequately address the surplus asymmetry, sponsors should be permitted to cancel the letters of credit if the plan has a solvency surplus (with plan assets taking into account the value of any existing letters of credit).

To minimize the risk to benefit security, letters of credit must be held by the plan's trustee and must be renewed annually, unless the sponsor makes additional contributions or a surplus emerges under the plan. In the event a letter of credit is not renewed (and subject to the above exclusions), the financial institution that issued the letter of credit must deposit the face amount of the letter of credit in the pension fund.

The availability of letters of credit would only partially address the need for longer solvency amortization periods.

What an appropriate amortization period is for solvency deficits, and whether it is different for financially vulnerable and financially strong companies

For investment-grade companies, the solvency amortization period should be extended to a minimum of 10 years. It is reasonable that amortization periods not be extended to companies that are financially vulnerable.
Conditions applicable to any extended solvency amortization period for companies under CCAA or BIA No comments.
Other alternatives to address funding issues other than relaxing funding requirements, such as special accounts that could be returned to sponsors on plan termination or if no longer needed to fund the plans If solvency contributions could be remitted to such a special account, it would address some of the asymmetry issues, specifically the trapped capital concerns. It would not, however, address the need for longer solvency amortization periods.

In addition, as compared to the letter of credit alternative, this alternative would require upfront cash payments to the separate trust, whereas letter of credit obligations might or might not have to be satisfied by cash payments in future. Consequently, CPR's preference is for the proposed letter of credit option.

Whether there should be greater disclosure to members regarding sponsor's financial condition, funding policy, funding decisions and contribution holidays We would support greater disclosure as to the funded status of the pension plan; however, member disclosure must be limited to data that can be made available to the investment community. We would also support disclosure of a statement of funding policy (which would include the sponsor's policy regarding contribution holidays). Any information provided to members regarding the sponsor's financial condition must be restricted to publicly available data (i.e., corporate credit ratings).

C. Void Amendments 
Proposal to prohibit plan improvements if resulting solvency ratio would be less than 85% We support the proposal to prohibit plan improvements if the solvency ratio is less than 85%. There may be circumstances where a sponsor of a plan with a solvency ratio less than 85% should be permitted to introduce benefit improvements provided the improvements are immediately funded.

D. Funding on Plan Termination 
Should full funding by plan sponsors be required on plan termination? We support the proposal to require plan sponsors to fully fund any solvency deficit on plan termination, provided surplus asymmetry is satisfactorily addressed.
If so, how should it be applied to financially vulnerable sponsors? No comments.
Should there be a lower priority claim on a terminated plan's assets for recent plan improvements? Yes. In our opinion, the introduction of such a lower priority claim would address a potential inequity between different member classes in the event the plan is terminated.

Pension Benefit Guarantee Fund 
Should a federal pension guarantee fund be established? We do not believe that there is a need for a pension guarantee fund for federally-regulated employers. As well, among federally-regulated employers, pension liabilities are concentrated among too small of a group of companies to allow the operation of an effective risk-based insurance program that applies to these employers only.


Appendix B

GOVERNMENT OF CANADA LONG-TERM BOND YIELD HISTORY

Government of Canada Long-Term Bonds

The CPR pension plan solvency deficit is the result of the decline in long-term bond yields to 47-year lows


Appendix C

Extract from Association of Canadian Pension Management's August 2005 report entitled "BACK FROM THE BRINK: SECURING THE FUTURE of Defined Benefit Pension Plans"

ATTACHMENT 1

ASSOCIATION OF CANADIAN PENSION MANAGEMENT

PROPOSAL FOR USE OF LETTERS OF CREDIT TO MEET SOLVENCY DEFICIT CONTRIBUTION REQUIREMENTS FOR REGISTERED PENSION PLANS

Overview

In today's environment of 45-year low interest rates, current five-year solvency deficit funding requirements are causing significant increases in pension contribution requirements for many Canadian pension plan sponsors. Furthermore, when long-term interest rates rise and/or equity markets perform favourably over a sustained period, as will inevitably occur, many mature plans with a solvency deficit today will subsequently find themselves with surpluses that are too large to be effectively utilized over the foreseeable future.

This attachment describes proposed changes to pension funding regulations to permit the use of letters of credit to cover all or a portion of the current solvency deficit funding requirements. This proposal is a viable means of providing alternative solvency funding that will assist financially sound employers in addressing the issues identified above.

