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Bell Canada, Canadian National Railway Company, Canadian Pacific Railway Company, Manitoba Telecom Services Inc. and NAC CANADA's Submission in Response to Finance Canada's Regulatory Framework for Federally Regulated Defined Benefit Pension Plans consultation:
Joint Submission to Department of Finance Canada on its May 2005 Pension Plan Consultation Paper
Submitted by the Chief Financial Officers of Bell Canada, Canadian National Railway Company, Canadian Pacific Railway Company, Manitoba Telecom Services Inc. and NAV CANADA
September 14, 2005
This submission to the Department of Finance is being made by the Chief Financial Officers (CFOs) of five federally-regulated employers in the transportation and communication industries, being:
Canadian National Railway Company
Canadian Pacific Railway Company
Manitoba Telecom Services Inc.
Our defined benefit pension plans, all of which are registered under the Pension Benefits Standards Act (PBSA), collectively cover approximately 83,000 employees and provide pensions to over 100,000 retired employees and their beneficiaries. Our pension funds collectively contain approximately $33 billion of assets, which represents over 35% of the assets of all of the defined benefit plans registered under the PBSA.
Our organizations are all making individual submissions to the Department on its May 2005 consultation paper entitled "Strengthening the Legislative and Regulatory Framework for Defined Benefit Pension Plans Registered under the Pension Benefits Standards Act, 1985".
We – the CFOs of our five organizations – strongly believe that the viability of defined benefit pension plans is threatened by the current legislative and regulatory framework, and that immediate action is required by the federal government to address this situation. Otherwise we will see a continuing and rapid diminution of the role of defined benefit plans in providing benefit security for Canadians. This submission articulates our concerns and our proposals for changes to the current framework.
We consent to this submission being posted on the Department of Finance Canada web site and to a copy of this submission being forwarded to OSFI.
Our Over-Riding Concern
The current solvency deficit funding rules are creating an unwarranted crisis for investment-grade companies that sponsor defined benefit pension plans.
The current solvency deficit funding rules are counter-productive:
- The solvency valuation test is an unrealistic worst case scenario. It assumes plan wind-up or plan sponsor insolvency. It is based on each employee being assumed to retire at the age that maximizes the plan's liabilities. For virtually all investment-grade companies, the plan wind-up or sponsor insolvency scenario is highly unlikely to occur for the foreseeable future.
- Today's low interest rates have created significant solvency deficits for many defined benefit plans. We acknowledge the need to fund going-concern deficits over a period up to 15 years, and are committed to funding them in this manner. However, the extra contributions required to fund solvency deficits are creating unwarranted negative business impacts on numerous defined benefit plan sponsors. While a five-year amortization period may be appropriate for companies that are financially vulnerable, for investment-grade companies (such as our five organizations) the extra cash flow requirement can and does create a huge drain on our businesses. This drain may adversely impact future employment prospects and compensation levels for our employees, and may divert investment monies away from productive uses within our businesses.
- These solvency deficit contributions will result in surpluses if long-term interest rates return to more normal historic levels and/or if future equity markets are more favourable. Due to today's surplus ownership rules, such contributions will subsequently become trapped capital that is unavailable for use by the plan sponsor, and yet is not needed for pension benefit security purposes for our organizations.
- The current solvency funding rules result in current and potential demands on corporate cash flow for pension funding which may in fact have a negative impact on a plan sponsor's credit rating, with the result that borrowing costs are higher than necessary.
The best pension benefit security for defined benefit plan members is a financially strong plan sponsor.
Other Critical Concerns
The Department's consultation paper asks whether there are any disincentives or obstacles preventing plan sponsors from adequately funding their plans and building up a funding cushion. We stress that there are indeed some major barriers to so doing. For plans where the plan sponsor is solely responsible for deficits (via amortization payments or at plan wind-up), there exists a major imbalance between risk and reward (known as "asymmetry"). While the plan sponsor is responsible for funding any deficits, the rewards for the plan sponsor for taking pension risk are uncertain and unappealing:
- Surplus assets are not freely available to the plan sponsor on an ongoing basis or upon plan wind-up
- The right to contribution holidays is not spelled out in legislation
- The existing dispute settlement mechanism (involving member consent) is both inequitable and cumbersome
- Due to the Monsanto decision, there is a potential requirement to allocate surplus on a partial plan wind-up, when in fact much or all of that surplus may have been created through the use of actuarial margins that we have built into our employer contributions in order to enhance benefit security for our plan members.
