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KPA Advisory Services Ltd. Submission in Response to Finance Canada's Regulatory Framework for Federally Regulated Defined Benefit Pension Plans consultation:

The Ambachtsheer Letter

Research and Commentary on Pension Governance, Finance and Investments

Letter # 282 
August 2005

Pension Reform:
Evolution or Revolution?

"Risk management for pension plans is not always adequate".

Discussion Paper, 2005
Régie des rentes du Québec

Two Pension Tipping Points

One year ago, in our August 2004 Letters, we identified two events that had the potential to be the tipping points towards initiating significant change in workplace pension arrangements. The USA/Global Letter opined that the United Airlines case had the potential to finally make it clear to all that DB plans are complex, often not fully-defined, risk-sharing 'deals'. Under financial stress, these 'deals' invite game theory-driven bargaining between such strange adversaries and bedfellows as retirees, older workers, younger workers, corporate boards, bond holders, shareholders, and the Pension Benefit Guaranty Corporation (PBGC). Pension regulators, securities regulators, actuaries, accountants, and the courts all play supporting roles in the scripts of these bargaining dramas. Last year's observation about UAL seems even more on the mark today. The case continues to make headline news, and more importantly, has caught the attention of Washington. The term 'pension reform' is now on everyone's lips from the White House to Capitol Hill.

If the UAL case was the pension tipping point south of the border, surely the Monsanto case played that role here. While much of the Canadian pensions industry was wearing sack cloth and ashes after the Supreme Court of Canada ruled that partial plan wind-ups required pro-rata surplus distributions, we offered a positive spin on the decision in our August 2004 Canadian Letter. We were encouraged to read that the Court understood the following:

Pensions have evolved over time from employer gratuities to enforceable legal claims.

  • The intent of pension legislation is to strike "a fair and delicate balance" between employer and employee rights and obligations.
  • Pension plans represent risk-sharing arrangements between employers and current and former employees. There should be a fair distribution of both risks and rewards between various stakeholder groups in any pension arrangement.

We concluded last year's August Letter by observing that the Court had handed the Canadian pension industry an important task. What are the necessary and sufficient conditions for creating and maintaining fair, sustainable risk-sharing pension arrangements? Clearly, that is the ultimate 'pension reform' question on which the Court believes everything else rests. Our challenge is to answer it.

There have indeed been a number of 'pension reform' proposals since August 2004. Rather than recite them in detail, the purpose of this Letter is to offer a broad perspective on pension reform. What, in an ideal world, should happen? Will the measures actually being proposed narrow the gap between where we are, and where we ideally should be? These are the questions to be addressed below.

What Should Happen?

Readers of this publication already know our answer to the 'what should happen?' question. The Ambachtsheer pension revolution has five key elements. Some of these elements build on ideas first expressed by Peter Drucker in his pensions book "The Unseen Revolution" 30 years ago:

  • Increase Pension Plan Participation
  • : the Dutch and the Australians have made workplace pension plan participation mandatory. This not only smoothes out lifetime income and consumption for workers, but also takes considerable pressure off their national, unfunded Pillar #1 social security systems. In addition, mandatory participation creates a strong incentive to innovate, and increase productivity in funded Pillar #2 workplace-based pension plans. As icing on the cake, diverse wide-spread Pillar #2 pension plan membership promotes the idea of 'an ownership society' far more effectively than partial funding under a remote Pillar #1 social security system, with or without the optional individual pension accounts proposed by the Bush Administration.
  • Foster Pension Plan Autonomy
  • : pension delivery organizations should operate as single-purpose, arms-length agencies, not beholden to any special interest groups in the labor, corporate, or government sectors. This will minimize the potential for 'agency' factors hi-jacking what should be the only mission of pension plans: to produce adequate, reliable pensions at a reasonable cost.
  • Make Risk-Bearing Transparent
  • : the inevitable risks embedded in pension arrangements should be made transparent, both with respect to magnitude, and with respect to who is actually doing the risk-bearing. This is especially important in DB schemes, where risks are borne collectively in complex ways by multiple stakeholder groups.
  • Refocus Pension Investments
  • : investment strategies should clearly be assigned one of three possible goals. Risk-minimization strategies focus on risk control. Adversarial trading strategies focus on generating net trading profits within pre-established risk-budgets. Long-horizon investing strategies focus on purchasing uncertain future cash-flows at reasonable prices. This third strategy makes pension funds important investors in society's means of production, which in turn implies a necessity on their part to act as responsible, knowledgeable, and assertive long-term business owners.
  • Improve Pension Plan Governance
  • : pension plans themselves must act as responsible, knowledgeable organizations. This implies a need for strong internal governance mechanisms. Without such mechanisms, it will not be possible to refocus pension investment programs and create needed risk-transparency along the lines set out above. In short, without good governance, pension plans will not achieve the required 'legitimacy' in the eyes of the stakeholder groups they are meant to serve.

If this is what should happen, will the pension reform proposals actually being floated move the Pillar #2 pension system in the right direction? That is the question we address next.

