Archived - REGULATORY IMPACT ANALYSIS STATEMENT

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Regulations Amending Certain Regulations made under the Pension Benefits Standards Act, 1985

Executive Summary

Issue: Pension plan funded levels have experienced much volatility in recent years.  In the early to mid-2000s, a sharp decline in long-term interest rates along with changes in actuarial standards, such as the longevity assumptions, resulted in increased plan liabilities.  Combined with poor investment returns, these factors led to many plans being underfunded on a solvency basis.

This funding level volatility resulted in the Government implementing funding relief regulations and special regulations for specific sponsors. The existence of the temporary solvency funding relief measures and special regulations points to the need to improve the legislative and regulatory framework respecting federally regulated private pension plans.

Description: The proposed amendments to the Pension Benefits Standards Regulations, 1985 are the following:

  • amendments to the funding rules to adopt a new standard for establishing minimum funding requirements on a solvency basis that will use average—rather than current—solvency ratios to determine minimum funding requirements;
  • the introduction of a solvency margin which would preclude sponsors from taking contribution holidays, unless the solvency ratio exceeds full funding plus the margin, which would be set at a level of five per cent of solvency liabilities; and
  • the removal of the five, fifteen, and twenty-five per cent quantitative investment limits in respect of resource and real property investments.

Cost-benefit statement: The key benefits of the proposed amendments would be to allow sponsors to better manage their funding obligations and give them greater flexibility in terms of investment allocation, in order to fulfill their funding obligations. It is also expected that the solvency margin would create a funding cushion that could absorb some fluctuation and mitigate the risk of the plan falling into an underfunded position. As a result, it is expected that the implementation of the amendments would help protect the interests of plan members and other beneficiaries

Modest additional costs are anticipated for the Office of the Superintendent of Financial Institutions to administer the proposed amendments, as it would be required to issue additional guidance to plan administrators. Employers would incur some costs in relation to the proposed amendments in respect of two areas: 1) additional contributions that may be required under the solvency margin; and 2) additional compliance costs arising from annual valuation report filings. 

Business and consumer impacts: The recent economic environment has placed significant stress on many plan sponsors, which could affect the viability of defined benefit pension plans and benefit security.  The proposed amendments to the Pension Benefits Standards Regulations, 1985 recognize the potentially negative impact of pension funding deficiencies on the sponsor, while at the same time providing protections to mitigate risks to plan members and retirees.

Domestic and international coordination and cooperation: Most of the provinces adopt the federal investment rules by reference.

Issue

Under the Pension Benefits Standards Act, 1985 (the "Act"), the federal government regulates private pension plans covering areas of employment under federal jurisdiction, such as telecommunications, banking and inter-provincial transportation.  The Office of the Superintendent of Financial Institutions (OSFI) is responsible for the supervision of such plans.  OSFI supervises some 1,380 pension plans or about 7 per cent of all pension plans in Canada, representing about 12 per cent of trusteed pension fund assets in Canada; 449 of the federal plans are defined benefit pension plans.

Under the Act and the Pension Benefits Standards Regulations, 1985 (the Regulations), minimum standards are set for a number of areas, including minimum standards for funding, investment, membership eligibility, vesting, locking-in, portability of benefits, death benefits and members' rights to information.  For defined benefit pension plans, the Act requires that promised benefits be funded in accordance with the standards provided for under the Regulations.

Recent Challenges and Government Action

Pension plan funded levels have experienced much volatility in recent years.  In the early to mid-2000s, a sharp decline in long-term interest rates along with changes in actuarial standards, such as the longevity assumptions, resulted in increased plan liabilities.  Combined with poor investment returns, these factors led to many plans being underfunded on a solvency basis.  More recently, the 2008 global credit crisis led to a sharp decline in global equity markets, which reduced the funded status of federally regulated private pension plans.

To address the pressure that increased funding requirements put on plan sponsors, the Government adopted two temporary Solvency Funding Relief Regulations (the "2006 and 2009 Regulations").  The 2006 and 2009 Regulations provided solvency funding relief by allowing plans to extend their solvency funding payment schedule from five to ten years, subject to the condition of either members' and retirees' consent, or securing the difference between the five- and ten-year payment schedules with a letter of credit. These measures provided for the solvency deficiencies of federally regulated defined benefit pension plans to be addressed in an orderly fashion while providing safeguards for pension benefits.  In addition, the Government also brought into force special regulations for two specific sponsors with the Canadian Press Pension Plan Solvency Deficiency Funding Regulations (2009), the Air Canada Pension Plan Funding Regulations, 2009 and the Air Canada Pension Plan Solvency Deficiency Funding Regulations (2004) in order to help these entities deal with their own specific challenges that involved funding of their pension plans.