When we encounter asymmetry between risk and reward in our day-to-day businesses, we invariably choose to minimize or avoid such an investment, or we divest. This common-sense business approach is being applied increasingly these days to the funding and management of defined benefit plans.
Immediate Action Required
Urgent government action is paramount
. We are presently facing onerous and volatile contributions arising from the five-year solvency deficit funding requirement which is driven by an artificial measure of our pension liabilities – and hence are facing the counter-productive implications described above.
While full symmetry of risks and rewards is desirable in order to improve the health of the defined benefit plan system, we recognize that this is not achievable in the immediate future. Accordingly, we strongly request a two-step solution:
- Step 1 involves immediate relief in respect of our over-riding concern regarding solvency deficit funding, which we believe can be accomplished through a change in the existing Regulations under the PBSA.
- Step 2 would, at a later date, include a more comprehensive set of changes to the PBSA and/or its Regulations, including resolution of the balance of our solvency deficit funding concerns.
We are seeking immediate relief from the existing solvency deficit funding rules for investment-grade companies.
We request an immediate lengthening of the solvency deficit amortization period to a minimum of 10 years and up to 15 years for investment-grade companies (with "investment-grade" defined using the standard conventions within the capital markets). We believe that it would be reasonable to retain the existing 5 year amortization period for financially vulnerable plan sponsors.
The existing Regulations under the PBSA permit the solvency deficit amortization period to be so extended, thereby permitting this immediately-needed change to be enacted promptly.
We stress that an extension of the solvency deficit amortization period is not simply a solution designed to appeal to shareholders, analysts and rating agencies. It is a solution that will permit available cash flow to be directed to plant, property or equipment investments that would make companies healthier and improve their ability to support their pension plans – thereby leading to greater benefit security in the long term for pension plan members. It will provide investment-grade plan sponsors with much needed flexibility without impacting benefit security, and, in doing so, will enhance the viability of defined benefit pension plans.
Step 2 would include a more comprehensive set of changes to the PBSA and/or its Regulations. These should include additional changes to address the balance of our solvency deficit funding concerns, as described below, as well as other changes such as those identified in the following section of this submission.
In addition to the lengthening of the solvency deficit amortization period as described in Step 1, the following additional changes are needed to the legislative framework to address our solvency deficit funding concerns:
A. To the extent that solvency contributions exceed the contributions being made towards a going-concern deficit, plan sponsors must be able to freely recover these monies at a later stage if a solvency surplus develops, without the usual impediments to surplus refunds. This will address our concern regarding "trapped capital". This is not an alternative to lengthening the solvency amortization period – it is needed in addition.
Practical approaches to addressing this concern include:
- Permitting plan sponsors to use letters of credit in lieu of solvency contributions, to the extent that these contributions exceed going-concern deficit contributions; or
- Permitting plan sponsors to hold funds in trust outside the registered pension plan, in lieu of solvency contributions, to the extent that these contributions exceed going-concern deficit contributions.
Such letters of credit or funds held in trust should be included as pension plan assets for the purpose of solvency valuations. In addition, the amounts covered must be permitted to be reduced or canceled if a solvency surplus later develops. With respect to the letter of credit alternative, we endorse the proposal set out in Attachment 1 of ACPM's August 2005 report entitled "Back from the Brink – Securing the Future of Defined Benefit Pension Plans".
Letters of credit have been widely used in Canada for securing non-registered pension benefits and have recently been adopted by Quebec as a mechanism for securing registered pension plan benefits.
Funds held in trust have also been widely accepted in the debt capital markets as an essential security feature of, or covenant for, infrastructure bond issuance. This structure could easily be applied to other long term obligations such as pension liabilities.
Thus, we propose that for investment-grade companies, it would be acceptable for the actual deficit funding contributions to be limited to those that amortize any going-concern deficit over a period of up to 15 years, and that one of the above-mentioned alternative security instruments (letter of credit, or funds held in trust) be permitted to cover the difference between those contributions and the contributions that would otherwise be required to amortize a solvency deficit over a minimum of 10 years and up to 15 years.
We regard these as practical approaches to partially address the asymmetry problem, and we believe they can be implemented through Regulation change alone.
