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RBC Financial Group's Submission in Response to Finance Canada's Regulatory Framework for Federally Regulated Defined Benefit Pension Plans consultation:

On RBC letterhead

September 12, 2005

Diane Lafleur
Financial Sector Policy Branch
Department of Finance
L'Esplanade Laurier
20th Floor, East Tower
140 O'Connor Street
Ottawa, Canada
K1A 0G5


As the sponsor of a very large private sector pension plan we are pleased to submit our comments on the consultation paper "Strengthening the Legislative and Regulatory Framework for Defined Benefit Pension Plans Registered under the Pension Benefits Standards Act, 1985" published in May, 2005 (the "Paper").

We are delighted that the government has recognized the need to review the legislative standards governing the funding of defined benefit pension plans and that you have sought input from informed and interested parties including RBC Financial Group.

We all recognize that the subject of defined benefit pension plan funding is complex. Many factors need to be taken into account in creating an optimal legislative regime and the discussion is needed for all Canadian jurisdictions. It is important for the government to act to provide clarity in pension legislation, regulation and arrangements that provides for a fair and balanced consideration of all stakeholder interests. We respectfully offer our comments in the attached document for consideration and action by the government. The document is structured to first provide a general critique on the current environment and second to provide responses to the specific questions raised in the Paper.

Yours truly,

Signed by Gary Dobbie
Senior Vice President.

Current Situation

The environment that now exists in Canada makes it imperative that an immediate and comprehensive review and overhaul be undertaken of the pension system. Some of the major concerns sponsors have with the current pension system are as follows:

1. Asymmetry: Asymmetry in the system unfairly impacts companies that have been generous in extending to their staff defined benefit plans. Deficiencies are the responsibility of the sponsor while surpluses are often shared or dedicated exclusively to plan members. Even though most sponsors can have contribution holidays when there is a funding surplus, the lack of sponsor ownership of surplus on wind ups and the potential for asset distribution and mandated annuity purchases on partial wind up are very very significant problems. The general result is that a sponsor who is able to fund above the minimum will not do so. Similarly, sponsors who consider offering new defined benefit pension plans will not do so. Sponsors who are able to, will opt out of offering defined benefit pensions. Defined benefit pension plans are a significant economic engine for investment in the growth of Canadian businesses. Without a balanced system we are significantly at risk of diminishing this economic growth. In addition defined benefit pension plan continue to diminish it will place added pressure on governments to significantly enhance the current state sponsored retirement programs like CPP/QPP and OAS

2. Low interest rate environment: The impact of solvency funding standards is beginning to take hold in the current low interest rate environment. Plan sponsors who once experienced only going concern funding or perhaps had long and consistent contribution holidays are now required to contribute large amounts to their pension plans. This places stress on the supporting business and, with asymmetry, it makes no economic sense to contribute.

3. Benefit loss: There are plans with large matured liabilities, insufficient assets for plan termination, and financially challenged employers who are unable to fund the benefits on plan termination. For some, the risk of benefit loss due to plan insolvency has materialized.

There is a philosophical point of departure between a going concern funding system and a solvency funding system. A going concern system places more weight on the assumption that the business will continue. The risk of benefit loss on insolvent plan termination is recognized but accepted, so that more risk is allocated to a future generation of plan members. A solvency funding system addresses the risk of benefit loss more rigorously, placing a greater burden on the contributing sponsor.

In today's low interest rate environment there is an obvious trend in thinking toward solvency as an appropriate standard for funding. Canadian policy makers and plan members are concluding that the risk of benefit loss is too high, and that the solvency funding system needs to be more robust. However it is simply incorrect to assume that altering solvency-funding standards will strengthen Canada's defined benefit system. Without correcting asymmetry, making solvency-funding standards more rigorous will only encourage more sponsors to seek a way out. It is clearly evident that the current bias against the sponsor has had a detrimental affect on the number of Canadians covered by a defined benefit pension plan as well as being a strong deterrent to the creation of new defined benefit plans. A recent Globe and Mail article on August 25 identified that "coverage by defined benefit plans declined to 34% of the work force in 2003, down from 44% in 1992"

A solvency-funding standard should have the following attributes:

  • Symmetry

. Decisive measures to restore symmetry are needed, most significantly through eliminating partial wind up surplus distribution and creating mechanisms for sponsor contributions in which the sponsor owns any funding excess.

