- Consulting with Canadians -

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

September 15, 2005

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

Dear Ms Lafleur:

Subject: Response to Department of Finance Consultation Paper on Strengthening the Legislative and Regulatory Framework for Defined Benefit Pension Plans Registered under the Pension Benefits Standards Act, 1985

We are forwarding our comments regarding the Consultation Paper entitled Strengthening the Legislative and Regulatory Framework for Defined Benefit Pension Plans Registered under the Pension Benefits Standards Act, 1985 issued by the Department of Finance in May 2005. We would be pleased to discuss with you any of our comments and provide additional information.

Our comments are presented under the following three items:

I Major Concern - Solvency Funding
II Solvency for Indexed Plans
III Response to "Issues For Discussion"

We look forward to your consideration of our comments and hopefully changes in the current legislation and regulation in order to improve the security of pension plan benefits and ensure the viability of defined benefit pension plans.

This submission can be posted on the Department of Finance website.

Sincerely,

William G. Fenton
Vice President, Finance, Chief Financial Officer and Treasurer

Attachments


Major Concern – Solvency Funding

NAV CANADA’s major concern with the current legislation governing defined benefit pension plans relates to the solvency funding requirements. We believe the requirements are flawed in:

    1. Their application to all pension plans irrespective of the sponsor’s financial strength;

    2. The calculations used to determine solvency deficits, in particular for indexed plans, and

    3. The absence of alternative solvency funding mechanisms.

As a result of low interest rates, pension obligations have increased significantly over the last two years. This has resulted in many pension plans moving from surpluses to deficits on a solvency basis. Our concern relates to the substantial solvency deficit contributions which could result in an unmanageable going concern surplus.

1. Application of Solvency Funding Requirements

NAV CANADA fully recognizes the need to make the necessary funding contributions to its pension plan on a going concern basis. Going concern funding contributions will be sufficient to fund our plan and provide benefit security to plan members on a going concern basis. However, the current legislation relating to solvency funding is problematic. The intent of solvency requirements is to provide security for plan members in the event that the plan sponsor becomes bankrupt or the plan is wound up.

Given NAV CANADA’s mandate for the provision of an essential public safety service, its enabling legislation was designed to ensure long term financial viability and stability – rendering a chance of insolvency as essentially non-existent. We have maintained AA credit ratings during the worst financial crisis in aviation history. Our credit rating is equal to that of most Canadian banks and comparable to that of many Canadian provinces. There is little, if any risk relating to our ability to meet all our long-term pension obligations. Consequently, the application of the current solvency funding requirements to NAV CANADA is not appropriate.

While we appreciate the need for solvency rules, to apply the same rules to all plan sponsors regardless of their credit quality is not reasonable because it fails to recognize the additional security of benefits that are offered by those plan sponsors who are very strong financially. Instead, it leads such plan sponsors to make unnecessary contributions which in turn detracts from their financial strength. In fact, some plan sponsors have and will respond by reducing funding to a minimum and by reducing plan benefits or converting to defined contribution plans. However, if there must be some form of security such as letters of credit or funds held in trust, then it should be on a risk-related basis.

In the case of a voluntary plan termination, which is extremely unlikely in our situation, we would suggest securing the obligations to our plan members and funding any deficit over a period of years following plan termination.

2. Calculation of Solvency Position

Indexed defined benefit pension plans are required to use real return bond yields as a proxy for the discount rates used to determine pension obligations for solvency purposes. The following graph illustrates the dramatic decline in such yields over the last two years. It is also important to note the widening spread between nominal and real rates of return which represents a naïve forecast of inflation.

Real Rate of Return vs Nomianl Rate of Return

Current real rates of return are placing significant solvency strains on indexed pension plans. In fact, if nothing is done to change the solvency funding legislation and regulations for indexed plans, we will see the end of guaranteed inflation protection in the private sector. This is a major policy issue which must be addressed. The attached paper outlines why indexed plans are different from non-indexed plans and why features of indexed plans must be specifically addressed in pension legislation if such plans are to continue.

3. Funding of Solvency Deficiencies

The current solvency funding requirements are counter-productive. They require plan sponsors like NAV CANADA to over-contribute substantial amounts of money knowing that there is high probability of generating surpluses in the pension plan which may be difficult to get back. Excess contributions are an ineffective use of capital and could have a negative impact on credit quality of plan sponsors. It is the solvency contributions that create these concerns. Going concern contributions are not an issue in this regard.

