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Watson Wyatt's Submission in Response to Finance Canada's Regulatory Framework for Federally Regulated Defined Benefit Pension Plans consultation:
Watson Wyatt's Submission on Department of Finance Consultation Paper
Strengthening the Legislative and Regulatory Framework for Defined Benefit Pension Plans Registered under the
Pension Benefits Standards Act, 1985
The purpose of this document is to provide Watson Wyatt's comments on the permanent and temporary measures contained in the Consultation Paper, Strengthening the Legislative and Regulatory Framework for Defined Benefit Pension Plans Registered under the Pension Benefits Standards Act, 1985 released by the Federal Department of Finance (Finance).
There is increasing recognition of the existence of a pension crisis in Canada, particularly in relation to funding of defined benefit (DB) pension plans. The number of chief financial officers (CFOs) who believe there is such crisis has increased to 43% in 2005 from 20% the previous year. Regulators and governments are also concerned by the current situation, as evidenced by the recent release of consultation papers on pension plan funding by the Régie des rentes du Quebec (Régie) and the Canadian Association of Pension Supervisory Authorities (CAPSA) - in addition to Finance's Consultation Paper.
We applaud the Consultation Paper's objective of improving the security of pension plan benefits and ensuring the viability of DB pension plans. Despite the current funding challenges many plans are facing, DB plans continue to have great human resources and business management value. These plans are also valuable to society as a whole, as their continued existence reduces reliance on (and consequently the cost of) publicly-sponsored programs.
Our comments on the specific aspects of the Consultation Paper, viewed in light of the preceding general remarks, are provided below.
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.
The greatest disincentive to building up a funding cushion is the significant imbalance, or asymmetry, between funding risks and rewards for DB plan sponsors. This asymmetry arises from the fact that for most single employer DB plans, the employer is responsible for paying off deficits but often cannot access plan surpluses that develop as a natural result of conservative funding policies.
Prior to the Supreme Court of Canada's 2004 decision in Monsanto, employers knew that if they ever terminated a DB plan, they could face litigation over entitlement to termination surplus. While this created an undesirable asymmetry for many employers, at least they could generally control whether and when to terminate a pension plan. Monsanto greatly exacerbated the existing asymmetry by requiring the distribution of surplus on a partial plan termination. Depending on the circumstances, the employer and departing members may end up in protracted negotiations or litigation over how to distribute that surplus - even though the surplus may be needed to protect benefits for continuing plan members.
In most cases, DB plans are provided voluntarily by plan sponsors. Accordingly, with greater asymmetry in the system, and as administration and funding rules become increasingly onerous and restrictive, there is an increasing likelihood that plan sponsors will convert their plans from DB to defined contribution (DC) pension plans, or terminate their plans altogether. Accordingly, governments and pension regulators must take concrete steps to address the problems present in the system, which will have an immediate and positive impact on plan sponsors' views towards establishing a funding cushion in their plans.
The Government of Canada is seeking views on whether the dispute settlement mechanism for surplus distribution contained in the PBSA requires improvement or clarification.
We do not have specific suggestions for improvements or clarifications to the current surplus dispute settlement mechanism in the PBSA. However, we note that the majority of surplus disputes arise in connection with either older or successor plans. In these cases, it is especially difficult for a plan sponsor to establish clear entitlement to surplus, as required by the PBSA to eliminate the need for a surplus sharing proposal. Accordingly, the ability of an employer to meet the threshold required to establish clear entitlement to surplus is limited. In addition, we recognize that the difficulty of locating and securing the consent of some groups (e.g., deferred vesteds) can further limit the application of the current mechanism.
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.
While we would prefer the concept of partial plan terminations under the PBSA to be eliminated and replaced by earlier vesting (as in Quebec), we would accept leaving the Superintendent with authority to require partial plan terminations under the PBSA in specified circumstances, provided there is no requirement to distribute surplus. Unlike in Ontario, which has a very expansive legislative view of the circumstances that can trigger a partial termination, the PBSA's provisions have not, in our experience, led to unreasonable administrative burdens or an inappropriately broad definition of what constitutes a partial plan termination.
For some plan sponsors, allocating surplus to employees on a partial termination may not be problematic. However, private-sector plan sponsors are accountable to shareholders, and when an employer has established a package of pension benefits that meets its attraction and retention goals, shareholders have reason to be concerned if surplus that results from responsible and conservative pension funding practices ends up being paid out as a windfall to plan members who have already been provided the benefits they were promised by the pension plan. The additional contributions that will eventually have to be made to the plan as a result of such surplus payouts has a direct impact on shareholder returns on their equity investment, as will the lengthy and costly legal disputes that arise over allocation of pension surplus.
