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Malcolm Kern's Submission in Response to Finance Canada's Regulatory Framework for Federally Regulated Defined Benefit Pension Plans consultation:
15 September 2005
Attn: Diane Lafleurï¿½
Financial Sector Policy Branchï¿½
Department of Finance L'Esplanade Laurierï¿½
20th Floor, East Towerï¿½
140 O'Connor Streetï¿½
Ottawa, ON K1A 0G5
Transmitted by email to: firstname.lastname@example.org
Department of Finance Consultation Paper Strengthening the Legislative and Regulatory Framework for Defined Benefit Pension Plans Registered under the Pension Benefits Standards Act, 1985
This letter presents my response the Consultation Paper referenced above. These comments reflect the opinions of the author only, and not necessarily those of my colleagues at Mercer Human Resource Consulting nor of the firm itself.
I am an actuary employed by Mercer Human Resource Consulting and have been involved in advising sponsors of defined benefit pension plans since 1979, including plans registered under the Pension Benefits Standards Act, 1985 and its predecessor. Early in my career I had the good fortune of being mentored by a man who had been consulting to plan sponsors since the 1950s, and who was generous in providing his insights into the history of the industry during his career. As a result of that grounding, and my own direct experience of over 25 years, I have had wide exposure to the issues and realities that have faced pension plans historically.
Whether there are any disincentives or obstacles preventing plan sponsors from adequately funding their plans and building up a funding cushion.
It is difficult to formulate a reasonable response to this query. One of my colleagues suggested that the question ought to have been whether there existed anything to encourage plan sponsors to build up a funding cushion.
It is interesting to note that in the 1950's and early 1960's, the then Department of National Revenue insisted that employer contributions to pension plans could be deductible only if they were irrevocably committed to providing pension benefits. This was done as a means of ensuring that employers did not deliberately over-contribute to the pension plan in order to obtain tax relief - clearly no reasonable employer would over-contribute to an arrangement if that meant he could never get those excess monies back.
Many plans continue to be governed by language put in place as a result of this one time tax policy, as the courts have determined that trust law does not allow for amendments that will remove this sort of language. The continuing reality of this historical legal constraint means that the asymmetry in surplus ownership is not merely "apparent", but real.
Part of the difficulty in coming to a regulatory solution to the problem is that, aside from defined contribution pension plans, there are two primary competing philosophies concerning the nature of the "deal" between employers and employees. One philosophy is that employers promise a specific or "defined" pension benefit to the employees, which the employees have the right to expect will be provided. This philosophy is reflected in the consultation paper's language concerning "adequate" funding, "guarantee" funds, and the like.
The other philosophy is also outlined in the consultation paper, namely that pensions are deferred compensation and the contributions to the pension plan ultimately are paid for by members, either directly by contributions or indirectly by wage or other benefit adjustments. This philosophy is also implied by the language of "contribution holidays".
These two philosophies are in fundamental opposition to each other. In my opinion it will never be possible to build a satisfactory regulatory regime until either: (a) one philosophy is established by fiat as the one which will govern the regulatory regime, or (b) two different types of pension arrangement are established, with one philosophy providing the rationale for one arrangement and the other providing the rationale for the other.
Personally, I believe it would be easier and in the better interest of plan members and plan sponsors for the latter option to prevail. That is, to identify two fundamentally different types of pension arrangement and build an appropriate regime for each.
One type of plan could be considered as a "pooled contribution pension plan" which is regulated in line with the philosophy that pension contributions are deferred wages. The entire asset base of the plan would be considered to be for the benefit of members as a collective. A surplus on plan termination would be used entirely to fund additional benefits, and a deficit would result in reduced benefits. The ongoing funding regime would place bounds around the level of benefits that can be promised, given the level of assets and contributions. If there were insufficient assets and contributions to support the benefits currently promised, benefits would be reduced. If there were more than sufficient assets to provide the benefits promised, after allowing for a reasonable "cushion", then benefits would be increased, possibly including the making of lump sum surplus disbursements. Governance structures for such a plan should recognize the nature of the arrangement, and give significant oversight powers to a board or committee that includes representatives of the plan members.
The other type of plan could be considered as a "true" defined benefit plan which is regulated to ensure that the specific promised benefits are delivered. The employer would be responsible for funding deficits on plan termination, and would be entitled to recover any and all surplus assets. Governance of such a plan should reside with the employer.
Ongoing funding requirements could very well be different between these two arrangements.