The PBSA requires that plan sponsors fund any solvency deficit over a 5 year period. Given the huge negative impact on the solvency positions of defined benefit pension plans as a result of the low interest rate environment, substantial cash contributions are required. Because NAV CANADA is required to recover its costs on an annual basis, pension costs have to be passed on to our customers through increased customer service charges at a time when there are severe financial challenges in the aviation industry. These contributions are not related to the cost of providing air navigation services in the current year, and should not be borne solely by the current generation of air carriers. It is inappropriate that short-term contributions would cause contributions in some future year to be reduced, to the benefit of a different generation of air carriers. If we instead borrow the funds to allow us to pay the higher pension contributions, this will increase our corporate interest expense.

The problem is further compounded by the fact that, if and when interest rates return to normal historical levels, plan sponsors may be unable to withdraw the resulting surplus. Courts or arbitrators could award to employees such surpluses that result from the unnecessary solvency contributions, even if these plan sponsors are still repaying the funds borrowed to make the contributions. The intent of improving the security through increased funding will actually detract from plan sponsors’ ability to manage its financial situation in a prudent manner. In fact plan sponsors will be inclined to move away from defined benefit plans or eliminate guaranteed indexing.

NAV CANADA fully appreciates the need for benefit security for its plan members. In that regard, it would be prepared to provide security for such benefits. We would propose using either a letter of credit or funds held in trust to secure our pension solvency obligations. This would effectively address the problem with trapped capital (the asymmetry issue) while still securing our obligations to plan members.

RECOMMENDATIONS

1. Application of Solvency Funding Requirements

We recommend that the application of solvency funding requirements to plan sponsors be based on a risk assessment of the plan sponsors. For highly rated companies (a credit rating of AA or higher) the solvency amortization period should be extended to 15 years. The amortization period for "investment grade" companies (generally defined as BBB or higher) should be extended to at least 10 years. Further analysis should be undertaken to develop a graduated scale around these rating levels.

2. Calculations of Solvency Position

a. Indexing

We recommend that the value of indexing be excluded from the calculation of solvency liabilities and funding requirements. Instead, the indexed benefit would be provided for through the going concern funding mechanism. In Ontario, plan sponsors have the option of excluding indexing from solvency contributions. The advantage of excluding indexing is that it directly addresses the special circumstances of indexed pension plans. It would also encourage the continuation of automatic pension indexing before this feature disappears altogether from private sector pension plans.

While excluding indexing from solvency calculations and funding requirements is our much preferred recommendation, if that can not possibly be done then we recommend substituting the Bank of Canada inflation target for the break even inflation rate. This would break the link between solvency contributions and real return bond yields without eliminating solvency funding for guaranteed inflation protection. Actuaries preparing valuation reports for indexed plans could be instructed to use a 2% inflation assumption together with the same interest rates based on nominal bond yields as are used for non-indexed plans. The advantage of this approach is that it would place indexed plans on the same funding framework as non-indexed plans. It would reduce but not eliminate the problem of overfunding on a going concern basis.

b. Discount Rates

We recommend eliminating the requirement for the use of annuity pricing in solvency calculations.  In an actual wind-up, our plan would likely have to continue operating for a lengthy period in order to ensure that the accrued pensions are fully paid, which means that the plan assets would continue to be invested in the markets.  Accordingly, for solvency valuation purposes, the factors used for valuing obligations to members opting to receive a pension upon plan wind-up should be based on yields on long term investment grade corporate bonds.  This approach would eliminate the most arbitrary and artificial part of the current funding regime – the use of hypothetical annuity prices when in fact the annuities are not available in the marketplace for a group of our size.

3. Funding of Solvency Deficiencies

We recommend that the legislation permit plan sponsors to post satisfactory security through either letters of credit or funds held on deposit for the difference between solvency and going concern funding requirements. This would eliminate the problem of trapped capital and would completely protect plan members in terms of security of their benefits. It would also adequately secure plan benefits in the unlikely event of a voluntary plan wind-up. The amount to be covered by either letters of credit or funds held in trust would be the accumulated difference between the contributions needed to fund the total deficit (going concern and solvency) over the appropriate period and the contributions needed to fund the going concern deficit alone over 15 years. If the plan were to have a solvency gain, then the plan sponsor should be permitted to either reduce the face amount of the letters of credit or reduce the amount of funds held in trust.