B. The hypothetical wind-up scenario that the Regulations under the PBSA prescribe as a basis for computing solvency liabilities leads to excessive margins, and should be revised for the following reasons:
- Solvency liabilities are a proxy for plan wind-up liabilities – an exact replication of wind-up liabilities is unnecessary and unachievable.
- The determination of solvency liabilities has been largely left to the Canadian Institute of Actuaries (CIA), but one of their assumptions is not realistic. In developing standards that reflect this hypothetical wind-up scenario (which includes an assumption that retired members' benefits will be settled via the purchase of a group annuity contract), the CIA's standards require actuaries to attempt to replicate group annuity prices. However, the Canadian group annuity market (with annual premiums estimated to be in the range of $500 million to $750 million) is too small for many pension plans to be able to discharge their obligations via an annuity purchase. We believe that this anomaly results in an overstatement of solvency liabilities.
- In addition, the CIA's standards for determining solvency liabilities do not accommodate the fact that if a company of our size were to wind up its defined benefit plan, the plan would have to continue operating for many years in order to ensure that the accrued pensions are fully paid, which means that the plan would be invested in the markets for many years. The CIA's standards do not recognize any assets beyond long Canada and provincial bonds in this situation, which is not realistic. Yet the U.S. has recognized this in its new funding rules, by valuing the "current liability" using a discount rate that is based on the yield on long term investment-grade corporate bonds.
- Further, there is almost no market for indexed annuities relating to a pension that automatically escalates in accordance with the Consumer Price Index (CPI). The CIA's standards link the cost of future inflation protection to the difference in yields between nominal and real return bonds. However, real return bond yields are artificially low due to a mismatch between supply and demand of real return bonds, as recognized by the Bank of Canada in its Autumn 2004 Bank of Canada Review. As a result, this measure overstates expected future inflation, and hence overstates the solvency liabilities computed for indexed pension benefits.
We therefore propose that solvency liabilities be determined by assuming that all members' benefit obligations upon plan wind-up be assumed for solvency valuation purposes to be invested in long term investment-grade corporate bonds.
Further, with respect to the absence of a market for indexed annuities, we propose that a simple proxy be created for the CPI for the purpose of determining solvency liabilities for retired and active members with respect to the indexing of their pensions (such as 2% or 3%, depending on recent average CPI increases; or alternatively, the Bank of Canada's mid point inflation target) – this would enable solvency liabilities to instead be determined using the yields on nominal bonds whose market operates much more efficiently than the real return bond market.
Balanced Approach to Strengthen the Legislative and Regulatory Framework
In seeking the above funding changes as a means of ensuring the long term viability of the defined benefit plan system, we recognize the need for a balanced approach when implementing changes to something as important to Canadians as the laws protecting their retirement income. In this regard, we would encourage certain other changes to be made towards strengthening the plan system. These include the following:
1. A requirement for plan sponsors to fully fund any deficit on plan termination (with such funding either, at plan sponsor discretion, made in a lump sum or amortized over a period of years).
2. Restrictions on plan improvements that cause the solvency ratio to drop below a specified threshold (such as 85% to 95%) – more costly plan improvements would then need to be financed by a lump sum contribution that brings the solvency ratio back up to the threshold.
3. A lower priority claim on pension assets with respect to recent benefit improvements in the event of a plan wind-up, in the situation where full funding is not available to all plan members on account of plan sponsor insolvency.
4. Greater disclosure of the funded status of the pension plan, the plan sponsor's funding policy, and the plan sponsor's financial viability. With respect to the latter, we note that over the last couple of years the information that is available publicly relating to the financial condition of plan sponsors has become much more extensive due to new disclosure rules applicable to publicly-traded companies.
5. The Canada Revenue Agency limit on employer contributions when there is an "excess surplus" does not adequately recognize the extent to which a plan can move from surplus to deficit or vice versa. An increase in the existing 10% surplus threshold would be reasonable.
We do not believe that there is a need for a pension guarantee fund for federally-regulated employers. 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.
We believe that the current legislative and regulatory framework for defined benefit pension plans jeopardizes the viability of defined benefit plans. Significant changes are required to the current framework, including immediate government action to address the onerous and volatile solvency contributions caused by the current Regulations under the PBSA. We believe that the changes we are proposing in this submission will go a long way towards ensuring the viability of defined benefit pension plans.
We look forward to the opportunity to continue our dialogue with the Department of Finance.