Whether the dispute settlement mechanism for surplus distribution in the PBSA requires improvement or clarification.
The mechanism in the PBSA has two serious failings, one technical and the other more fundamental.
The technical failing in the PBSA concerns the definition of "former member" as it applies to those who must consent to a surplus withdrawal by the employer. This definition includes everyone who has ever participated in the plan, except those who have transferred their entitlements to a locked-in RRSP under a specific section of the current Act prior to the plan terminating. Technically, this leaves open the question as to whether the following types of individuals must give consent:
- individuals who were never vested, and those had their entitlements fully discharged by a return of employee contributions, if any;
- individuals whose benefits were "small", or otherwise qualified to be paid in cash, rather than transferred to locked-in RRSP; and
- individuals whose benefits were settled prior to 1987, under the old Act.
It would seem that none of these individuals really have any continuing claim on or interest in the plan. In many long-standing plans, these individuals might significantly outnumber the active members and former members who continue to have benefits owing under the plan. By including these individuals in the consent group, the PBSA effectively gives them a veto over any reasonable agreement that the plan sponsor might reach with the current members.
The more fundamental issue concerns the fact that the mechanism only applies to a specific action to withdraw surplus. Consequently, unless the plan is being terminated, the mechanism does not provide a final resolution to the issue of surplus use and ownership.
Some mechanism that will allow the parties to an ongoing plan to agree to a clarification of surplus ownership provisions in the plan is required.
In the context of a regime that provides for "pooled contribution pension plans" as well as "true" defined benefit plans, this would amount to a mechanism for the parties to an already existing plan for which plan language is not definitive to agree as to whether the plan will be governed hereafter as a "pooled contribution pension plan" or as a "true" defined benefit plan. A mechanism for the parties to negotiate a change in a pension plan from one sort of arrangement to the other would also be needed.
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.
In the absence of a requirement to deal with surplus at the time of a partial termination, the declaration of a partial plan termination does only two things:
- makes individuals who have not yet participated in the plan for two years vested, and
- requires a partial plan termination report, detailing individual member entitlements, thereby generally increasing administrative costs and delaying the settlement of member's benefits.
Under the old PBSA, when vested occurred only after 10 years of employment and the attaining of age 45, the provision of immediate vesting on a partial plan termination provided a meaningful benefit policy. Today, however, there seems to be little point to the concept of a partial plan termination.
Worse, if a partial plan termination can be triggered by the termination of only one or two individuals who happen to be the only plan members employed at a single location, the concept becomes ridiculous.
In the context of a "pure" defined benefit plan, where surplus on plan termination is clearly owned by the employer, even the requirement to deal with surplus on a partial plan termination is a requirement without real policy significance.
A partial plan termination could still be a meaningful concept in the context of a "pooled contribution pension plan" where plan assets belong to plan members collectively. In such a case, it might be a mechanism to provide for an adjustment to benefits to reflect the surplus or deficit position of the plan at the time of a major membership departure, thereby reducing the likelihood of undue subsidization of one group of members in favour of another.
Whether there are alternative financial vehicles, such as letters of credit, that could allow for greater funding flexibility.
In dealing with this question, it is necessary to distinguish between "pooled contribution pension plans" and "pure" defined benefit plans. In the context of a "pooled contribution pension plan", where contributions are considered deferred wages, and benefits are adjusted to whatever can be provided by those contributions, the use of a letter of credit makes no sense whatsoever.
Letters of credit are used extensively to provide a degree of benefit security to unregistered pension arrangements providing benefits over and above the levels available to registered plans under the Income Tax Act. These letter of credit arrangements are far from ideal - they involve many risks, and a close attention to detail in order to provide actual security to plan members. Much depends upon a diligent trustee who is prepared to call the letter of credit upon any breach of the conditions, including missing deadlines for reporting information or renewing the letter. The apparent security offered by letters of credit can, due to inattention or lack of action, easily evaporate when most needed.
The prevalence of use of letters of credit in the SERP arena can be readily explained by a cost analysis. For an employer with a high credit rating the economic cost of a letter of credit arrangement can be significantly less than the tax cost of funding the arrangement in the traditional way through an RCA. (The tax cost being related to the difference between the 50% rate applicable to the RCA and the lower marginal tax rate applicable to the employer.)