TIME IS OF THE ESSENCE

Plan sponsors are currently adjusting their operations in terms of cashflow as well as pension benefits to address the current inappropriate solvency funding requirements. We believe the impacts of these requirements are very detrimental to:

  • the future of defined benefit plans including guaranteed indexing,
  • the financial flexibility of major Canadian corporations,
  • the Canadian economy including the transportation sector,
  • the adequacy of retirement income for plan members, and
  • the aviation industry.

Notwithstanding a number of other issues which are of concern and have been presented in the Consultation Paper, current legislation and regulations relating to the application, calculation and funding of solvency requirements is the most pressing. Action must be taken now to provide interim or partial solutions to the solvency funding problems before permanent and irreversible damage is done to the structure of defined benefit plans in Canada.


Solvency for Indexed Plans

Current real rates of return are placing significant solvency strains on indexed pension plans. In fact, if nothing is done to change the solvency funding legislation and regulations for indexed plans, we will see the end of guaranteed inflation protection in the private sector. This is a major policy issue which must be addressed. This paper outlines why indexed plans are different from non-indexed plans and why features of indexed plans must be specifically addressed in pension legislation if such plans are to continue. The issues relating to indexed plans are not discussed in the Department of Finance Consultation Paper entitled "Strengthening the Legislative and Regulatory Framework for Defined Benefit Pension Plans Registered under the Pension Benefits Standards Act, 1985".

In NAV CANADA’s case, our pension plan is well funded on a going concern basis, although our most recent actuarial valuation report discloses a modest unfunded actuarial liability on a going concern basis due to conservatism in our actuary’s assumptions. However, we have a large solvency deficiency, attributable entirely to guaranteed indexing provisions in our pension plan. If indexing were provided on an ad hoc basis rather than a guaranteed basis, but still included in our going concern funding contributions, we would not have any solvency deficiency. Because we guarantee inflation protection, current regulations require us to make massive additional contributions which will likely never be useable, and may never be recoverable.

The Arbitrary Nature of Indexed Solvency Liability Valuations

Solvency liabilities are generally computed by reference to the new Canadian Institute of Actuaries’ Standard of Practice for Determining Pension Commuted Values (the "Commuted Value Standard"). For plan members who are assumed to elect a monthly pension on plan windup rather than a lump sum settlement, an adjustment to the discount rate is made to reflect the difference between commuted values and typical group annuity pricing. The basis for computing solvency liabilities for non-indexed plans is well founded in market data for relatively small plans. An annuity market that accommodates larger plans does not exist. As outlined below, the annuity market is virtually not existent for indexed plans – of any size.


Non-Indexed Liabilities Indexed Liabilities

There is an active market for Government of Canada bonds with a full range of term to maturity, including an active derivative market, so that market pricing of various issues produces an unambiguous and internally consistent yield curve. There are, at present, only four issues of Government of Canada real return bonds (maturing in 2021, 2026, 2031 and 2036). Most real return bonds are held by pension funds and individuals to match specific inflation-linked retirement income objectives, and are not actively traded. There is no derivative market for government-issued real return bonds, and it is unlikely that one will emerge unless corporations begin issuing real return bonds. The tax treatment of real return bonds makes them relatively unattractive to non-registered investors – the inflationary increases in the face amount are ordinary taxable income as they accrue, even though the extra value is not paid until maturity.
The Bank of Canada has indicated its intention to maintain sufficient supply of nominal return bonds to ensure market liquidity. The Bank of Canada’s stated objectives for selling real return bonds stress cost-effectiveness compared with other funding sources. That is, they sell real return bonds at a price that is expected to reduce overall borrowing costs. The Bank of Canada can achieve this objective by limiting the supply of real return bonds.
The Commuted Value Standard is designed to track a wide range of changes in the shape and level of the Government of Canada bond yield curve. The Commuted Value Standard relies on hypothetical real return bond yields derived from the shape of the nominal yield curve.
There is an active competitive market for non-indexed annuities (subject to capacity constraints). Insurers are unwilling to sell fully indexed annuities because of the absence of risk-minimizing investment strategies.
The Canadian Institute of Actuaries (CIA) surveys pension practitioners who have been involved in non-indexed group annuity purchases for pension plans, and provides annual guidance on an appropriate adjustment that converts commuted values into annuity prices. Purchases of indexed annuities by pension plans are so rare that survey data is unavailable. Anecdotal evidence suggests that the CIA’s recommended adjustment may be insufficient to cover the actual pricing of indexed annuities.