The existence of the temporary solvency funding relief measures and special regulations points to the need to improve the legislative and regulatory framework respecting federally regulated private pension plans on a permanent basis.

Objectives

On October 27, 2009, in order to strengthen the legislative and regulatory framework for federally regulated private pension plans, the Government announced a series of proposals to improve the legislative and regulatory framework respecting federally regulated private pension plans.  Divided into five main themes, the announcement notably included the modernization of the investment rules as well as modifications to the pension plan funding rules to allow sponsors to better manage their funding obligations, while at the same time protecting member benefit security.

In this regard, amendments to the Regulations have been proposed in respect of the funding and investment rules.  The Government is committed to bringing the other proposals forward at the earliest opportunity.

The proposed regulatory amendments have two main objectives.  First, amendments are proposed to the Regulations in respect of funding rules of pension plans to ensure that the rights and interests of pension plan members, retirees and their beneficiaries are protected. More specifically, these amendments would mitigate the effects of short-term fluctuations in the value of plan assets and liabilities on solvency funding requirements as well as place restrictions on employer contribution holidays.  Second, proposed amendments to investment rules would provide more flexibility for plans to choose the investment options that best suit their investment needs. In particular, the objective is to adopt flexible, prudent and effective principles-based investment rules.

Description

Defined Benefit Pension Plan Funding Rules

Defined benefit pension plans must file actuarial valuations every three years, or annually in the case that a plan experiences a solvency deficiency, as required by the Superintendent of Financial Institutions (the Superintendent).  Where these valuations show a pension plan's assets to be less than its liabilities, payments must be made into the plan to eliminate the deficiency over a prescribed period of time, as described below. 

Every actuarial valuation of a defined benefit plan must be conducted using two different sets of actuarial assumptions: "solvency valuations" use assumptions consistent with a plan being terminated, while "going-concern valuations" are based on the plan continuing in operation.  Under the current funding rules, if a solvency valuation reveals a shortfall of plan assets to plan liabilities, the Regulations require the plan sponsor to make "special payments" into the plan sufficient to eliminate the deficiency over five years.  Where a deficiency exists on the basis of a going-concern valuation, the Regulations require special payments to eliminate the going-concern deficiency over fifteen years.  In general, the payments that a plan sponsor must remit to a plan in a given year include the amount necessary to cover the ongoing current service costs associated with the plan, plus any "special payments" required in that year to pay down a funding deficiency over the relevant time period.

Amendments to the Funding Rules

Three Year Average Solvency Ratios

Under the current requirements of the Pension Benefits Standards Regulations, 1985, solvency deficiencies must be amortized over a five year schedule, according to the current solvency ratio (i.e. plan assets divided by liabilities determined on a solvency basis).  This approach can result in fluctuations, sometimes dramatic, in the year-over-year special funding obligations faced by plan sponsors.  Moreover, these additional requirements can be faced at a time when other economic factors may be posing challenges to the sponsor in other areas, which adds an element of "pro-cyclicality" to the current approach.

Amendments to the funding rules would adopt a new standard for establishing minimum funding requirements on a solvency basis that will use average—rather than current—solvency ratios to determine minimum funding requirements. The average solvency position of the plan for funding purposes would be defined as the average of the solvency ratios over three years, i.e. the current and previous two years. The three solvency ratios used in the determination of the average would be based on the market value of plan assets. Past deficiencies would be consolidated annually for the purpose of establishing solvency special payments.  To put this funding model into effect, annual filing of valuation reports would be required.

This approach would generally reduce the effects of short-term fluctuations in the value of plan assets and liabilities on solvency funding requirements.  This measure would change the timing and the profile of contributions such that the impact of shocks to the funded status would be spread over a longer period.  In the case of adverse shocks to pension plans' funding position, the increase in required special payments would initially be less than under current solvency funding rules, but required payments would tend to be higher in later periods.  Similarly, when a pension plan's funding position improves, as a result of strong investment returns, for example, solvency special payments would decline more gradually, which would further strengthen the financial position of the plan. This approach would help mitigate the "pro-cyclicality" of the current funding rules.

The amortization period for solvency deficiencies would remain at five years. The going-concern methodology and its fifteen year amortization period would also remain unchanged. Annual valuations would be required to support the new solvency funding standard.

Because of the reduction in volatility of solvency deficiencies that would result from the use of the average solvency ratio method, it is proposed to maintain the amortization period at five years for solvency deficiencies. In periods of substantial market downturns, such as was experienced in 2008, the use of the average solvency ratio method with a five year amortization period would dampen the effect of a market downturn on funding requirements without the potential adverse impact on benefit security of a significantly longer amortization period.