Pension Reform in the USA

While Social Security reform has stalled in the USA, the UAL saga has created enough momentum to result in the floating of a series of measures to stabilize the finances of corporate DB plans. Congress' Pension Protection Act sponsored by John Boehner (R-Ohio) seems to be the best candidate to be passed into law at this point. The legislation has seven goals:

  1. Tighten Funding Rules: for corporate DB plans this means a standardized market-based yield curve to discount accrued pension promises, raising the minimum solvency funding target from 90% to 100%, shortening the amortization period for solvency deficits to seven years, and prohibiting the use of credit balances in lieu of cash contributions if the funded ratio is under 80%. Similar measures for multi-employer plans.
  2. Increase Contribution Room: corporations can continue to contribute to DB plan up to a new ceiling of 150% of the accrued liability.
  3. Prevent 'Gaming': pension benefits cannot be increased and lump sum distributions cannot be made if a plan is less than 80% funded. Executives cannot be given "generous deferred compensation arrangements if the corporation has a severely under-funded pension plan".
  4. Improve the Financial Condition of the PBGC: while tighter funding rules should improve the future financial prospects of the PBCG, the Act also proposes modest PBCG premium increases.
  5. Strengthen the Legal Status of Cash Balance Plans: details to be announced.
  6. Improve Disclosure: more detailed and timely information to be included on Form 5500 and 4010 filings.
  7. Improve Financial Advice to DC Plan Participants: the bill is to clarify that employers do not incur legal liability for individual advice given by professional financial advisers to plan members, and to require that financial advisors are "fully qualified to offer quality advice solely in the interests of plan members".

While these measures are deemed to be quite radical in some quarters, others think them to go not nearly far enough. For example, seasoned Washington-based pension attorney Steve Saxon recently called the Boehner bill "a stop-gap measure" which does little to address the fundamental flaws of the American corporate DB system. Unfortunately, he correctly points out, wholesale conversion to DC plans does not solve America's looming retirement income crisis either. In his words, "it is time (and perhaps long overdue) for us in Washington to develop better opportunities for Americans to save for retirement" (see the July issue of PLANSPONSOR, p.86). We heartily agree with Mr. Saxon.

Pension Reform in Canada

Thus far, legislators and pension regulators in the English-speaking Canada have not been any more insightful or creative than those in the USA in reforming their respective pension systems. The Québec pension regulator Régie des rentes offers a refreshing contrast to these uninspiring records. In a consultation paper issued earlier this year, the Régie makes the following telling observations (our words):

  • A combination of factors have turned DB plans into serious financial burdens for many employers. The 5-year amortization period for solvency deficits can be especially troublesome.
  • The asymmetrical treatment of pension balance sheet surpluses and deficits in tax, accounting, and legal contexts creates strong incentives for employers to under-fund and adopt aggressive investment policies.
  • Actuarial methods are generally imprecise, lacking in theoretical rigor regarding the measurement and management of risk. For that matter, none of the other pension fiduciaries seem to be able and/or willing to measure and manage balance sheet risk either.

These observations lead the Régie to make a series of reform proposals, including:

  • Funding targets should include a buffer for adverse experience. Preliminary research indicates "15% of the value of solvency liabilities would be sufficient for most plans".
  • Increase the amortization period for solvency deficits to 10 years.
  • Allow financial instruments (e.g., letter of credit from a qualifying financial institution) to be used to guarantee amortization payments for solvency deficits.
  • Limit contribution holidays to the year immediately following an actuarial valuation.
  • Permit agreement in advance on the allocation of balance sheet surpluses in excess of the required target buffer for adverse experience. Such an agreement would be negotiated between representatives of the employer, the employees, and pensioners.

Implementation of these Régie proposals would move the regulatory framework for Québec-registered DB plans significantly towards the new Dutch framework with its tough capital adequacy requirements in relation to pension guarantees, and its underlying philosophy of explicit risk-sharing. We noted in last month's Letter that the net result of these measures in the Netherlands has been a move towards reducing the level at which pensions are guaranteed in collective pension schemes, making the actual level of pensions paid (subject to a nominal floor guarantee) conditional on the financial status of the pension plan balance sheet.

Pension Reform: Evolution or Revolution?

The measures being proposed in Washington's Pension Protection Act offer a classic example of the evolutionary approach to pension reform. Tighten up the funding standards a bit, raise the surplus ceiling a bit, increase PBGC premiums a bit, reduce opportunities for gaming a bit, say some nice things about Cash-Balance and DC plans, and maybe everything will turn out OK. Maybe, but not likely.

Québec's Régie des rentes proposals go much further. First, its consultation paper is far more blunt in opinionating that there continues to be a serious lack of transparency in DB plan risk measurement and management protocols. Second, its reform proposals are far more ambitious, starting with the concept of a balance sheet buffer against adverse experience, through to the facilitation of contribution payment guarantees by qualified commercial third-parties (rather than guarantees through a non-commercial, hamstrung government agency), and offering encouragement to DB balance sheet stakeholders to fully articulate their 'pension deal', including claims on potential future surpluses. The Régie's attitude and proposals begin to approach those of the Dutch pension regulator with its new revolutionary 'fair-value'-based capital adequacy approach to risk management in shared-risk pension plans.

It should by now be clear where we stand on the pension reform 'evolution or revolution?' question. The time for evolution has come and gone. The time for revolution has arrived. That means making workplace-based pensions available to the entire workforce. It means delivering pensions through expert, single-purpose, arms-length pension organizations. It means making risk-bearing transparent, both with respect to 'how much', and with respect to who is doing the risk-bearing. It means integrating risk management with asset return generation. Finally, it means fostering governance processes in pension organizations that have 'legitimacy' in the eyes of all stakeholder groups. Thus these processes must be, and must seen to be, both expert and even-handed with respect to the financial interests of all stakeholder groups.

While the implementation of such a package of reforms would be revolutionary rather than evolutionary, its elements are by no means 'pie-in-the-sky' abstractions. Each element already has a concrete counterpart somewhere in the real world. What has been missing is the leadership to turn all the pieces into one coherent whole. Through its proposals, Québec's Régie des rentes has made the prospect of a genuine pension revolution in North America just a little brighter.

Published by KPA Advisory Services Ltd., 151 Bloor Street West, Suite 702, Toronto, Canada M5S 1S4
Tel: (416) 925-7525 Fax: (416) 925-7377 e-mail: kpa@kpa-advisory.com website: www.kpa-advisory.com
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