If a large indexed plan were actually to wind up, some means other than the purchase of indexed annuities from the Canadian life insurance industry would likely have to be found. The possibilities include:

  • Offering lump sum settlements to pensioners as well as actives
  • Seeking bids from foreign insurers
  • Offering actuarially equivalent annuities with fixed rates of annual escalation in place of indexing linked to CPI
  • Continuing to operate the wound-up pension plan for an extended period until capacity in the Canadian life insurance industry emerges or the remaining pensioners are old enough that the inflation risk could be accepted by an insurer at a reasonable price
  • Merging the pension plan with that of a continuing related or successor employer.

Confirmation of Problem – Bank of Canada

The above discussion is further supported and expanded in a recent Bank of Canada research paper. The current method of determining solvency liabilities assumes future inflation will be at the "Break-Even Inflation Rate" or BEIR – the difference between real return bond yields and nominal return long bond yields. One of the conclusions of the research paper states:

    "As a result of the potential distortions and the difficulties in accounting for them, the break even inflation rate should not be given a large weight as a measure of inflation expectations at this time."

The paper discusses the following factors that bias or distort the breakeven inflation rate as a measure of inflation expectations:

  • Cash-flow mismatch
  • Term structure of inflation expectations
  • Inflation-risk premium
  • Liquidity-risk premium
  • Market segmentation and supply constraints

Capital Markets

The following is commentary from the Capital Markets on real return bonds.

RBC Capital Markets:

    "RRB’s look hideously expensive relative to nominals, but both cyclically and secularly rising demand coupled with tight supply should keep them that way."

BMO Nesbitt Burns:

    "The recent slide in long-term rates has not been driven by any significant changes in the inflation outlook. If anything, inflation expectations have nudged higher, as core inflation in Canada, the U.S. and Europe is back close to 2%. Instead real yields have fallen sharply around the world, with Canadian RRB yields dropping to just 2%, or lower, depending on the maturity."

    "Simply put, real yields at current levels are not sustainable, given that they should be comparable to prospects for GDP growth (which is closer to 2.5%-to-3% in the industrialized world)."

    This article goes on to cite a number of reasons for the unsustainable yields:

    "A mismatch of long-term liabilities and assets for pension plans has prompted a global rush for long-term fixed-income product. While this is not a major issue for Canadian pension plans, domestic yields are nevertheless feeling the downward pull from heavy demand from the U.S. and Europe."

    "Asian central bank buying of Treasuries and agency debt is distorting bond yields lower."

Scotia Capital:

    RRB’s are expensive. "A break-even rate of 270 basis points is relatively high given current inflation on the order of 2.0%, and inflation risks that remain low due to factors like the strong currency and concerns about economic growth."

In short, our comparison of the calculation of solvency liabilities for indexed and non-indexed pension plans, the research by the Bank of Canada and the comments from the Capital Markets all confirm that solvency liabilities as currently calculated using real return bonds do not reflect the "market value" of indexed pension liabilities. There is virtually no market in which the pension obligations can be settled, and the value suggested by the small market for real return bonds is artificially inflated.

The Problem with Fully Funding Indexed Solvency Liabilities

Funding a pension plan is a difficult, if not impossible, balancing act. If not enough money is contributed, benefits will be underfunded, security will be at risk, employees will discount the value of the benefits they are earning, and opportunities to defer investment income tax will be lost. If too much money is contributed, surplus emerges, and in the extreme, "runaway surplus" is created. Runaway surplus is a situation in which expected annual interest on going concern surplus exceeds the annual normal cost, and going concern surplus can be expected to grow forever, despite a permanent contribution holiday. While the emergence of a modest actuarial surplus in a continuing pension plan merely indicates that contributions have been made too soon, the emergence of runaway surplus amounts to misappropriation of the sponsor’s funds.

In managing this balancing act, the difficulty is particularly pronounced in an indexed plan because of:

  • the lack of a range of attractive investment vehicles that match the character of the liabilities;
  • increased solvency liabilities relative to going concern liabilities, in most instances; and
  • the inability to use ad hoc cost of living increases for pensioners to relieve the pressure on mounting surpluses.

