Death Knell of the Nest Egg? 

Pensions

Death Knell of the Nest Egg?

Private pension plan deficits are threatening Canadians' financial futures.

FROM: MAY-JUNE 2006 ISSUE | BY LUIS MILLAN

When David Dodge speaks, the country tends to listen. And now that the Governor of the Bank of Canada is the latest to add his voice to a growing chorus of financial professionals concerned about the state of private pension plans in Canada, people are beginning to pay attention. "I hope nobody thinks it can be business as usual. It's important to rectify this problem," Dodge said a day after the release of a study on employer-sponsored pension plans by CGA-Canada.

Traditional pension plans, otherwise known as defined benefit plans, are indeed in dire straits. Aggressive investment policies coupled with poor equity returns and rock-bottom interest rates during a bull market that began in 2001 led to staggering pension funding shortfalls. And it's getting worse. Though the median Canadian pension fund posted a solid 9.5 per cent gain last year, the majority of plans, 59 per cent, are currently operating in the red. The total deficit of the country's largest corporate defined benefit plans jumped from $23 billion in 2003 to $26 billion in 2004, according to the CGA study, which, by its own admission, offers a conservative assessment of the current situation. The funding gap is even larger when the numbers are adjusted to include the indexation of benefits, from $160 billion in 2003 to $190 billion in 2004.

Pension under-funding, while a grim challenge that must be grappled with, is not the only perceived threat to Canada's traditional pension system. Pension accounting rules and practices that ill-serve the investment community have been widely castigated as has pension legislation deemed to be unnecessarily complex and inflexible. Recent court rulings loudly condemned by employers and roundly applauded by labour have only served to acerbate tensions between the two camps.

The Rise of Defined Contribution Plans

With baby boomers heading for retirement in droves and pensioners living longer than ever, it's no surprise then that the viability of the defined benefit plans, which promise a steady income to retirees based on years of service and wage level, is increasingly under question. Calls for reform of the pension system have never been louder, and government departments such as the federal Department of Finance and Régie des rentes du Québec are now in the midst of examining ways of achieving a balance between benefit security and sound plan funding. "The status quo just isn't working," observes Ian Markham, director of pension innovation with management consulting giant Watson Wyatt Canada.

Maintaining the status quo will likely drive a growing number of employers to examine alternatives. In fact, it's already happening south of the border. The list of corporate titans shifting the burden of retirement security on to workers seems to be growing with each passing day. Over the past couple of months corporate behemoths such as IBM, Verizon Communications Inc., and Alcoa announced that they will eliminate defined benefit pension plans for most new salaried employees and replace them with defined contribution plans in which pension benefits are not pre-determined. Instead, benefits depend on the contributions made on behalf of individual employees and on the actual rate of return on those contributions. Further, the responsibility of managing the fund often lies with the employee.

In short, no promises are made to workers with defined contribution plans. And that is proving to be appealing to employers. In 1985 there were approximately 112,000 defined benefit plans in the United States; today there are 29,000. In Canada, the decline of defined benefit plans has not been as dramatic, falling by roughly six per cent since 1992. But that may quickly change. "There is a big waiting game happening right now," says Markham. "Employers are waiting to see what government is going to do and see whether the balance will shift." If not, Markham speculates that there may be a "much quicker move away" from defined benefit plans.

That's not a development the Governor of the Bank of Canada would welcome. "The managers of defined benefit pension plans have both the ability and desire to invest in the kinds of assets that the average individual investor might not normally consider," said Dodge recently. "Pension managers have superior knowledge of financial markets and of the associated risks. That makes them willing to invest in alternative asset classes."

A Three-Pillar System

The Canadian pension system is essentially composed of three pillars — government income support such as Old Age Security and Guaranteed Income Supplement programs, public pensions like the Canada and Quebec Pension Plans, and private pensions which consist of tax-deferred retirement saving plans (RRSPs) and employer-sponsored pension plans. The reserves of future retirees, one of Canada's largest pools of investment capital, was estimated to be $1.3 trillion at the beginning of 2004, a figure that has doubled in after-inflation value since 1990, according to a study published early this year by Statistics Canada. An impressive figure except that by the end of 2003, assets held in employer pension plans and RRSPs were still struggling to regain the levels achieved in 2000, taking inflation into account. "Shaky market conditions in the first years of the new century have had an impact on the financial reserves of the funds," points out the study, echoing observations made by the CGA report.