In the context of registered pension plans, however, there is no tax disincentive to funding, but rather a tax incentive (at least for all but non-profit organizations). The principal attractiveness of a letter of credit would lie in the ability to avoid the current constraints on access to surplus assets. (To understand this, suppose a plan which is currently in deficit later experiences good results. A direct contribution now could produce surplus later, and be effectively locked into the plan. A letter of credit posted now would no longer be needed later and simply not renewed, thus recovering the otherwise unrecoverable contribution.) If the regime were changed to distinguish between "pooled contribution pension plans" and "pure" defined benefit plans, and to establish the employer's ownership of, and access to, surplus assets, then most of the incentive to consider letters of credit would be eliminated.
Having said that, however, there might still be a role for letters of credit as a form of private Pension Benefit Guarantee Fund on the one hand, or as an alternative vehicle for providing for any mandatory "cushion" over and above the current solvency liability (as such a cushion is in reality a form of inaccessible surplus), should such a cushion ever become a requirement (as is being proposed by Quebec).
It should be stressed, however, that if a role is to be granted letters of credit or similar instruments, there will need to be considerable regulation implemented concerning the events that will trigger the trustee's ability to call in the letter of credit, including failure to renew, failure to provide updated financial information by various deadlines, as well as events relating to insolvency, receivership, etc., etc. It might also be considered whether some sort of action should be possible against a trustee who failed to act on such events, resulting in a loss to plan members, or whether such a provision would simply make trustees unwilling to accept such responsibility in the first place.
What the appropriate amortization period is and whether it is different for financially vulnerable and financially strong companies.
If the objective of the funding regime is to ensure that benefits promised should be paid with a high degree of certainty, then it makes no sense whatsoever for the amortization period for solvency shortages to be longer for financially vulnerable companies than for financially strong companies. If anything, the reverse would be more appropriate.
The selection of an amortization period is in essence a balancing of the public policy objective of ensuring that benefits promised are paid with the practical realities that too harsh a regime simply means fewer pension plans, and a greater potential reliance on the public purse in old age.
It seems more appropriate that such balancing decisions should be made in the context of the economic and political realities of the entire pension system, rather than on the basis of the realities facing individual plans or sponsors. This would suggest that if a lengthening of the amortization period is desirable currently, given the economic conditions of the past few years, then such a lengthening should apply generally. To apply different rules to different plan sponsors can have a significant impact on their relative competitiveness, thereby distorting the markets and the economic environment further.
What types of conditions or rules should be attached to any extended amortization period for solvency funding for companies under CCAA or BIA.
In the absence of a requirement for full funding on plan termination, the flexibility for OSFI to permit an extended amortization period for solvency funding when a company is under CCAA or BIA, as was done in the case of Air Canada, makes a certain amount of sense. This is because in the absence of any such flexibility, the plan will terminate in a solvency shortfall and benefits to members will be reduced. Any additional payments toward the solvency shortfall will clearly improve the members' position, even if some reduction in benefits is ultimately required.
If, however, the PBSA were changed to require full funding on plan termination, as has been done in other jurisdictions such as Alberta, then the situation is much less clear. In such a case, a plan termination would produce a claim on the assets of the insolvent company, in effect increasing the solvency ratio. By delaying the realization of that claim, it is possible that the position of pension plan members could be made worse than if the company were liquidated immediately. This concern is reduced if the obligation to fund termination shortfall has a higher priority than that of other creditors, but is not eliminated even then.
The preceding comments presuppose a "pure" defined benefit plan scenario. For a "pooled contribution pension plan", the amortization period really is a mechanism for current and future employees to contribute out of current earnings toward the pensions of their elders and predecessors. To be sure, the pressures on all parties, including employees, to agree to things they otherwise would not entertain can be great when a company is under CCAA or BIA. It is a political question whether it is better public policy to permit significant flexibility to negotiate innovative solutions under such situations or to protect (typically younger) current workers from undue pressure from their elders to concede too much.
Whether there are alternatives to address funding issues other than relaxing funding requirements. For example, would special accounts for pension plans be feasible?
The creation of special accounts, whether real or notional, to track solvency payments so that excess amounts could be returned to the plan sponsor if ultimately unnecessary seems fraught with complications. To be sure, it would be an improvement over the current situation where access to surplus assets is extremely difficult, if not impossible, on an ongoing plan basis.
However, this complication makes no sense whatsoever in the context of a "pooled contribution pension plan", where the contributions are considered to be deferred wages. Its only meaningful application would be to "true" defined benefit plans, for which a more straightforward ownership of surplus by the plan sponsor would be simpler and more appropriate.
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.