  • Letter of credit
  • . Letters of credit should be recognized as a plan asset for solvency valuations. This is a very meaningful way to offset asymmetry and address risk of plans and sponsor insolvency.
  • 100% funding target
  • . The funding target should be 100%. It is too onerous to require a margin above 100%.
  • Contribution holiday threshold
  • . Full funding for purposes of contribution holidays should be defined at a level above 100% solvency. This is an alternative to reducing the triennial valuation cycle and it encourages voluntary funding above 100% solvency.

If the focus is on solvency, then going-concern valuations should not be required. They would remain optional for the plan sponsor.

It should be clear in legislation that any decisions made within the minimum funding requirements, and any decisions made to contribute above the minimum on a solvency or going concern basis, are decisions of the contributing sponsor and not of the pension plan administrator. This is important because a fiduciary duty imposed on a contribution decision is tantamount to an obligation to contribute as much as permitted, regardless of the impact of that funding on the supporting business. Employers and other plan administrators should not be placed in this untenable conflict.

If a rebalancing of sponsors' interests and the burden on business is not achieved, Canada's defined benefit pension system will continue to weaken. The defined benefit promise (together with defined contribution schemes) is an important component of Canada's retirement system to encourage retirement wealth accumulation (thereby reducing reliance on the general taxpayer) and as an important source of investment in the future of Canada. It should be a feasible and economically sustainable option for sponsors to provide a defined benefit plan, but the current unfairness does not encourage that. Society recognizes that the ideal system is one that allocates risk among sponsors, employees, pensioners and the public purse sensibly and realistically.

Addressing Asymmetry

The growth of surplus during the late 1990's and emerging disputes around ownership coupled with the reluctance of legislating to directly address this issue has resulted in the courts to tend towards interpreting the pension arrangements as a classic trust rather than a contract or business trust.

The ideal environment for businesses to support defined benefit pension plans is one in which the obligation to members is to provide the promised benefit, and in which the potential for economic gain and loss in setting aside funds to pay those benefits is balanced. The sponsor who assumes the funding risk would own surplus on wind up. The right to take a contribution holiday would be clear. Assets would be available to the sponsor for withdrawal when the funding is excessive. There would be no partial wind-ups requiring distributions of actuarial surplus. In such an environment the contributions made to fund the benefits would equal the actual cost of the benefits and this would help encourage sponsors to fund above the minimums and allow employers sufficient reason to justify the cost of providing defined benefit programs for their employees. In this day and age of dynamic global competitiveness companies will consistently and perhaps more frequently merge, outsource and reconfigure their operations to be competitive. It is necessary for a small economy like Canada to provide an environment that supports economic growth and the current legislative environment surrounding partial windups is contrary to that objective. Ultimately, in such an environment, the contributions made to fund the benefits would equal the actual cost of those benefits. The system would encourage sponsors to fund above minimums and allow employers to justify the cost of providing defined benefits to their employees.

The status quo is different from this ideal. In order to correct the status quo completely, sweeping changes legislation that redefines existing rights –with retroactive application is required.

However, there are several measures that should be implemented to make a significant correction to asymmetry. All or substantially all of the following measures are needed:

  • Partial Wind-up

: The notion of partial wind-up should be eliminated, as has been done in Québec, in all jurisdictions. This is the single most important problem in the system today. .

  • Letter of credit
  • : Letters of credit should be a recognized asset in solvency valuations. This would be an important improvement to the system for financially healthy employers who are otherwise reluctant to make contributions that result in trapped capital. This increases funding flexibility without reducing security of benefits. This mechanism is urgently needed if the government is going to allow asymmetry to persist.
  • New plans: Legislation that creates a more balanced and fair environment for new defined benefit plans should be enacted.
  • New rules for future contributions: A symmetrical environment could be created prospectively for existing plans. For example, legislation could be created to support freezing benefit accruals in a current plan at the current solvency level, while a new fund is set up to provide for future service accruals, increases in past service benefits and funding of deficits for past service. The sponsor would have clear ownership of surplus in the new fund and benefits would be paid from the first fund until it is depleted.
  • Contribution holiday

: Statutory provisions should expressly grant a presumed right to a contribution holiday unless there is a contrary stipulation in the current plan rules. The sponsor's ability to amend the plan to expand contribution holidays should be clearly supported by legislation. Although currently the common law provides this result, and most legislation can be interpreted consistently with this result, express legislative codification of these rules is needed.