Instead of requiring an immediate surplus distribution, the legislation could state that surplus distribution is only required on partial termination if mandated by the plan terms, as is the case in Alberta and British Columbia. Including such a provision would give plan sponsors and members some flexibility while falling short of mandating universal surplus distribution on partial pension plan terminations.
We recommend deferral of surplus distribution until full plan termination despite concerns that have been raised over the administrative difficulties of tracking plan members who have terminated employment and received a lump sum settlement of their pension benefits. In the event that a full termination occurs shortly after a partial termination, the difficulties in tracking members affected by the partial termination are not significantly greater than the difficulties that exist on a full termination due to the protracted negotiations normally required to arrive at a surplus distribution formula acceptable to all parties. However, in the event that a full termination occurs decades after a partial termination, it is not clear that the affected members have any greater claim on surplus than members who terminate in the normal course of business.
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?
We agree that DB plan sponsors should be able to use letters of credit (LOCs) and other approved financial instruments (such as trust funds held outside the pension plan) to allow for greater funding flexibility by guaranteeing amortization payments for solvency deficits. Such guarantees permit employers to provide full security toplan members in the event of a real insolvency, while reducing the risk of surplus in other circumstances.
Although the tax advantages of registered investments and other practical considerations would likely mean that LOCs would only be attractive in limited circumstances, some regulatory constraints on their use are appropriate. We recommend the measures proposed in Measure 4 of the Régie's Consultation Paper, Toward Better Funding of Defined Benefit Pension Plans, which include the following:
- The guarantee must ensure a level of security at least equal to the payment of money into the pension fund;
- The amount of the guarantee need only be sufficient to cover the payments that the employer would otherwise be required to make for the amortization of solvency deficits;
- The guarantee can be reduced or cancelled by the payment of an equivalent contribution into the pension fund, the emergence of a surplus on a solvency basis or if the plan is terminated and the guarantee is no longer needed.
In addition to the preceding measures, we believe some additional conditions for consideration include requiring that LOCs and other guarantees be:
- Used only to cover the excess of minimum solvency contributions over minimum going concern contributions (i.e., not used in place of recommended going concern contributions);
- Held by the pension fund trustee (with fees paid by either the trustee or the sponsor);
- Exercisable by the pension fund trustee independently of action, inaction or (especially) incapacity of the sponsor; and
- Issued by a Canadian financial institution in good standing that deals at arm's length with the sponsor.
The institution of such legislative and regulatory conditions should provide plan sponsors with sufficient flexibility to encourage their use, which will provide enhanced benefit security for members without unnecessarily creating large going concern plan surpluses. However, despite their value, it must be remembered that LOCs and other financial instruments are not a panacea - they have a continuing cost, and LOC's use up the plan sponsor's credit facility, which may still discourage their use.
Extending Solvency Funding Period to 10 Years
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.
Discussion about employer responsibility for funding often presumes that sponsors of DB plans are fully responsible for their employees' retirement income security in all circumstances. This is not so. Whether specified in the plan documents or not, every DB plan includes elements of risk for employees. For example:
- Fulfillment of the promised benefit depends on continuation of employment to the target retirement age;
- Completion of the funding of benefits for past and future service depends on the continuation of the employer's business;
- Inflation protection is often discretionary; and
- The employer invariably reserves the right to curtail future benefit accruals should the plan become too expensive or cease to meet business needs.
This last element of risk has become particularly important in recent years. It requires a drastic reduction in early retirement subsidies (for example) to offset the effect of declining interest rates on current service costs. Under today's funding rules, maintaining required contributions at an affordable level will only be possible for some employers if a reduction is made in the rate of future benefit accrual.
Most plan sponsors are incapable of assuming all of the risks - they are not in a position to guarantee their own survival. The pension industry needs to be free to develop new risk-sharing arrangements that preserve the risk pooling and professional investment management elements of defined benefit pension plans, while reducing fluctuations in short-term liquidity demands and accounting expense for plan sponsors. At the same time, funding for existing and new arrangements will need to preserve or enhance the likelihood that minimum benefits will be paid, and improve plan member understanding of their residual risks. Five-year amortization of solvency deficits may minimize the risk of forfeiture of benefits upon plan sponsor insolvency but it is an obstacle to the inclusion of risky benefits and will in many cases lead to lower benefit levels for a given expected contribution level.
In light of these considerations, we endorse the movement to a 10-year amortization period for most DB plans. We believe that such a change will help facilitate the development of new risk-sharing arrangements that provide plan sponsors with additional flexibility. Financially vulnerable plans could still be required to amortize over a 5-year period.