While it seems perfectly reasonable that pension plan members should have access to sufficient information to assess the likelihood that the benefits they are planning on will in fact be realized, the requirement to provide information concerning a plan sponsor's financial condition would be problematic.
In the case of a "pooled contribution pension plan", the information about a plan sponsor's financial condition is largely irrelevant from a purely pension point of view - it may be relevant to the issue of the likelihood of continued employment, but that seems beyond the purview of the PBSA.
In the case of a "pure" defined benefit plan, information about a plan sponsor's financial condition would be quite relevant, but it is questionable how such information could be communicated to plan members. In the case of a public company, presumably all such relevant information is already in the public domain in the form of the company's annual report to shareholders and periodic financial statements. To require information to be provided to plan members that is not already in the public domain would have serious securities law repercussions.
In the case of a private company, the provision of corporate financial statements to pension plan members would be equivalent to making those financial statements public. This would likely be seen as a serious disincentive for a private company to sponsor a defined benefit pension plan.
Purely pension related information, however, could be provided beyond that currently required. For example, calculation and disclosure of the actual solvency ratio could be required rather than simply the requirement to disclose that the solvency ratio exceeds one.
The issue of void amendments cannot be addressed properly in isolation from the other items under consideration and in the absence of a distinction between "pooled contribution pension plans" and "pure" defined benefit plans.
In the context of a "pure" defined benefit plan, where full funding on plan termination was required, and where such a termination debt had a high priority claim on the assets of an insolvent employer (or was covered by a letter of credit), and where the power to make plan amendments lies entirely with the employer, the need to impose a regulation to prohibit benefit improvements seems largely unnecessary from a pension plan perspective.
In the context described above, the only value of a prohibition on plan improvements would be to address the possibility of unfair preference, whereby the insolvent takes actions to prefer one type of creditor above another - in this case, one group of plan members over another, or plan members in general over other creditors. This is likely better handled by a "look back" regime which considers not only plan amendments but also the recent exercise of discretionary provisions long contained within the plan. This might be better handled under bankruptcy and insolvency legislation, with changes to the pension regime limited to enabling provisions.
The situation is somewhat different in the context of a "pooled contribution pension plan", however. Under such an arrangement, the improvement of past service benefits when the plan is significantly under-funded is in effect an action by the governing body to subsidize past services at the expense of the wages of current and future active members. While there might be situations where the current and future active members truly do intend to support their elder brethren, it would likely be very difficult to ensure that free and informed consent was truly given to such an action.
In this context, the mischief done by such an amendment is realized more in the long term than in the event of imminent plan termination. Consequently, a priority scheme that rolls back recent amendments would be a less effective measure.
In summary, if the regulatory regime were changed to recognize the two distinct types of pension plan as suggested in this letter, it would be appropriate to implement the existing provision to void amendments where the effect of the amendment to be to reduce the solvency ratio of a "pooled contribution pension plan" below 85%, and to not implement such a provision in respect of a "pure" defined benefit plan.
Full Funding on Plan Termination
In any consideration of a requirement for full funding on plan termination, it is crucial to consider the difference between those plans which are in reality "pooled contribution pension plans" and those that are "pure" defined benefit plans.
In a "pooled contribution pension plan", contributions are considered to be deferred wages. A requirement to fully fund all deficits on plan termination should therefore logically amount to a charge on the wages of the last active employees - an untenable and unenforceable result. In practice, of course, the requirement for this final payment would be born by the employer alone. This amounts, in effect, to a bonus benefit paid to past employees over and above the wages and deferred wages agreed to - a bonus paid, in effect, for poor plan management.
Under such a scheme, a fiduciary administrator, charged with managing the plan to the best benefit of plan members only, without regard to the employer's interests, ought to manage the plan on a "risky" basis. If the risk pays off, the plan members gain. If the risk goes bad, the members are held harmless by the employer. No responsible employer should ever agree to participate in such an arrangement. Nor could such an arrangement ever be considered to be good public policy.
In the context of a "pure" defined benefit plan, however, where surplus is fully owned and accessible by the employer, the requirement for full funding on plan termination makes good public policy sense. Implementation of such a requirement, however, needs to be phased in such a way as not to encourage the wholesale termination of pension plans prior to the change in regulation. I would suggest that the amount of solvency shortfall be crystallized as at a given effective date, and considered to be the amount of shortfall the employer would not be required to fund upon a subsequent plan termination. This "non-accountable" shortfall would then be written down over time in line with the then current amortization requirements. After a period of five years (or longer if the amortization schedule is extended) from the effective date, the full shortfall on plan termination would have become the responsibility of the plan sponsor.