All else being equal, solvency liabilities would be much larger than going concern liabilities in all pension plans because they are computed using a discount rate that reflects the cost of settling the benefits, whereas going concern liabilities are computed using the expected future rate of investment return on plan assets. That is, the solvency discount rate is based on bond yields whereas the going concern discount rate is based (at least in part) on expected equity returns. As it turns out, the actual gap between solvency liabilities and going concern liabilities is a particularly large problem for plans with guaranteed indexing. To understand why this is so, consider the circumstances of a pension plan with guaranteed indexing in comparison to other popular pension plan designs:

  • In a non-indexed final earnings plan, the absence of provision for future pay increases in the measurement of solvency liabilities means that the benefits valued on a solvency basis are substantially less than the accrued benefits on a going concern basis. This difference in benefits valued offsets the gap that would otherwise arise from the difference in discount rates. As a rule, solvency liabilities for a non-indexed final earnings plan are less than going concern liabilities, in spite of the difference in discount rates. Exceptions can arise if a plan has unreduced early retirement benefit options that are not routinely exercised by plan members or if nominal bond yields are particularly low relative to long-term investment return expectations.
  • In a non-indexed flat benefit or career average pension plan, solvency liabilities that are higher than going concern liabilities are more common, but ad hoc upgrades to provide inflation protection for past service benefits are a frequent, almost routine, application of surplus. Ad hoc cost of living increases for pensioners can relieve pressure on going concern surplus in any kind of non-indexed pension plan.
  • In a final earnings plan that provides guaranteed indexing to deferred pensions such as the NAV CANADA Pension Plan, there is only a small difference between going concern accrued benefits and solvency benefits. The difference is due to the nature of the inflation protection for the period from the valuation date to the expected retirement date. On a going concern basis, provision is made for future pay increases (inflation, productivity, merit, and promotion), whereas on a solvency basis provision is made for inflation alone. As compared to a non-indexed plan, the difference in the benefits valued in an indexed plan offsets the gap that would otherwise arise from the difference in discount rates to a much lesser extent. The net effect is that it is common for solvency liabilities to be greater than going concern liabilities in an indexed plan.
  • Even for a plan that does not provide indexing to deferred pensions but only provides indexing after retirement, the difference between going concern accrued benefits and solvency benefits (and the resulting offset to the gap that would otherwise arise from the difference in discount rates) is typically smaller than in a non-indexed plan because post-retirement indexing will lead to an earlier assumed retirement age on a solvency basis. Moreover, any gap that does emerge between solvency liabilities and going concern liabilities is problematic because there is no discretion to use surplus to provide inflation protection when indexing has been guaranteed.

For best average earnings pension plans that do not include guaranteed indexing, contributions required to fund a solvency deficiency are usually also required on a going concern basis. On the other hand, as a result of the excess of solvency liabilities over going concern liabilities, the contributions required to fund a solvency deficiency in an indexed plan will often produce a large going concern surplus, even if investment returns are no better than the actuarial assumptions.

Summary

As a result of an arbitrary measure of the cost to settle hypothetical plan wind-up obligations in a non-existent marketplace, indexed plan sponsors are required to make funding contributions that have a good chance of contributing to excess surplus. Unlike sponsors of non-indexed plans who withhold the security of inflation protection, indexed plan sponsors have little opportunity to mitigate funding volatility through investment strategy or periodic benefit improvements. For indexed plan sponsors seeking a remedy, indexing must surely be the primary target for benefit cutbacks.

Possible Mitigation

1. The best way to address this untenable situation is for legislators to permit the value of indexing to be excluded from the calculation of solvency liabilities. This is the approach taken in Ontario. Under accepted actuarial practice, the value of indexing is still included in the hypothetical "wind-up liabilities" and reported to readers of an actuarial report – but the sponsor and the actuary then have the option of excluding the value of indexing from "solvency liabilities", and hence from the calculation of minimum special payments. The advantage of this approach is that it directly addresses the special circumstances of indexed pension plans, without aggravating the chronic underfunding of flat benefit plans that are subject to periodic past service upgrades. It also facilitates the continuation of automatic pension indexing.