In addition, we believe that an even longer amortization period, such 15 years, is appropriate for companies with an excellent credit rating and for jointly-sponsored pension plans (JSPs) in which contribution rate changes are shared with employees. Where the deficit funding risk resides entirely with the plan sponsor, it may be appropriate to recognize a shorter amortization period for the portion of the solvency deficit that is less than, for example, 90% funded.
This is not to say that the difference between the contributions produced by this amortization schedule and the contributions towards any going concern deficit should be made in cash. LOC's or other approved financial instruments should be able to be used for this purpose, as mentioned above.
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.
This issue is closely related to the issue of full funding on plan termination. Where full funding on plan termination is not required, it will often be in the interest of all parties to provide accommodation so that the company can continue to operate as a going concern and fund the pension benefits over time. Where full funding on plan termination is required, it may be in the best interest of pensioners and long-service employees for the plan administrator to exercise a claim on the company's assets through the Companies Creditors Arrangement Act (CCAA) process. Lengthening amortization periods for plans that guarantee full funding on plan termination could inappropriately weaken security for older plan members if discretion is not applied in the application of the proposed changes.
Notwithstanding our preceding comments, we agree that special conditions should be made available for companies under the protection of the CCAA and/or the Bankruptcy and Insolvency Act (BIA). We believe that these conditions should be similar to those adopted in relation to Air Canada, which included the following:
- Allowing the amortization of solvency deficiencies over a longer period than required by the PBSA, pursuant to a schedule set out in Regulations;
- In exchange for the longer amortization period, the company must satisfy a number of conditions, including:
- Providing appropriate disclosure of information to plan beneficiaries regarding the funding relief;
- Filing a statement with the Office of the Superintendent of Financial Institutions (OSFI) that plan beneficiaries consent to the funding of their pension plans in accordance with the Regulation; and
- Remitting specified outstanding payments to the pension plans (e.g., current service contributions) prior to emerging from CCAA or BIA protection;
- After emerging from CCAA protection, the company may be required to issue secured promissory notes that are a charge over the company's assets in order to provide a degree of protection should the company be liquidated in the future; and
- Establishing an expiry date for the funding relief, while allowing the company to opt out of the relief at an earlier date.
We believe that the establishment of conditions similar to those outlined above will provide security to plan members while giving the plan sponsor the flexibility needed to emerge from legislative protection under the CCAA and/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?
In addition to allowing the use of LOCs and other guarantees, as discussed above, we wish to propose two alternatives for the funding of DB pension plans:
- Plan sponsors could be permitted to make solvency contributions to a separate notional account within the pension fund. By legislative amendment, any surplus in this notional account would be clearly identified as belonging solely to the plan sponsor on termination.
- Plan sponsors could be allowed to issue obligations to the pension plan in respect of solvency contributions to the extent they exceed the going concern contributions. Such obligation would need to be of sufficient legal standing to have some priority in the event of bankruptcy of the sponsoring employer.
Both of these measures, if implemented, could increase pension funding flexibility while enhancing benefit security and addressing the current asymmetry that exists in the sharing of risks and rewards between plan sponsors and members.
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.
The relative importance of information on the pension fund's financial condition and the plan sponsor's financial condition depends upon the extent of the plan sponsor's obligation to fund the plan's past and future benefits. At one extreme, the financial condition of individual participating employers is not particularly relevant in a fixed cost multi-employer pension plan. At the other extreme, the sponsor's financial condition is far more important than the initial contributions to a brand new pension plan with past service benefits.
Additional disclosure to plan members regarding funding decisions and contribution holidays can best be accomplished through requiring that pension plans establish a written funding policy and provide that policy to members, retirees and other beneficiaries. A funding policy would cover additional important issues such as the relationship of investment policy to liability structure. When surveyed regarding whether or not their largest non-bargained pension plan had a funding policy, only one CFO indicated that they had a formal, written one - the remainder have informal policies as implied in the plan's actuarial funding valuation report. Requiring that plans establish and disclose a funding policy will enhance the information currently available on funding decisions, contribution holidays and other issues, and we believe will be accepted by most plan sponsors if their asymmetry concerns are adequately addressed.
Regarding information on the plan sponsor's financial condition, we believe that plan sponsors should only be obligated to provide a summary of publicly-available financial information. This will provide enhanced disclosure by eliminating the requirement for members to locate this information themselves, while preserving necessary corporate confidentiality, particularly in relation to employers that are not publicly-traded. We note that this will present a communications challenge, since most employees do not understand financial statements and language - but in this world of increasing transparency, its time may have come.