The 1990s, in some ways, was the golden era of pension plans. Rates of return on plan assets were higher than anticipated by actuarial valuations. (See sidebar.) Between 1990 and 2000, pension plans had an 11 per cent average rate of return, while the average rate-of-return assumption used for actuarial valuations on the basis of an ongoing plan was 7.5 per cent. That led to the emergence of large surpluses, which sparked legal battles over what to do with them. Some plan sponsors financed benefit improvements, others reduced employer-required pension contributions, and yet others sought to withdraw them.

Enticed by attractive returns, pension plans adopted more aggressive investment policies during the '90s. In 1990, 64 per cent of pension plan assets were invested in fixed-income securities and 36 per cent in variable-income securities, according to data from the Pension Investment Association of Canada. By the year 2000, there was a complete turnaround, as 62 per cent of assets were invested in variable-income securities while fixed-income securities dwindled to 38 per cent. According to the CGA study, which examined 30 per cent of all defined benefit plans in Canada, the figures haven't changed much today, with the average pension fund in Canada investing 56 per cent in equities, 37 per cent in bonds, two per cent in real estate and five per cent in other instruments.

Equities Over Bonds?

The notion that equities earn a significant risk premium over bonds "became an article of faith" in the pension investments world of the 1990s, says prominent pension expert Keith Ambachtsheer. It was commonly held that an investment strategy that leaned heavily on equities would lead to a five per cent premium over the long term, based on historical experience. But recent research suggests that the equity premium is far more modest, in the one to two per cent range.

"What is really amazing is that pension fund managers haven't sought to better insulate the funds they manage," notes Rock Lefebvre, vice-president of research and standards at CGA-Canada. They should be trying to find ways to protect the capital in those funds, but they're not. They obviously feel that overall the markets will fare better. They're essentially relying on the capital markets to fix the problems."

But the "problems" that pension plans are facing do not only stem from "shaky" markets. In the period from 2001 to 2003, the average rate of return for pension funds was 3.1 per cent but actuarial valuations projected rates of return on the order of seven per cent according to the Régie des rentes du Québec, a provincial agency that oversees pensions. Making matters worse was the decline of interest rates. With lower interest rates, it costs more to purchase retirement annuities for plan members.

Then there's the element that, as Lefebvre puts it, "nobody speaks about too much." Between 2001 and 2003, many pension plans took contribution holidays because prior actuarial valuations showed surplus assets. "People keep identifying equity returns as the sole problem when in fact it's a combination of poor returns taken in tandem with contribution holidays that were ill-afforded," says Lefebvre. The results have been nothing short of disastrous — nearly 60 per cent of Canadian defined benefit pension plans were in the red at the end of 2004, a figure that rises sharply to 96 per cent if taking into account indexation of benefits.

By all accounts it is unlikely that stock market returns alone will correct the situation. And that's not good news for plan sponsors. Pension legislation across the nation compels plan sponsors to fund going concern deficits with special payments — in addition to normal contributions — over 15 years, and solvency deficits with special payments over a period not exceeding five years. According to a study conducted by Mercer Human Resource Consulting, an average special payment representing 10 per cent of the employer's payroll will need to be made by plan sponsors per year over the next five years to fund current solvency deficits. In hard figures, $15 billion per year will need to be injected into defined benefit plans over the next five years to make up for the investment losses.

Faced with such a hefty bill, the business community began clamoring for changes — and quickly. That's when the issue of asymmetry first made its appearance.

Resolving the Asymmetry Issue

No doubt, the past five years have proven to be a rude awakening for plan sponsors. For the first time in nearly two decades the cost of pension plan sponsorship has become, as one pension expert put it, "evident and painful." So painful that a growing number of pundits and plan sponsors assert that defined benefit plans in Canada are in peril unless significant changes are made to the legislative and regulatory framework, beginning with the issue of asymmetry. The Association of Canadian Pension Management goes so far as to assert that all solutions are predicated on the resolution of the asymmetry issue — that is, the supposed mismatch that exists between risk and reward in defined benefit plans.