2. A less satisfactory change that would break the link between solvency contributions and real return bond yields without eliminating solvency funding for guaranteed inflation protection would be to substitute the Bank of Canada inflation target for the BEIR. Actuaries preparing valuation reports for indexed plans could be instructed to use a 2% inflation assumption together with the same interest rates based on nominal bond yields as are used for non-indexed plans. The advantage of this approach is that it places indexed plans on the same funding framework as non-indexed plans. It reduces but does not eliminate the problem of overfunding on a going concern basis.

This approach could be supported by the additional step of a regulatory change allowing an administrator of a wound up pension plan to purchase an annuity with a fixed rate of escalation to settle an indexed pension obligation. However, this additional step is not, in our view, a prerequisite for a rationalization of the solvency funding regulations for indexed plans.


DEPARTMENT OF FINANCE
CONSULTATION PAPER
May 2005


Issues for Discussion NAV Canada's Views

A. Surplus  
Are there any disincentives or obstacles preventing plan sponsors from adequately funding their plans and building up a funding cushion, including:  
  • 10% excess surplus limit (Act)
No issues with the current limit.
  • Surplus ownership asymmetry: negotiated and non-negotiated plans (Act & Regulations)
Main objective of funding is to provide stability of contributions in the long-term and security of benefits. It is totally inappropriate for plan sponsors to bear the current solvency contribution risks in an environment where such contributions may subsequently become trapped capital that is unavailable for use by the plan sponsor and yet not needed for benefit security. Because of the uncertainty around surplus ownership, many plan sponsors have adopted a minimum funding policy. If we want sponsors to move away from a minimum funding policy and to promote benefit security and stability of contributions, the question of surplus ownership must be clarified so that those who pay for the deficits have free access to the surpluses. Therefore we desire legislative clarity of sponsors’ rights to contribution holidays, as well as sponsor ability to recover solvency contributions if the plan subsequently develops a large surplus. Under the current rules we will not build up a funding cushion within the plan.

B. Funding  
Are there 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? (Regulations) Plan sponsors should be allowed to either utilize letters of credit or place funds in a trust separate from the pension fund in lieu of solvency contributions. Such instruments would provide the same security to plan members as cash contributions to the pension fund.

With either of these alternatives, we recommend that their use be limited to solvency deficits. The face amount to be covered by such a vehicle would be the accumulated difference between the contributions needed to fund the total deficit (going concern and solvency) over the required period and the contributions needed to fund the going concern deficit alone over 15 years. If the plan has a solvency gain, then the sponsor should be permitted to either cancel the letters of credit or reduce the amount of funds held in the separate trust.

To maximize benefit security, letters of credit or funds held in a separate trust must be held by the plan’s trustee and letters of credit must be renewed annually, unless the sponsor makes additional contributions or a surplus emerges under the plan. In the event a letter of credit is not renewed (and subject to the above exclusions), the financial institution that issued the letter of credit must deposit the face amount of the letter of credit in the pension fund.

The letter of credit or funds held in trust should be included in the plan solvency assets but not in the going concern assets. Also, letter of credit or funds held in trust should be used in plan assets when calculating the solvency ratio of the plan.

In the case of funds held in trust, the trustee would be given instructions similar to the letter of credit process. It is paramount that the law should provide that the legal documentation for either letters of credit or funds held in trust would exempt those amounts from being considered part of the pension fund assets for any purpose other than inclusion in the plan’s solvency valuation calculation.

It is important that plan sponsors have the flexibility to reduce letters of credit or funds held in a separate trust as market conditions improve and long term interest rates increase.

The availability of either the letters of credit or separate trust fund alternatives does not address the need for longer solvency amortization periods.

What is an appropriate amortization period for solvency deficits, and is it different for financially vulnerable and financially strong companies? (Regulations)