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 85 per cent, and to reduce the priority of claims against pension plan assets for recent benefit improvements that have not yet been fully funded. Specifically:
- Is an 85 per cent solvency ratio an appropriate threshold for applying the proposed controls and conditions on plan improvements?
- Should pension plans with solvency ratios below 85 per cent be permitted to make the plan improvements provided that offsetting funding is provided at the time that the improvement comes into effect?
- Would the proposed priority scheme improve security of longer-established benefits?
We endorse the adoption of the void amendment provisions as outlined in the Consultation Paper. Specifically:
- We believe that 85 percent is an appropriate approximate threshold, although a range of between 85 percent and 95 percent would be acceptable, depending on the plan sponsor's financial stability.
- We believe that plan improvements should still be permitted for plans with a solvency ratio below this threshold, providing offsetting funding is provided.
- We believe that the proposed priority scheme is equitable and would enhance the security of longer-established benefits.
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 plan sponsors.
Requiring full funding on plan termination is consistent with the legislative and regulatory practice in a number of jurisdictions. We do not oppose the introduction of this requirement into the PBSA, although we believe that care must be taken in applying this requirement to financially vulnerable plan sponsors. As noted above, in our comments on special amortization rules for companies in CCAA/BIA protection, a requirement to fully fund on plan termination will change the optimal strategy for the plan administrator and retired pension plan members, and could undermine the survival of the company. Accordingly, we favour the development of special regulations or administrative protocols to provide the Superintendent with latitude to relax the standard funding rules for plan sponsors under CCAA or BIA protection, similar to the measures introduced for Air Canada.
Pension Benefit Guarantee Fund
The Government of Canada is seeking views on the viability of a federal pension benefit guarantee fund including any comments on its possible design, operation and powers.
We question whether it would be possible to operate a federal pension benefit guarantee fund (PBGF) on a financially self-sufficient basis. If properly based on a genuine risk assessment, the premiums would have to increase substantially as an employer's financial position weakened. Thus the premium would simply compound the financial pressure on an employer when it would least be able to sustain the cost. Taking into account the size of some of the larger DB plans registered under the PBSA, a tremendous deficit is likely to develop in a PBGF in certain economic eras that will end up being borne by the larger plan sponsors with a low risk profile. In fact, if the plans with a low risk profile were to pay off their solvency deficits and thereby minimize their PBGF premiums, eventually the financial burden will have to fall on taxpayers unless the Government was to renege on its PBGF promises.
We also suggest that the plans subject to federal jurisdiction do not create a base of sufficient size to effectively pool the risk of default. The experience in Ontario has shown that one or two large claims on the fund can place the fund in an unsustainable position.
Finally, the adoption of other measures, including the ability to use LOCs to guarantee solvency deficiency amortization payments, the application of the void amendment rule, and the introduction of special funding measures for plan sponsors under CCAA or BIA protection, should greatly restrict the need for such a fund.
Instead of a traditional PBGF, consideration could be given to establishing a government fund that would underwrite LOCs or other funding guarantees for employers that have difficulty obtaining them. This would enhance members' benefit security while avoiding a large financial drain on plan sponsors occasioned by traditional PBGF assessments.
The Consultation Paper did not solicit views regarding whether the PBSA and/or regulations should be amended to allow for other forms of cost sharing than pure DC plans. Nevertheless, we believe that comments on this important issue are necessary in the context of the aim of the Consultation Paper as a whole.
There are many ways to design pension plans in which the employer's obligation is limited to contributions according to a fixed schedule, or in which risk is shared between employers, employees, and retirees. Gains and losses in such plans do not need to be shifted entirely to individual employees, as is the case in pure DC plans. They can continue to be pooled amongst employees and across generations of employees. The employer responsibility will also vary over time according to the total compensation needs of employees and labour market benchmarks.
Improved clarity and symmetry around ownership of surpluses and deficits should be an objective of any new innovation in plan design or legislation. However, it is important to bear in mind that one size does not fit all. If the amendments restrict a sponsor's options to either pure DC (with the employee appearing to assume all the risk) or pure DB (with the employer appearing to assume all the risk), then many opportunities for sound retirement income planning will be lost.
1.ï¿½ The Conference Board of Canada and Watson Wyatt, Initial Summary of Findings, 2005 Survey on Pension Risk. [back]
2.ï¿½ Monsanto Canada Inc. v. Ontario (Superintendent of Financial Services),  S.C.C. 54. [back]
3.ï¿½ Supra note 1. [back]