Letter of credit could provide funding relief
Last month’s federal budget gave pension plan sponsors some much sought funding relief, a move that many in the pension industry say will partly help out employers facing shortfalls in their defined benefit (DB) pension funding.
The relief measures apply to solvency funding obligations, which are determined by an assessment as to whether the plan has enough cash to cover its obligations to employees in the event it is wound up.
Current pension rules allow a plan sponsor to make up that deficit over a period of five years. The relief measures in the budget give plan sponsors several options through which to take 10 years to fund that solvency deficit.
One of those options is through the use of a letter of credit, which is similar to a line of credit an individual can get from a bank. A plan sponsor can arrange a letter of credit through a financial institution, for one year at a time. The fees for such letters of credit may vary depending on the creditworthiness of the plan sponsor and the amount the bank is vouching for, but it’s typically around one per cent of the amount. During that 10-year period, the plan sponsor continues to pay into the funding deficit in regular installments.
“It’s good to see the government finally tackling this issue for one thing,” said Scott Perkin, president of the Association of Canadian Pension Management (ACPM).
But he said there has still been no action on the issue of “risk asymmetry” — a term people in the pension industry use to refer to the fact that DB plan sponsors are held liable for funding deficits but not allowed to reap the benefits of a funding surplus.
The use of a letter of credit alleviates this concern somewhat. If interest rates rise or equity markets perform well, a contribution in cash may turn into a surplus, which a plan sponsor cannot recover in most instances. With a letter of credit option, on the other hand, a solvency surplus simply means the letter does not ever need to be deposited.
“It’ll help. It’s not a total solution,” said Perkin. “For example, companies that are struggling are those that will have more difficulty getting a letter of credit. So it’s not going to help companies in financial trouble. So we need the government to look at broader issues, things like asymmetry and things like funding policies.”
The proposed changes will affect only the pension plans that are federally regulated. The question Perkin has now is whether other provinces will follow suit in making this option available. With the adoption of Bill 102 last May, Quebec became the first jurisdiction to allow for a letter of credit. In British Columbia, the Court of Appeal upheld a trial judge’s decision to reject the use of a letter of credit because it’s not an asset under the province’s Pension Benefits Standards Act.
Ian Genno, principal at Towers Perrin, said he’s in favour of the proposal in that it gives plan sponsors alternatives without increasing risk for members.
“The letter of credit mechanism itself helps to ensure plan members are in no worse a position than they would have been if the payments were spread out over five years,” said Genno. “I see no downside for plan members and greater flexibility for plan sponsors, which ultimately benefits plan sponsors as well as plan members, if it made the business of the plan sponsor more viable.”
Plus, Genno noted, the letter of credit is only one of two ways that private-sector employers can extend the amortization period to 10 years. The other option provided for in the budget is to inform plan members and hope no more than one-third of plan members, active or retired, object.
But Murray Gold, lawyer and head of the pension department at the law firm of Koskie Minsky in Toronto, said he’s concerned about what happens when a bank refuses to renew a letter of credit.
“In order for (a letter of credit) to be of value, it has to be reliable and continue to be in place. It has to be renewed,” said Gold. “If the financial institution refuses to renew it, then you have precipitated a crisis that will compel someone to choose possibly between the bankruptcy of a company on the one hand and funding the pension plan on the other.”
That’s because when a letter of credit is called in, the bank is obliged by the terms of that letter to fund the payment.
“But they usually secure that. In order to pay out the letter of credit, they would deplete the cash that the company has, draw it down to some significant degree,” said Gold.
Either way, the company is in a position of having to make a very large payment at a time when it can least afford to.
Who makes this decision is also a matter of concern. If it’s an independent trustee, then that person might have some leverage as long as there are clear rules to protect him from liability. But if a plan is administered by a committee of the board directors and a custodial trustee, then “you’ve got to have someone ready and willing to pull the trigger, and it’s a very difficult and awkward decision.”