Pension Benefit Guarantee Fund
It is my opinion that a Pension Benefit Guarantee Fund covering only pension plans regulated by OSFI is simply an unworkable concept. The number of plans are simply too small, and the plan liabilities too narrowly concentrated, to allow for any degree of risk pooling, even in theory.
In practice, the much larger regimes of Ontario and the US have been unable to properly operate on a true risk pooling basis, and currently present significant risks to the taxpayers of those jurisdictions. Indeed there is much anecdotal evidence that suggests that the very existence of a PBGF arrangement represents a put option that encourages riskier behaviour by plan managers as the situation in the plan or industry gets worse.
The perceived need for such a PBGF scheme would be entirely eliminated by a requirement that pension plans must remain fully solvent at all times, as is in place in the Netherlands. If public policy requires a very low likelihood of pension plan failure, then such a full funding regime would be a better choice in the long run. Of course, public policy must weigh the benefits of encouraging the existence of defined benefit pension plans with the risks of occasional failure.
As noted earlier, it might be possible to impose a form of private guarantee scheme by the mechanism of requiring the sponsor of a "pure" defined benefit plan with a solvency deficit to provide a letter of credit for the amount of the shortfall as an alternative to immediate contributions. Such an arrangement would avoid the problem whereby well managed pension plans are "taxed" to cover the failures of poorly managed plans.
Another alternative to a guarantee fund might be to require full funding of shortfalls on plan termination, and to give that debt a higher priority under bankruptcy and insolvency laws.
These latter two alternatives only make sense in the context of a "pure" defined benefit plan, and would not work in the context of a "pooled contribution pension plan".
Throughout this response I have drawn upon a distinction between pension plans which can be considered "pure" defined benefit plans and those which would be better considered "pooled contribution pension plans". The current regulatory environment does not permit such a distinction to be made with any definitiveness, except in very limited circumstances. In my opinion the most important regulatory change required is establish a distinct categorization and regulatory regime for these two types of arrangements.
Clearly, this presents a major transitional issue: How will already established plans be categorized into these two distinct classifications? I suggest that a set of criteria such as the following might be implemented:
- any plan which is currently in surplus on a solvency basis and in which the plan documents provide (or are amended to provide) that surplus on plan termination inures entirely to the benefit of plan members would be registered as a "pooled contribution pension plan";
- any plan for which the employer establishes (or has already established) that it is entitled to the surplus under the pension plan in the manner associated with PBSA s.9.2(1)(a)(i) would be registered as a "pure" defined benefit plan;
- any plan which is currently in deficit on a solvency basis and for which the employer agrees to become fully responsible for the deficit on plan termination, and for which the terms of the pension plan would provide that the employer was entitled to any surplus on plan termination if the validity of all amendments concerning surplus made prior to some recent date (say January 1, 2000, for example) were accepted without question, would be registered as a "pure" defined benefit plan;
- any plan where the employer and at least 2/3 of the current active members and 2/3 of the current inactive members agree to the categorization of the plan would be registered according to the agreed upon classification; and
- any plan which cannot be categorized by the above mechanisms by some prescribed date would either be terminated according to the rules currently in effect or submitted to arbitration along the lines set out in PBSA s.9.2.
In addition to, or in conjunction with, the agreement or arbitration schemes set out in the latter two points, it should be possible for the parties to agree on some split use of any currently existing surplus. This could include, perhaps, a crystalization of the amount of current surplus that could be withdrawn by the employer or utilized by the employer for a so-called "contribution holiday" in the context of a plan that would thereafter be governed as a "pooled contribution pension plan".
Once the regime is fully in place, a "pooled contribution pension plan" could be converted to a "pure" defined benefit plan with the consent of the employer and at least 2/3 of the then current active members and 2/3 of the then current inactive members provided it was at that point not in a surplus position on a solvency basis. Conversely, a "pure" defined benefit plan could be converted to a "pooled contribution pension plan" with the consent of the employer and at least 2/3 of the then current active members and 2/3 of the then current inactive members provided it was at that point not in a deficit position on a solvency basis.
I submit these comments and opinions in the sincere belief that a regulatory regime such as described herein would provide a solid framework for a robust pension industry over the long term. I would be pleased to be available to provide any further elaboration on these points that the department may find useful.