A Deepening Crisis 

FROM: SEP-OCT 2009 ISSUE | BY JEFF BUCKSTEIN

Although the funding woes afflicting Canadian corporate pensions have been well-documented for many years, the recent market meltdown couldn’t help but decimate the pension situation further. In fact, the problems that rang Canadian alarm bells earlier this decade “look like a tempest in a teapot, compared to what’s going on now” says Ian Edelist, the principal and consulting actuary at Eckler Ltd. in Toronto.

The statistics bear proof. The Office of the Superintendent of Financial Institutions estimates 83 per cent of federally-registered defined benefit pension plans were under-funded (based on a solvency calculation which takes into account values if the plan were forced to liquidate) in December 2008; up from 71 per cent only six months before.

CGA-Canada has produced two extensive reports on defined-benefit pension plans in Canada. The reports documented national funding gaps – the amount by which asset valuations are insufficient to meet liability obligations – of $160 billion at the end of 2003 and $190 billion at the end of 2004.

Ironically, many of the widely-acknowledged root causes of the corporate pension crisis date back to the halcyon days of the late 1990s when markets were booming, and many pension plans sat in a healthy surplus position with asset valuations more than sufficient to meet obligations. Experts cite temporary pension contribution holidays and overconfidence that markets would continue to appreciate in value as key catalysts.

The Income Tax Act stipulates that federally regulated defined benefit pension plans can generally accrue no more than a 10 per cent surplus over going-concern liabilities. (Going-concern and solvency are both key valuations that firms use to determine whether they are in a surplus or deficit position with respect to pension funding.)

“Some argue if that limit hadn’t been there, pension plans would have been able to build up larger surpluses when times were good to deal with the situation we have now when times are bad. Some plans that are currently in deficit might not be in deficit, or might not be as badly in deficit now,” says Scott Perkin, president of the Association of Canadian Pension Management.

The enhanced benefits some employers offered when markets were booming may have also exacerbated the current pension woes. For instance, notes Gail Stephens, FCGA, city manager, Victoria, B.C., some plans featured double digit contributions from both employee and employer – up to about 16 or 17 per cent of salary, a rate which is “not sustainable.”

“People started thinking pension plans were a free lunch. They didn’t realize how costly and therefore what a valuable benefit they were,” says Edelist, who notes it wasn’t until late 2002, when markets plunged, that observers began to ruminate about spent surpluses and eroded buffers.

Between 2001 and 2005, the percentage of Canadian companies running a surplus in their defined benefit pension plans fell from 23 per cent to 6 per cent, with the median of this group having only 85.6 per cent of the required balance in their plans, says Stephens.

“We talk about the ‘perfect storm’ that occurred in the early part of the decade when interest rates were really low and markets were not performing terribly well. We’re going through a similar situation now with even lower interest rates and worse market performance,” says Perkin. “What’s really creating problems for many companies is the solvency valuation. The prescribed interest rates used to do this valuation are at really low levels and assets (are) underperforming the markets.”

Experts suggest a number of measures could help alleviate the corporate pension crisis in Canada. “Should we allow employers a longer time to fund solvency deficits? Most plans don’t terminate today so you’re funding towards a contingency that might never occur,” Perkin points out. The federal government addressed that issue by announcing in its 2009 budget it would double from five to 10 years the period corporations have to fund their pension shortfall. Several provincial and territorial jurisdictions have followed suit.

Extending the period to cover any pension shortfall should be beneficial as long as money is actually transferred into the pension plan, and sponsors don’t turn to an instrument like a letter of credit to earn a deferment, says CGA-Canada’s director of accounting standards, Amar Goomar, CGA. Letters of credit were popular during the early 2000s as companies sought guarantees from banks to cover their pension fund obligations. But in most instances the company was merely buying a deferment, hoping equity values would continue to appreciate, thereby increasing the plan’s value, he explains.

Another area attracting close scrutiny involves indexing for inflation, which can end up costing employers a great deal of extra money over time. If contractual inflation protection was only offered on an ad-hoc basis when the plan could afford it, “that would lessen the funding and contributions employers had to make,” Edelist says.

A Target Benefit Plan, which is already in existence in certain multi-employer sectors, such as the trades, would allow companies to reduce pensions for both active and retired employees if the employer discovers there isn’t enough money in the plan to cover liabilities at a certain valuation date, Edelist notes.

Nova Scotia’s Pension Review Panel recommended that Target Benefit Plans be more widely utilized across the province, with employers obligated to pay at least 50 per cent of the total contributions, when it issued its final report in March 2009.

Another possibility is to utilize a Pension Security Trust (also known as a Pension Security Fund), as a side fund to the regular pension fund. Solvency contributions from corporate sponsors would go into this trust. If the employer ever went bankrupt or the plan was terminated, this fund could be used to cover members’ benefits. Conversely, if the side fund attained a large enough buffer or there were more assets than required for employees upon termination, any residue could go back to the employer, explains Edelist.

Alberta and British Columbia’s Joint Expert Panel on Pension Standards reported in November 2008. One of its key recommendations was to allow sponsors of defined-benefit pension plans “to contribute funds in excess of those required on a going-concern basis to a separate fund (a Pension Security Fund) from which amounts in excess of the calculated wind-up basis, after building in a reasonable margin, could be withdrawn by the sponsor.”

“Right now, companies minimally fund their plan because once the money goes in they feel they can’t get it back out. I think this side fund is a great mechanism to allow companies to more than minimally fund their pension plan. This would provide a lever with which to return such funds to companies should the balance become quite large,” Edelist says.

Experts stress that a solution to the funding shortfall plaguing Canadian pension plans is even more crucial given the much larger societal problem that Canadians as a whole are ill-equipped for retirement. About one-third have no retirement savings at all, while another third have inadequate savings for an independent retirement.

The number of defined benefit pension plans offered by firms has also dropped precipitously, from 41 per cent of Canadian employees covered by such plans in 1991, to only 30 per cent by 2006, according to Statistics Canada. (Workers covered by defined contribution plans, under which employees take responsibility for their own investment strategy, rose significantly over that period).

“We need to find ways to improve that situation and incent employers to provide retirement savings programs,” stresses Perkin. If future retirees don’t have a pension plan they are likely to rely upon the state for income adequacy and security. And government programs such as the Canada Pension Plan, Old Age Security, and the Guaranteed Income Security don’t pay a lot, he warns.

Demographics may also serve to exacerbate the pension crisis in future. Life expectancy is increasing while the retirement age decreases. Furthermore, a massive wave of baby boomer retirements will be occurring over the next two decades, as the population of senior citizens in Canada is expected to swell to over 20 per cent by about 2025, leaving an ever smaller base of workers to support growing legions of retired people.

Stephens suggests a key role for government and regulators may be to ensure Canadians have access to financial vehicles to save for retirement. She cites the tax-free savings account as a good example. The question they need to consider is, “how can we ensure all Canadians save so that they can retire without hardship?” insists Stephens.            

Alberta and British Columbia’s Joint Expert Panel also emphasized that point. “Governments should have as a stated public policy objective the encouragement of occupational pension plans as part of the ‘second pillar’ of the retirement income system, complementing government programs and individual savings.”

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