Last nails in the coffin for defined benefit system?

It’s tough enough offering a defined benefit pension plan — laws and regulations shouldn’t make it more so
By Steve Bonnar
|Canadian HR Reporter|Last Updated: 11/08/2004

There are no shortage of complaints and consternation about Canada’s defined benefit (DB) pension system.

Despite good investment returns in 2003, many DB plans remain underfunded. At the same time, regulatory systems continue to add significantly to the burden of administering DB plans.

Perhaps as a result, the proportion of the workforce covered by DB plans is dropping.

To be sure, Canada is not alone in this regard. Similar trends are emerging in the United Kingdom and Australia. According to Statistics Canada, between 1992 and 2002, the number of private-sector DB plans in Canada dropped from 7,400 to 5,900, a 20-per-cent decline.

Overall workforce coverage, in the public and private sectors combined, dropped from 45 per cent to 40 per cent during the same period.

In the U.K., the trend is similarly stark in the private sector. Total plan membership dropped from 6.5 million in 1991 to 5.7 million in 2000, a drop of more than 12 per cent.

In Australia, DB plans that are open to new employees are now basically extinct. This happened over a very short period of time as a result of legislation requiring employers to offer DC arrangements.

The trend in Canada and the U.K. is prompted by both demographic issues — more mobile workforces and greater life expectancy — and sponsors’ concerns about the costs of DB plans primarily caused by capital market movements. The capital markets downturn in 2000 caused plan costs to increase, sometimes significantly.

A look at the largest 100 companies on the Toronto Stock Exchange that sponsored DB pension plans substantiates this. At the end of 2000, the average plan had assets equal to 108 per cent of liabilities, based on financial statement measures.

That ratio dropped to 95 per cent by the end of 2001 and suffered a further drop to 84 per cent by the end of 2002.

In spite of good equity returns in 2003, the average ratio remained at 84 per cent at the end of 2003, and less than 20 per cent of companies reported any pension surplus at all.

The reason? Pension fund returns represent only one factor in determining the funded ratio. Changes in pension liabilities are the other major factor. Pension liabilities increase as bond yields decrease because bond yields dictate the discount rate used to determine pension liabilities. And bond yields have decreased since 2000.

The average discount rate used for year-end 2000 financial statements was seven per cent, which then dropped to 6.4 per cent by the end of 2003. For a typical pension plan, a drop of this magnitude caused the liabilities to increase by five to 10 per cent.

These are the natural ramifications of capital markets. Little can be done about this. But from a regulatory perspective it does not make sense to have laws that make it even more difficult to finance a DB plan.

Most recently, laws covering pension surplus ownership have proven problematic for plan sponsors in some provinces.

The Supreme Court of Canada’s recent

Monsanto

decision provided an interpretation of wording in the Ontario Pension Benefits Act that is unfriendly to plan sponsors. The legislation of several other provinces (Manitoba, Newfoundland, Nova Scotia, and Saskatchewan) and the federal legislation contain very similar wording.

The

Monsanto

decision gave the right to a share of plan surplus to all employees affected by a partial windup, reducing a plan’s ability to apply present surplus to future shortfall.

The decision provides additional incentive for plan sponsors to defer contributions to DB plans as much as possible by spending surplus as it emerges — either by taking contribution holidays or improving benefits, including improvements used to facilitate downsizings.

Plan sponsors understand they must make additional contributions when a DB plan is in deficit. But as a result of the

Monsanto

decision, it appears they are not entitled to any advantages if those contributions should result in a surplus.

If an employer terminates a significant proportion of the plan membership, either due to a downsizing or sale, the plan may need to be partially woundup.

If the plan has a surplus, this surplus needs to be distributed. In practice, this means that at least part of the surplus must be paid to the plan members affected by the partial windup, despite the fact that the plan is ongoing and the remaining members’ entitlements are not yet settled.

In this environment, it is only logical for a plan sponsor to defer making contributions to a pension plan within the limits of the law. This is not in the long-term best interests of the sponsor, the plan members or the pension system as a whole. It results in:

•lower levels of benefit security;

•more volatile contribution requirements; and

•a tendency for sponsors to avoid DB plans altogether.

In recent discussions, plan sponsors have pointed to the current uncertainty surrounding surplus as the greatest threat to the continuation of an economically viable DB pension system in Canada.

If this problem is to be fixed, legislative change is required in many Canadian jurisdictions. At a minimum, the change must confirm the sponsor’s right to take contribution holidays and eliminate the need to distribute surplus in the event of a partial plan windup.

Alberta and British Columbia already have provisions in their legislation that clearly state employers are not required to distribute surplus on partial windups. Quebec has gone a step further and eliminated the concept of partial windup completely. The rest of the country should follow the lead of these provinces.

It seems strange to be talking about removing uncertainty with respect to the use of pension plan surpluses in today’s environment where they rarely exist. But this may be the best time to implement change.

Change will need the agreement of all of the system’s stakeholders — plan sponsors and plan members, together with their representatives. And what better time to start the discussions than when the distribution of current surplus is a moot point?

Sadly, if we don’t see legislative change, the reduction in DB plans in the private sector will surely continue.

Steve Bonnar is a principal with Towers Perrin. He can be contacted in the Toronto office at steve.bonnar@towersperrin.com.

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