The determination of an appropriate amortization period should be risk based. For highly rated companies (a credit rating of AA or higher) the solvency amortization period should be extended to 15 years. The amortization period for "investment grade" companies (generally defined as BBB or higher) should be extended to at least 10 years. Further analysis should be undertaken to develop a graduated scale around these rating levels. It is reasonable that amortization periods not be extended for companies that are financially vulnerable.
Are there alternatives to address funding issues other than relaxing funding requirements? For example, would special accounts that could be returned to sponsors on plan termination or if no longer needed to fund the plans be feasible. (Act & Regulations) If solvency contributions could be remitted to such a special account, it would address some of the asymmetry issues, specifically the "trapped capital" concerns. It would not, however, address the need for longer solvency amortization periods. In addition, as compared to the letter of credit alternative, this alternative would require upfront cash payments to the special account, whereas letter of credit obligations might or might not have to be satisfied by cash payments in future. Funds accumulated in the special account must revert back to the plan sponsor even if the plan text is silent on the question of surplus ownership or provides that the surplus reverts to plan members.
Should there be greater disclosure provided to plan members regarding a plan sponsor’s financial condition, funding policy, funding decisions and contribution holidays and how should this be done? (Act & Regulations) We would support greater disclosure as to the funded status of the pension plan; however, such disclosure must be consistent with the data which is publicly available to the investment community. In that regard there is extensive data already available (eg. quarterly financial statements, MD&A, AIF, Press releases and other reports on credit). We would also support disclosure of a statement of funding policy (which would include the sponsor’s policy regarding contribution holidays).

C. Void Amendments  
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 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 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?

(Regulations)

This change is particularly important to sponsors who are involved in collective bargaining situations. We support such a proposal, but recommend that the threshold be 95% instead of 85%. There may be circumstances where a sponsor of a plan with a solvency ratio less than 95% should be permitted to introduce benefit improvements provided the improvements are immediately funded.

D. Funding on Plan Termination  
Should full funding by plan sponsors be required on plan termination? (Act & Regulations) We would support a proposal to require plan sponsors to fund any solvency deficit over a period following plan termination provided surplus asymmetry is satisfactorily addressed.
If so, how should it be applied to financially vulnerable sponsors? (Act & Regulations) This is a complex issue which requires further review and consideration.
Should there be a lower priority claim on a terminated plan’s assets for recent plan improvements? (Regulations) Yes. In our opinion, the introduction of such a lower priority claim would address a potential inequity between different member classes in the event the plan is terminated.

If recent improvements could have a lower priority claim in the event of a wind-up, this information should be disclosed to affected plan members.


E. Pension Benefit Guarantee Fund  
What are your views on the viability of a federal pension guarantee fund including its possible design, operation and powers? We do not believe that there is a need for a pension guarantee fund for federally-regulated employers. In addition, if it is assumed that the funding of this Guarantee Fund would come from federally regulated pension plan sponsors, it would be far too large of a contingent obligation and we simply would not be prepared to insure another company’s risks in this regard. As well, 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.

If the PBGF premium is based only on the solvency position of the plan, as opposed to the risk of the plan sponsor becoming bankrupt or insolvent, there would be a negative impact on financially sound plan sponsors that have a low risk of bankruptcy.


Issues not addressed in Finance paper  
Should determination of solvency liabilities be modified as follows:  
  • Exclude indexing provisions from calculation of solvency liability?
We would strongly support this exclusion. With current low real return bond yields, together with the Canadian Institute of Actuaries’ new transfer value rules and solvency valuation guidance, indexing provisions have become increasingly costly from a solvency funding perspective. Without such exclusion, there will be increasing pressure from plan sponsors to reduce or eliminate existing indexed benefits.

A less satisfactory approach, but better than the status quo, would be to allow a proxy to be used (for solvency liability determination purposes) in lieu of a provision which indexes pensions to all or a fraction of the change in the CPI. The proxy would be a flat percentage (such as 2%, depending on recent inflation levels; or the mid-point in the Bank of Canada’s inflation target). This approach would enable solvency liabilities to be delinked from yields on Real Return Bonds, since these are quite imperfect in their role as indicators of future inflation.

  • Base discount rate for members opting to receive a pension in a solvency valuation on high quality corporate bonds?
We would support this. The current rules for determining solvency liabilities are totally impractical for large Canadian pension plans, since a full termination of a plan with near-term settlement of its obligations via annuity purchase (as contemplated by the current solvency funding rules) is not feasible.
  • Permit smoothing of solvency discount rate?
We would like to have the flexibility to smooth the solvency discount rate (an option currently permitted under Ontario regulations). This would allow consistency with the smoothing permitted in determining solvency asset values). A mechanism such as this must be found to address the situation we find ourselves in today, with historically low interest rates, even if this only provides temporary relief.

The Canadian Institute of Actuaries (CIA) should be asked to address this issue.