Perkin said the ACPM is in discussion with the trust industry to clarify what the rules are around the triggering of a letter of credit. “Hopefully, that will put to rest some concerns some have had around the use of letters of credit,” said Perkin. He noted that it’s a well-known tool in other matters of corporate financing, just not in the pension context.
The underlying problem Gold sees in the budget proposal is a tendency to focus on the “narrow” objective of avoiding surpluses.
“The risk of overfunding is wildly overstated,” said Gold. “If there is overfunding, then employers can take very significant contribution holidays, and there are regimes under which they can enter into to withdraw a surplus, though that’s very rare. A letter of credit works fine if everything’s going well, but what happens when there’s a bankruptcy?”
An employer’s view
Company reluctant to fund ‘temporary’ liability
When Butler Brothers Supplies Ltd. in Victoria sought a letter of credit to fund its solvency liabilities three years ago, one of its main reasons was the inability of a plan sponsor to recover pension plan surplus.
Butler Brothers Supplies, which sells aggregate and concrete in southern Vancouver Island and employs 70 people, 50 of whom are unionized, was looking at a $97,900 surplus in its defined benefit plan. However, a “snapshot” valuation of the plan’s status were it to wind up at that moment showed a liability of about $174,300.
In management’s view, this liability was caused by the “poor showing of the stock markets, which we assumed, and which was subsequently proven, to be a temporary situation,” controller Ian Sunderland told Canadian HR Reporter in an e-mail.
Sunderland said the company saw benefits for both members and the plan sponsor in seeking a letter of credit. The gain for members was the immediate guarantee provided by the letter of credit — an improvement over the amortization payments option, which would mean that the liability would only be funded at the end of five years.
The benefit for the company was “it would not be required to make contributions to the pension plan that are unnecessary under the going-concern valuation. Because of legal uncertainties regarding surplus ownership in Canada, it is doubtful that the company would be able to withdraw a solvency surplus when the causes of the original solvency deficit were shown to have disappeared,” he added.
The Superintendent of Pensions Financial Institutions Commission rejected this plan, prompting the company to turn to the courts. The British Columbia Supreme Court agreed with the superintendent.
“Assuming the letter of credit is an asset, it is an asset with a condition. That is to say, it is an asset which the plan may realize upon if, and only if, the plan is terminated,” wrote Justice R. Dean Wilson in Butler Brothers Supplies Ltd. v. British Columbia (Financial Institutions Commission). “I read the wording of the (Pension Benefits Standards) Act to mandate a current contribution of the plan, without conditions, upon the solvency deficiency being identified. To put it another way, the legislation proscribes the conditional funding of solvency deficiencies. It places the entire risk on the employer.”
Having also lost at the B.C. Court of Appeal, Butler Brothers sees no recourse. “We can only wait for the government to change the laws to allow letters of credit to be used to fund solvency deficits,” said Sunderland.
The relief measures apply to solvency funding obligations, which are determined by an assessment as to whether the plan has enough cash to cover its obligations to employees in the event it is wound up.
Current pension rules allow a plan sponsor to make up that deficit over a period of five years. The relief measures in the budget give plan sponsors several options through which to take 10 years to fund that solvency deficit.
One of those options is through the use of a letter of credit, which is similar to a line of credit an individual can get from a bank. A plan sponsor can arrange a letter of credit through a financial institution, for one year at a time. The fees for such letters of credit may vary depending on the creditworthiness of the plan sponsor and the amount the bank is vouching for, but it’s typically around one per cent of the amount. During that 10-year period, the plan sponsor continues to pay into the funding deficit in regular installments.
“It’s good to see the government finally tackling this issue for one thing,” said Scott Perkin, president of the Association of Canadian Pension Management (ACPM).
But he said there has still been no action on the issue of “risk asymmetry” — a term people in the pension industry use to refer to the fact that DB plan sponsors are held liable for funding deficits but not allowed to reap the benefits of a funding surplus.