  • Business transaction
  • : Legislation should make it clear that actuarial surplus need not be included when assets and liabilities are transferred to a successor employer's pension plans. The role of the legislation should be to ensure that existing levels of benefit security, up to 100% solvency, are protected in these transactions.
  • Ongoing surplus withdrawal
  • : Withdrawal of surplus by the sponsor while the plan is a going concern should be permitted, where surplus is in excess of a margin (for example, 10%), at the option of the sponsor:
  • 1. If the sponsor is entitled to surplus upon wind-up; or
  • 2. With a prescribed and workable level of member consent (for example, less than 45% opposition).
  • Surplus ownership on total wind-up

: There should be statutory provisions that presume sponsor entitlement to surplus, unless provided otherwise in plan rules and other trust documents. The process for determining ownership as provided in plan rules and other documents should be fair and efficient. If a sponsor can establish ownership there should be no conditions on recovery of those assets by the sponsor, such as Ontario's current member consent rule.

From all points of view, a system in which the asymmetrical treatment of surplus and deficits has been eliminated will offer more incentives for improved funding from plan sponsors, which will greatly benefit plan members.

Funding Measures

Several measures affecting solvency-funding standards, in combination with correction of asymmetry, would strengthen the current system without undue burden.

Letter of Credit

Letters of credit should be a recognized asset in solvency valuations. A letter of credit is an effective form of security, since payment to the pension plan from the issuing institution would be required in the event that the letter of credit is not renewed. A contribution by the sponsor would offset the amount to be paid under the letter of credit.

Contribution Holidays

Contribution holidays are an essential element of a fair and balanced retirement system and they should not be constrained unless absolutely necessary. However, there are two ways in which contribution holiday rules should be modified. Both measures respect the principle underlying a contribution holiday, that when a plan is adequately funded contributions are not required.

The first addresses the definition of adequate funding for this purpose. Since solvency status fluctuates considerably, it is desirable (if there is a fair and balanced employer/employee retirement system) for plans to be funded at some level above 100% solvency. Placing the threshold above which a contribution holiday is permitted at a level above 100% solvency would encourage above-minimum funding by plan sponsors (presuming, of course, that symmetry is restored). Over time, funding margins would be achieved.

Secondly, the threshold level (excess over solvency liability) should reflect the mismatch of assets to liabilities. For example, a plan with more equity exposure than the liabilities justify will have a higher threshold:

  •  The method to calculate the threshold should be suggested by the CIA and should take into account that contribution holidays are allowed only after the threshold is reached;
  • The mismatch is difficult to measure, especially considering new types of investment options. Issues of timing for purposes of measuring the asset mix would also have to be addressed.
  • The rules should be flexible enough to allow actuaries and sponsors to demonstrate that the threshold should be lower to reflect the plan's unique circumstances
  • The 10%/20% limit imposed by the Income Tax Act which prevents contributions when a modest surplus exists should be raised to accommodate this build-up of funds.

Solvency Valuations

A solvency valuation should be a pure or nearly pure wind up valuation that reflects the benefits that would actually be paid on plan wind up. In the solvency valuation, current service cost should be calculated on a solvency basis. Considering potential volatility because of demographic factors, current service cost could be calculated as the average annual increase in the discounted actuarial value of benefits on a solvency basis over, say, the next three to five years, projected assuming going concern-type demographic assumptions and salary increases. It should be assumed that asset earn the discount rate used in the valuation.

Full Funding on Wind Up

It is clear that an employer should not be able to terminate a plan and continue in business without funding benefits in full over a specified and reasonable period of time of say 5 years.

For some plans a full wind up is problematic because of large pensioners' liabilities, especially if the pensions are indexed. The Canadian annuity market cannot absorb large purchases of annuities. Furthermore, when pensions are indexed the annuity prices are far too high, or the insurance product is simply not available. Legislation is needed to allow the payment of commuted values in place of the mandatory purchase of annuities, or to allow the employer to use the commuted value to purchase an annuity product that is currently available in the market.

This problem currently exists for partial wind up as well as full wind-ups in many jurisdictions. If the partial wind up is not eliminated, it should be made abundantly clear that annuity purchase is not required.

Going Concern Valuations

A going concern valuation where required or where voluntarily adopted by plan sponsors should not include a funding margin. The objectives of a going concern valuation are to establish stable and foreseeable contributions and the proper allocation of costs over time and between generations. There should be no regulatory intervention in the selection of assumptions; these should be based solely on CIA practice standards.

Submissions on Funding RBC Responses to Specific Questions in the Consultation Paper:

Are there disincentives or obstacles preventing plan sponsors from adequately funding their plans and building up a funding cushion?

Yes. The key problems are lack of sponsor ownership of surplus on plan wind up, and the potential for asset distribution on partial wind up coupled with the current partial wind up legislative inequity.

Should there be partial plan terminations under the PBSA and if so, should there be a requirement to distribute surplus at the time of the partial wind up?