The amendments to the Regulations also include certain transitional rules, which include for example, rules to determine the average ratio in the first actuarial report filed after the coming into force of the new funding rules, as well as rules to determine transition requirements for sponsors subject to the temporary Solvency Funding Relief Regulations in both the 2006 and 2009 version.  The transitional rules are intended to bridge the period between the current funding rules and the time when the three year average ratio approach can be fully adopted.

While the average solvency ratio would be used for minimum funding purposes, the current solvency ratio would still be the relevant measure for all the other purposes under the Act and the Regulations, including, for example, information statements sent to the beneficiaries. 

Solvency Margin

With respect to defined benefits plans, an employer is required to remit to a pension fund amounts to fund the accrual pension benefits, known as "normal costs".  Under the current regulations, in situations where the plan is considered fully funded, the employer is not required to remit all or part of this amount. In this situation the employer is considered to be taking a "contribution holiday". The ability of employers to take contribution holidays when its solvency ratio reaches 1.0 provides an incentive to discontinue remitting its normal cost payments.

The introduction of a solvency margin would set a level, higher than a 1.0 solvency ratio, under which employers would be required to maintain their normal cost contributions to the plan.  It would operate as a restriction against employer contribution holidays, which would not be permitted unless the solvency ratio exceeded full funding plus the margin, which would be set at a level of five per cent of solvency liabilities. A solvency margin would act to create a funding cushion in order to protect plan benefits.

The solvency margin would not be explicitly funded.  Solvency funding requirements would continue to be based on an objective of bringing the solvency ratio of the pension plan to 1.0.  The difference is that where the current solvency ratio exceeds 1.0, but is less than 1.05, the employer would have to maintain making its normal cost contributions.

Investment Rules

Under the present framework, pension investment is governed under a principles-based prudent person framework, and has five quantitative limits:

  • a pension plan may not own more than thirty per cent of the voting shares of a single entity;
  • a pension plan may hold no more than ten per cent of its portfolio in a single investment;
  • a pension plan may hold no more than five per cent of its portfolio in a single parcel of real estate or Canadian resource property;
  • a pension plan is limited to having its total of Canadian resource properties be no more than fifteen per cent of its portfolio; and,
  • a pension plan is limited to having its total of Canadian resource properties and real estate be no more than twenty-five per cent of its portfolio. 

Amendments to the Investment Rules

In a prudent person environment, the quantitative limits in respect of real estate and resource property are considered cumbersome and no longer required. Thus, the proposed amendments to investment rules would see the removal of the five, fifteen, and twenty-five per cent quantitative investment limits in respect of resource and real property investments.

The Government intends to propose further modifications to the investment rules in respect of the ten per cent concentration and a general prohibition on pension fund investment in the shares of its sponsoring employer in future regulatory amendments.

Regulatory and Non-Regulatory Options Considered

Funding Rules

During public consultations, many plan member organizations, including labour unions, advocated their support for remaining on a five year schedule while a number of defined benefit plan sponsors made representations seeking a ten year amortization period.  The year-over-year volatility in funding requirements for solvency deficiencies was also raised as a critical concern.

The option of extending the solvency funding payment schedule from five to ten years has been considered. The intent of such a measure would be to provide the employer with funding relief; however, it would not address the structural and recurrent issue related to funding rules, i.e., the volatility of the year-over-year funding status of pension plans. In the proposed amendments, the average solvency position of the plan for funding purposes would be defined as the average of the solvency ratios over three years. In doing so, the funding status of pension plans would be less exposed to market fluctuations and mitigate the "pro-cyclicality" of the current funding rules.

In addition, an extension of the funding payment schedule was considered, but extending the period for an employer to fund its deficiencies may result in an increased probability of a plan terminating in an underfunded position.  Therefore, extending the solvency funding payment period to more than five years without any additional protections could negatively affect benefit security.  The proposed amendments are not expected to negatively affect the protection of the plan member benefits. 

Investment Rules

As described above, the Government proposes to remove the current investment quantitative limits related to resource properties and real estate.  During public consultations, the Government received many representations from pension plan sponsors and pension service providers indicating that, in a prudent person environment, the quantitative limits were unnecessarily cumbersome and were no longer required.  Similar representations were made in respect of the thirty per cent rule, which states that a pension plan may not own more than thirty per cent of the voting shares of a single entity.  The Government has examined this rule and has concluded that it remains appropriate at this time for prudential reasons. Specifically, the Government believes that removing the thirty per cent rule would increase the potential for pension plans to own and operate companies.

Benefits and Costs

Benefits

Overall, the key benefit of the proposed amendments would be to allow sponsors to better manage their funding obligations and give them greater flexibility in terms of investment allocation in order to fulfill their funding obligation, including during times of volatility. It is also expected that the solvency margin would create a funding cushion that could absorb some fluctuation and mitigate the risk of the plan falling into an underfunded position. As a result, it is expected that the implementation of the amendments would help protect the interests of plan members and other beneficiaries.

