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CN's Submission in Response to Finance Canada's Regulatory Framework for Federally Regulated Defined Benefit Pension Plans consultation:
September 15, 2005
Ms. Diane Lafleur
Financial Sector Policy Branch
Department of Finance
20th Floor, East Tower
Dear Ms. Lafleur,
Thank you for the opportunity to participate in the consultation process concerning the legislative and regulatory framework for Defined Benefit Pension Plans registered under the PBSA.
On balance, we believe that Canada has a very well-functioning defined benefit pension plan system. The system is anchored on affordable employee payroll deductions that are matched by significant corporate contributions and the clear promise to fund future benefits by plan sponsors. Within a going concern framework, adequately circumscribed by reasonable actuarial assumptions, the level and security of benefits are properly safeguarded in the vast majority of instances.
Unfortunately, general media and press accounts would at times leave some to believe that the Canadian pension system is in crisis. Nothing is actually further from the truth. By international standards, the Canadian defined benefit pension plan system is in excellent shape. It objectively offers very competitive benefits coupled with a high degree of financial security for plan members.
In our considered view, the overriding issue is not to "strengthen" defined benefit plans, but rather to ensure that they remain sufficiently flexible and affordable to corporate plan sponsors. In this regard, the system is clearly at a crossroad and faces serious risks that must be addressed forthwith by the regulator.
We have summarized in the attached document our comments on the key policy issues listed in your consultation paper. However, we would like to draw your attention to the two most important issues that must be addressed in priority to maintain a proper balance of pension regulations. Those two issues are closely intertwined and relate to excessive cash funding requirements currently imposed on plan sponsors.
Lack of Clarity on Surplus Ownership
Under existing regulations, plan sponsors bear the full financial burden of any pension deficit throughout the life of the plan. This is our clear corporate promise and we fully stand behind it. However, the current regulation and case law are unclear as to who owns the surplus. This creates an unacceptable asymmetry of risks and rewards which must be corrected. The lack of clarity on who owns the surplus creates strong disincentives for corporate sponsors to fund cash deficits in a timely manner. This issue is exacerbated in situations where funding requirements arise solely as a result of solvency deficits.
In the current environment of historically low-interest rates, many pension plans that are in a going concern surplus, like the CN plan, may nevertheless be required to fund solvency deficits over a very short period. In these situations, cash funding actually increases the going-concern surplus without the required clarity on who owns the surplus in the first place. This is commonly referred to as the "trapped capital" issue and this problem will be seriously compounded when interest rates return to more normal levels.
Calculation and Funding of Solvency Deficits
The current solvency rules initially designed to assess the security of benefits for plan members are fundamentally flawed and the resulting funding requirements unduly onerous for plan sponsors. The test is flawed because it is based on unrealistic assumptions and calls for stark remedies that are not warranted in many circumstances:
In its current form, the solvency test is almost surreal as it attempts to measure the health of a pension plan by assuming that it is dead. As applied by OSFI, the test fails to recognize the organic link that exists between a pension plan and the strength of its corporate sponsor. To illustrate this point, how many banks would pass an artificial test that assumed a sudden and total withdrawal of its deposits? How many life insurance companies could have enough funds set aside to meet an immediate claim on all of their outstanding life insurance contracts? This simple business reality is adequately recognized by financial sector regulations which are based on tests that are more going concern in nature. The same logic should apply for assessing pension plan solidity on a case-by-case basis.
A solvency test slightly below 100% can occur in plans with going concern surpluses that are also backed-up by financially strong corporate sponsors. As a reference point, most pension promises around the world are either simply not funded or often only partially funded with shares of debt of the sponsors. So what is wrong with Canadian plans with 90-95% funded ratios that are well invested in segregated assets and supported by strong sponsors? Objectively, nothing is wrong! This is why, for instance, the U.S. Labor Department proposes funding targets that recognize the financial health of the plan sponsor and accelerate cash funding requirements only when below a 90% solvency ratio.
The use of a discount rate based on life companies' implicit annuity interest rate is simply unrealistic. Why are diversified portfolios of assets suddenly exchanged for fixed annuity quoted by insurance companies that are attempting to make a profit in a totally different market context? More realistically, solvency tests should be based on long-term corporate bond rates as is the case under U.S. pension regulation.
For financially strong companies with well-managed pension funds, there is no reason to arbitrarily require the funding of solvency deficits in five years as opposed to the fifteen years allowed for going concern deficits. The foundation of pension plan management in Canada and a key to its success is the long-term horizon of its investment policies. In the current low interest rates environment, the consequences of artificial point-in-time solvency tests applied indiscriminately can be far-reaching. Indeed, by some estimates, the total deficit shortfall of Canadian pension plans was in excess of $150B at the end of 2004. Unless pension rules are changed, huge cash resources will be diverted away from other productive uses which would benefit the Canadian economy.
In short, corporate plan sponsors can no longer afford the consequences of unrealistic discount rates and unduly conservative amortization periods. Unless the Federal Government acts swiftly to address these issues, plan sponsors will be forced to curtail benefit improvements and to consider abandoning defined benefit plans altogether in favor of other pension arrangements. The serious potential damage to the financial health of corporate sponsors is not in the interest of Canada, the employees, and the pensioner of Canadian corporations, especially at a time of intense international competition from firms that operate in countries where such rules do not exist.
Accordingly, we urge the Department of Finance to implement the following recommendations:
In the immediate short term: to change pension regulations to introduce solvency tests based on a discount rate aligned with long-term corporate bond rates and to lengthen the solvency deficit funding amortization period to fifteen years, at least for investment-grade companies.