No, there should be no partial plan termination under the PBSA. The idea of a partial plan termination with surplus distribution, mandated annuity purchases, and accelerated full solvency funding for part of a plan, all while it is otherwise a going concern, is unworkable. It creates the single most significant barrier to the sustainability and adequate funding of defined benefit pension plans today. The current environment favours small special interest groups of members to the detriment of the majority of plan members.

If there is a concern that large changes in the plan warrant a new funding valuation, this objective can be achieved without creating a partial wind up. Similarly, full vesting, grow-in benefits or portability for members affected by a significant event can be achieved without creating a partial wind up.

Are there alternative financial vehicles such as letters of credit that could allow for greater funding flexibility? What types of conditions or rules should apply to them to ensure that the risk to benefit security is minimized?

A letter of credit is an appropriate financial vehicle for solvency funding and should be recognized as a pension asset in solvency valuations. This would allow financially healthy employers to select the best way, cash or security, to finance the immediate funding requirement. The face amount should not exceed the contributions otherwise required to fund a past service solvency deficiency and contributions should be used to replace the letter of credit over time.

What is an appropriate amortization period for funding a deficiency and should it differ for financially vulnerable and strong companies?

Five years is an appropriate amortization period for funding a solvency deficiency. It should not differ for financially vulnerable and strong companies, since neither the pension regulator nor the actuary performing a valuation should be required to assess the financial health of a business. Extension of the amortization period should occur only in extreme circumstances such as when the CCAA or BIA applies.

What types of conditions or rules should apply to an extended amortization period for solvency funding for companies under CCAA or BIA?

The conditions and rules for extending amortization for companies under the CCAA or BIA should suit the particular circumstances of each case. It is not possible to say in advance what every business in these situations should be expected to do or would be able to do, in order to have the longer funding period.

Are there alternatives to address funding issues other than relaxing funding requirements, such as special accounts?

The most significant measure to address funding issues is to restore balance and fairness for sponsors. This would be most effective if done retroactively to create sponsor entitlement to surplus on wind up and eliminate surplus distribution on past and future partial wind-ups. If retroactive change is not forthcoming, then we strongly support forward-looking measures such as special accounts that segregate new contributions from the existing fund and grant sponsor entitlement to the new fund and the elimination of partial wind-ups for the future.

Should there be greater disclosure to plan members regarding a plan sponsor's financial condition, funding decisions and contribution holidays? How should this be done?

We support disclosure about contribution holidays and the funded status of a plan. Clarity and understanding about these matters would be beneficial to all concerned. Disclosure of the funded status of the plan based on the most recent filed information, and about the minimum contribution requirement resulting from the most recently filed valuation or valuation update, should be made annually.

Greater disclosure of a plan sponsor's financial condition to members should not be required. For publicly traded companies it would not be appropriate to give pension plan members more information than is available in the market. Reliance should be placed on the market for this assessment. For privately held employers the information is private and confidential. However, it may be appropriate for the pension regulator to have access to financial information about a privately held employer if circumstances warrant. Careful analysis of the circumstances that should trigger this requirement and the type of information that could be required would be needed.

Should the prescribed solvency ratio for void amendments be 85%, should plans below the threshold be permitted to improve benefits if offsetting funding is provided when the improvement comes into effect, and should recent benefit improvements have lower priority against pension assets?

A void amendment rule that prevents benefit improvements is very intrusive and would not be a significant preventive measure against benefit loss. Solvency status fluctuates significantly, making this approach to prevention a hit and miss proposition. However, if the rule is implemented a low threshold such as 80% (averaged over two or three years) together with regulatory discretion to allow amendments, it might be workable. A better way to address benefit improvements is to create a priority scheme for insolvent plan termination in which recent improvements have less priority than benefits already in place when the amendment was made.

Should full funding on plan termination be required, and how should this be applied to financially vulnerable companies?

It is clear that an employer should not be able to terminate a plan and continue in business without funding benefits in full. A funding period of five years would be appropriate. This should apply to all employers with exceptions made in extreme circumstances such as under the CCAA and BIA.

Would a federal pension guarantee fund be viable, and what design, operation and powers should it have?

A federal pension guarantee fund would not be viable. If it were restricted to plans regulated under the PBSA the pool would be too small and the spreading of risk could not be optimal given the importance of large plans in the group. Even if it could be applicable across Canada a guarantee fund would be expensive and the risk premium system would have to be complex in order to share risk appropriately. Experience with guarantee funds shows that it is extremely difficult to make the system self-supportive, and taxpayers bear this risk.