It's also proving to be the most contentious and divisive issue. Under existing regulations, plan sponsors bear the full financial burden of pension deficits throughout the life of the plan. Current legislation prevents plan sponsors from accessing pension funds in a surplus position; surpluses instead are used for benefit increases and contribution holidays. Further, in the event of plan termination, sponsors must share surpluses with plan members. And thanks to a landmark ruling made by the Supreme Court of Canada two years ago, in the Monsanto case, when a defined benefit pension plan is partially wound up the plan administrator must distribute a surplus at that time and not a subsequent date.

"Our concern is that with the mismatch between risk and reward, the natural inclination for plan sponsors is to fund their plans as minimally as possible, and ultimately that is not a good thing for benefit security for plan members," says Scott Perkins, the president of the Association of Canadian Pension Management. The organization is calling on governments to provide plan sponsors with greater flexibility to withdraw plan surpluses and pass legislation that would "rectify the Monsanto problem."

Not everyone accepts the logic behind the asymmetric risk argument. In a position that has been warmly embraced by labour, Ambachtsheer asserts that it is a fallacy to claim that all risks in defined-benefit plans are borne by plan sponsors. The financial security of traditional pension plans can no longer be taken for granted. "Historically, we haven't been really good at allocating risks to those who are actually bearing them. If the plan goes broke and there's not enough funds, guess who's bearing that risk? It's the pensioners and the workers. So the idea that the risk is only on one side is just not correct," says Ambachtsheer.

While Lefebvre agrees with that assessment, he believes that pension legislation should allow sponsors and members to define their own pension deals and to establish surplus and deficit sharing arrangements according to time-weighted formulas which take into account the contribution values of each party.

Though labour rejects outright the notion of asymmetry, it is not firmly opposed to relaxing some regulations surrounding funding requirements such as allowing alternative financial instruments like letters of credit to be used to fund deficits or extending the amortization period for solvency deficits from five to ten years. Both measures, argue plan sponsors, would provide them with greater flexibility in cash flow management. "The key question is how secure are pensions," says Joel Harden, a senior researcher with the Canadian Labour Congress. "Can I count on it being there when I retire and how much of it will be there when I retire? We have to reduce the unfunded liabilities. That's where I think we can work with employers in some cases to provide them with flexibility towards financing their debt."

Addressing Deep-Rooted Problems

While under-funding is in and of itself a serious pension problem in Canada, the CGA study contends that it is "a symptom of deeper problems rooted within the larger pension administration regime." Pension legislation, for one, should be harmonized across provincial jurisdictions. Pension regulators should uniformly apply common rules, take a far more proactive approach, and more closely monitor pension plans in a deficit position, says Lefebvre. Regulators, for instance, should require more frequent actuarial valuations where conditions warrant it.

Current Canadian accounting rules need to be examined as well. Various smoothing mechanisms introduced to insulate a company's financial statements against shocks in its pension plan assets have allowed billions of dollars worth of pension deficits to be recorded off-balance sheet. According to a study conducted by National Bank Financial on 79 Canadian firms representing 80 per cent of the S&P/TSX market capitalization, off-balance sheet pension deficits amounted to a staggering $21 billion at the end of 2002. Lefebvre believes it would be unwise to immediately adopt the approach taken by the United Kingdom, which consists of recognizing the cost of a pension plan at its fair market value. That would be too radical, says Lefebvre, as pension plans are long-term vehicles.

Actuarial standards also should not be overlooked. A consultation paper prepared by the Régie des rentes du Québec bemoans the "lack of precision" that characterizes actuarial standards used for plan funding. "The lack of precision in the actuarial standards gives wide latitude in choosing valuation assumptions, which makes actuaries more vulnerable if pressure is put on them by parties to a pension plan at the time of determining the assumptions to use," says the consultation paper. It adds, while calling for more precise standards of practice, that the determination of actuarial assumptions does not seem to take into account, objectively and explicitly, the risks to which pension plans are exposed. In fact, the Canadian Institute of Actuaries is in the midst of reviewing its standards, and by all indications the exercise will lead to a tightening of assumptions while providing more disclosure over the funded status and its risks.

So much to do, so much on the line. As the Governor of the Bank of Canada points out, these difficult issues cannot be avoided. The stakes are simply too high. "For the future health of our economy, we must get the analysis right and then we must act," says David Dodge. The pension situation in Canada may be ripe for reform but it remains to be seen whether the business community, plan members, and legislators can work together to deal with an issue that has been described as one of the most perplexing financial issues facing Canadians.

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Luis Millan is a Montreal-based freelance journalist.