As is the case when letters of credit are utilized for supplemental pension arrangements, the letters of credit would be held by the plan's trustee. If the plan sponsor failed to renew the letters of credit, the trustee would call the existing letters of credit and the financial institutions that issued the letters of credit would be required to deposit the face amount of the letters of credit in the pension fund. Consequently, the issuance of letters of credit will have the same favourable impact on a less-than-fully-solvent plan's benefit security as the remittance of additional contributions to the plan.

Detailed Proposal

It is proposed that plan sponsors be able to elect to meet all or a part of their required solvency special payments (but not going concern special payments) by arranging for a letter of credit for the solvency special payments. The intent is that the sum of the plan's assets and the face amount of the letters of credit at any point in time will equal the expected assets at that time as if the solvency special payments had been made in cash. The proposed amendment to pension regulations would specify the following:

1. The sponsor may arrange a letter of credit in lieu of some or all of its required solvency special payments.

2. Once a letter of credit has been arranged for a specified amount of foregone contributions, it must remain in effect in such amount as long as the contributions remain unpaid or, if earlier, until the plan has a solvency surplus (with plan assets valued at market value and taking into account the value of the letters of credit in place).

3. The letters of credit must be held by the pension fund trustee, and exercisable by the pension fund trustee independently of action, inaction or incapacity of the sponsor. Failure to renew a letter of credit will result in the letter of credit being called by the trustee, unless the letter of credit is no longer required (either as a result of the employer remitting the previously-foregone contributions or the plan reverting to a solvency surplus as per paragraph 2). Failure by the plan sponsor to remit any statutory minimum required contributions to the plan year in which they are due will result in all outstanding letters of credit being called by the trustee. (There may be circumstances where it is appropriate to call only a portion of the letters of credit.)

4. The letters of credit must be issued by financial institutions whose credit is rated by DBRS as "A-" or higher (or equivalent rating from another major credit rating agency), and who deal at arm's length with the plan sponsor.

5. In addition to the contribution requirements under existing regulations, additional contributions are required in the amount of the deemed interest on the accumulated balance of foregone solvency contributions, computed using the solvency liability discount rate used in the previous actuarial valuation.

6. To simplify the plan trustee's monitoring requirements, it is proposed that the plan sponsor be required to arrange, at the beginning of each year, the necessary letter of credit for the portion of that year's contribution requirements that will be met via letter of credit. The trustee would then be provided with the appropriate schedule setting out the statutory minimum contribution amounts for that year, including the portion being met by letter of credit. Any increase in contribution requirements for such year must be contributed to the pension fund in cash. Less restrictive requirements may be appropriate if the corporate trustee community deems that the monitoring is manageable.

7. In determining the solvency position of the plan, the face amount of the letters of credit is included in the plan assets.

8. In determining the going concern financial position of the plan (and hence the going concern special payments), any letters of credit in place would not be taken into account.

9. The face amount of any letters of credit in place can be reduced by the amount of any solvency special payments for a fiscal year that are in excess of the minimum requirement for such fiscal year.

10. The face amount of any letters of credit in place can be reduced if, at the effective date of the actuarial valuation, the sum of the market value of the plan assets and the face amount of the letters of credit exceeds the plan's solvency liabilities, in which case the face amount of the letters of credit can be reduced so that the sum of the market value of the plan assets and the adjusted face amount of the letters of credit equals the plan's solvency liabilities.

11. Normal (current service) cost contributions may be reduced to the extent that there is a going concern surplus, subject to there also being a solvency surplus. If the normal cost "contribution holiday" exceeds the solvency surplus, then such excess must be treated like unpaid solvency contributions (i.e., it is added to the minimum letter of credit face amount). In computing such surplus amounts, the face amount of any letters of credit in place is excluded in the calculation of the going concern surplus, and included in the calculation of the solvency surplus. Normal cost contributions may not be reduced if solvency liabilities exceed the sum of the plan's assets and the face amount of any letters of credit in place.

12. The plan sponsor is responsible for paying any fees for securing the letters of credit. If it is required that the fee for a letter of credit be paid from the pension fund, then the sponsor must first contribute the amount of the fee to the fund, in addition to any other required contributions.

13. Annual actuarial valuations would be required while any letters of credit remain in place.

14. A letter of credit would have to be in place as at the date at which a solvency contribution is due in order for the letter of credit to be utilized in lieu of contributing this amount.

15. In determining the plan's solvency ratio (i.e., the ratio used to compute any transfer deficiency contributions required when lump sum benefit payments are made from the plan), the face amount of any letters of credit would be included in the plan assets.