In the context of a broader legislative review: to clarify the ownership of surplus issues to achieve a more adequate risk and reward balance between plan members and corporate sponsors.
We trust that you will receive these comments and recommendations in the spirit of a balanced proposal to maintain a solid defined benefit pension plan system in Canada. Finally, we consent to the public disclosure of our comments and are ready to answer any further questions that you may have.
Defined Benefit Pension Plans under PBSA
CN's Comments on the Department of Finance Consultation Paper
The Government of Canada is seeking views as to whether there are any disincentives or obstacles preventing plan sponsors from adequately funding their plans and building up a funding cushion.
Yes, there currently are strong disincentives. The sponsors find themselves in a situation where they may be forced to give more than the promised benefits. This situation is likely to result in the sponsors wanting to reduce risks and the promised benefits in the future. The disincentives include:
(1) The issue of asymmetry in surplus ownership, which needs to be clarified. We believe that it is appropriate for a sponsor to have access to the surplus funds given that it is responsible to fund deficits as they arise.
(2) The prospect of having to distribute a portion of the plan's surplus to those members who are included in a partial plan termination.
|The Government of Canada is seeking views on whether the dispute settlement mechanism for surplus distribution contained in the PBSA requires improvement or clarification.|
Yes, significant improvements are required in this area. Unless the plan text specifies that plan members are entitled to some of the surplus, the sponsors should clearly have discretion over the use of surpluses.
|The Government of Canada is seeking views on whether there should be partial plan terminations under the PBSA and if so, should there be a requirement to distribute surplus at the time of the partial termination.|
Partial plan terminations are not only a disincentive to funding more than the minimum required but also they represent an important administrative burden for the sponsor. We support the decision of the Quebec regulator to eliminate partial plan termination, which require that plan members be immediately vested. We believe that it is inappropriate to have any part of a surplus distributed upon a partial plan termination to those members included in the partial termination.
Also, 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). The only viable solution is to eliminate partial plan terminations.
The Government of Canada is seeking views on whether there are alternative financial vehicles, such as letters of credit, that could allow for greater funding flexibility.
What types of conditions or rules should be required if greater funding flexibility is given to plan sponsors, to ensure that the risk to benefit security is minimized?
Several financial vehicles have been proposed as alternatives to fund deficits. However, the best alternative is the use of letters of credit as they promote benefit security while giving employers greater flexibility in cash flow management. Cash flow management is a major concern for sponsors operating in asset-intensive industry such as the transportation industry.
Some of the rules that should apply for letters of credit include:
(1) The government should not seek higher funding levels from sponsors who are making use of letters of credit.
(2) The cost of letters of credit and deemed interest should be tax deductible.
|The Government of Canada is seeking views on what the appropriate amortization period is and whether it is different for financially vulnerable and financially strong companies.|
Extending the solvency period to 15 years would be more appropriate for financially strong companies meeting certain criteria. There is no reason for a different time frame from the going concern valuation for financially strong companies.
|The Government of Canada is seeking views on what types of conditions or rules should be attached to any extended amortization period for solvency funding for companies under CCAA or BIA.|
If the objective is to ensure the security of the promised benefits, it is not appropriate to allow an extended amortization period for solvency funding only for companies under CCAA or BIA.
|The Government of Canada is seeking views on whether there are alternatives to address funding issues other than relaxing funding requirements. For example, would special accounts for pension plans be feasible?|
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 use of a letter of credit, this alternative requires upfront cash payments to the separate trust.
|The Government of Canada is seeking views on whether there should be greater disclosure provided to plan members regarding a plan sponsor's financial condition, funding decisions and contribution holidays and how this may be done.|
We 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., credit ratings).
C. Void Amendments
The Government of Canada is seeking views on its proposal to implement the void amendments of the PBSA based on a prescribed solvency ratio level of 85ï¿½per cent, and to reduce the priority of claims against pension plan assets for recent benefit improvements that have not been fully funded.
We support the proposed change but if the goal is to help guarantee existing obligations, we believe that a threshold of 90 per cent is more appropriate.
The plan sponsor could be permitted to make benefits improvements when the solvency ratio is at or below 90% only if the improvements are immediately funded.
In our opinion, the introduction of a lower priority claim for more recent benefit improvements would address a potential inequity between different member classes in the event the plan is terminated. If recent improvements have a lower priority claim in the event of a wind up, this information should be disclosed to affected plan members.
D. Full Funding on Plan Termination
|The Government of Canada is seeking views on full funding on plan termination, and in particular how it should be applied to financially vulnerable sponsors.|
We support the proposal to require plan sponsors to fully fund any solvency deficit on plan termination, provided the surplus asymmetry issue is satisfactorily addressed.
This could be done through a lump sum payment or special annual payments starting at the effective date of wind up.
E. Pension Benefit Guarantee Fund
|The Government of Canada is seeking views on the viability of a federal pension guarantee fund including any comments on its possible design, operation, and powers.|
We do not believe that there is a need for a pension guarantee fund for federally regulated employers. Pension liabilities among federally regulated employers are concentrated among too small of a group of companies to allow the operation of an effective risk-based insurance program that would apply to these employers only. In addition, if it is assumed that the funding of this Guarantee Fund would come from pension plan sponsors, it would be far too large of a contingent obligation and we simply would not be prepared to insure another company's risks in this regard.