Additionally, by encouraging more stable funding, the amendments would reduce the probability of having to adopt other temporary regulations. Ad hoc temporary regulations in order to adapt to a particular situation are inefficient, due to the substantial resources that are required to put them into effect, and because they can result in a lack of certainty over the regulatory framework.

Costs

Only modest additional costs are anticipated for OSFI to administer the proposed amendments, as they would require additional guidance be issued to plan administrators.  Existing supervisory procedures and information systems would not require significant changes and can be accommodated in the existing OSFI budget.

Employers would incur some costs in relation to the proposed amendments in respect of two areas: 1) additional contributions that may be required under the solvency margin; and 2) additional compliance costs arising from annual valuation report filings.  In respect of the first area, there would be additional costs to the employer to the extent that it would have otherwise taken a contribution holiday, but is now required to maintain its normal cost contributions.  In respect of the second area, the preparation of annual valuation reports would result in an additional compliance cost, but these would be marginal given that the majority of plans are already filing annual valuation reports due to their underfunded status.  

There would be no direct or indirect cost to beneficiaries of pension plans. 

Rationale

Funding Rules

As demonstrated during the last few years, the ability of employers to meet the current funding requirements has been made more difficult, in light of the year-over-year volatility in required payments, which has resulted from a number of factors, including volatility in the equity market and changes in interest rate levels.  This volatility results in unstable funding requirements that could create sudden financial stress for many plan sponsors, which could affect their business operations and ongoing viability.  This could ultimately lead to a reduction in pension benefits. 

These amendments would mitigate the effects of short-term fluctuations in the value of plan assets and liabilities on solvency funding requirements. The five year funding period is generally seen as an appropriate timeframe to eliminate any solvency deficiency, as it represents a balance between the funding of plans and the protection of pension benefits.  The implementation of a restriction of employer contribution holidays in the form of a five per cent solvency margin would promote the adequate funding of defined benefit pension plans.

Investment Rules

The investment rules, which have not been reviewed in fifteen years, were originally set under market conditions that do not reflect the present environment. The quantitative limits in respect of real estate and resource property are considered unnecessarily cumbersome. During public consultations, there was a wide degree of support from plan sponsors and industry experts for eliminating all the quantitative investment rules to rely exclusively on the prudent person standard.  Certain unions and plan members advocated retaining the quantitative limits for benefit security purposes.  Repealing the limits on real estate and resource property investments would be a balance between these two points of view. 

Consultation

On January 9, 2009, the Government released a discussion paper entitled "Strengthening the Legislative and Regulatory Framework for Private Pension Plans Subject to the Pension Benefits Standards Act, 1985."  This was followed by a series of public meetings, led by Mr. Ted Menzies, Parliamentary Secretary to the Minister of Finance, in Ottawa, Halifax, Montreal, Toronto, Vancouver, Whitehorse, Edmonton and Winnipeg.  Concerned stakeholders were afforded the opportunity to make their views known to the Government by speaking at one of the public meetings or by making a written submission.  Although the deadline for written submissions was initially March 16, 2009. it was extended to May 31, 2009 based on the level of interest and stakeholder engagement.

The Government received a wide range of views during the consultation.  Over 200 unique submissions were made on behalf of a range of stakeholders, including plan sponsors, industry associations, pension actuaries, members of the legal profession, labour unions, pensioner organizations and plan members.  In addition, dozens of individuals made their views known at the various public meetings.  The views expressed through the public meetings and consultation paper responses regarding defined benefit plans were diverse in areas such as solvency measurement and funding, benefit security and investment strategies. 

Implementation, Enforcement and Service Standards

It is the intent of the Government that the proposed amendments would apply to valuations of 2009. Valuation reports, which outline the payments the sponsoring employer must make to the pension plan, must be filed with the Superintendent within six months after the valuation date.  For most plans, the reports have an effective date of December 31, 2009. Thus, most reports must be filed by June 30, 2010 and would be subject to the proposed amendments.  

OSFI's current supervisory process, which includes examining regular reporting and analyzing plans' risk profile, would enable OSFI to monitor compliance with the proposed amendments.  The Superintendent has the authority to issue a direction of compliance to the administrator of a pension plan, an employer, or any person to ensure that the funding requirements are being met. 

The amendments would not require any significant change in OSFI procedures or significant additional personnel resources.

Contact

Leah Anderson
Director
Financial Sector Division
Department of Finance
L'Esplanade Laurier, 20th Floor, East Tower
140 O'Connor Street
Ottawa, Ontario
K1A 0G5
Email: leah.anderson@fin.gc.ca
Telephone: 613-992-6516
Facsimile:  613-943-8436