The use of a letter of credit alleviates this concern somewhat. If interest rates rise or equity markets perform well, a contribution in cash may turn into a surplus, which a plan sponsor cannot recover in most instances. With a letter of credit option, on the other hand, a solvency surplus simply means the letter does not ever need to be deposited.
“It’ll help. It’s not a total solution,” said Perkin. “For example, companies that are struggling are those that will have more difficulty getting a letter of credit. So it’s not going to help companies in financial trouble. So we need the government to look at broader issues, things like asymmetry and things like funding policies.”
The proposed changes will affect only the pension plans that are federally regulated. The question Perkin has now is whether other provinces will follow suit in making this option available. With the adoption of Bill 102 last May, Quebec became the first jurisdiction to allow for a letter of credit. In British Columbia, the Court of Appeal upheld a trial judge’s decision to reject the use of a letter of credit because it’s not an asset under the province’s Pension Benefits Standards Act.
Ian Genno, principal at Towers Perrin, said he’s in favour of the proposal in that it gives plan sponsors alternatives without increasing risk for members.
“The letter of credit mechanism itself helps to ensure plan members are in no worse a position than they would have been if the payments were spread out over five years,” said Genno. “I see no downside for plan members and greater flexibility for plan sponsors, which ultimately benefits plan sponsors as well as plan members, if it made the business of the plan sponsor more viable.”
Plus, Genno noted, the letter of credit is only one of two ways that private-sector employers can extend the amortization period to 10 years. The other option provided for in the budget is to inform plan members and hope no more than one-third of plan members, active or retired, object.
But Murray Gold, lawyer and head of the pension department at the law firm of Koskie Minsky in Toronto, said he’s concerned about what happens when a bank refuses to renew a letter of credit.
“In order for (a letter of credit) to be of value, it has to be reliable and continue to be in place. It has to be renewed,” said Gold. “If the financial institution refuses to renew it, then you have precipitated a crisis that will compel someone to choose possibly between the bankruptcy of a company on the one hand and funding the pension plan on the other.”
That’s because when a letter of credit is called in, the bank is obliged by the terms of that letter to fund the payment.
“But they usually secure that. In order to pay out the letter of credit, they would deplete the cash that the company has, draw it down to some significant degree,” said Gold.
Either way, the company is in a position of having to make a very large payment at a time when it can least afford to.
Who makes this decision is also a matter of concern. If it’s an independent trustee, then that person might have some leverage as long as there are clear rules to protect him from liability. But if a plan is administered by a committee of the board directors and a custodial trustee, then “you’ve got to have someone ready and willing to pull the trigger, and it’s a very difficult and awkward decision.”
Perkin said the ACPM is in discussion with the trust industry to clarify what the rules are around the triggering of a letter of credit. “Hopefully, that will put to rest some concerns some have had around the use of letters of credit,” said Perkin. He noted that it’s a well-known tool in other matters of corporate financing, just not in the pension context.
The underlying problem Gold sees in the budget proposal is a tendency to focus on the “narrow” objective of avoiding surpluses.
“The risk of overfunding is wildly overstated,” said Gold. “If there is overfunding, then employers can take very significant contribution holidays, and there are regimes under which they can enter into to withdraw a surplus, though that’s very rare. A letter of credit works fine if everything’s going well, but what happens when there’s a bankruptcy?”
An employer’s view
Company reluctant to fund ‘temporary’ liability
When Butler Brothers Supplies Ltd. in Victoria sought a letter of credit to fund its solvency liabilities three years ago, one of its main reasons was the inability of a plan sponsor to recover pension plan surplus.
Butler Brothers Supplies, which sells aggregate and concrete in southern Vancouver Island and employs 70 people, 50 of whom are unionized, was looking at a $97,900 surplus in its defined benefit plan. However, a “snapshot” valuation of the plan’s status were it to wind up at that moment showed a liability of about $174,300.
In management’s view, this liability was caused by the “poor showing of the stock markets, which we assumed, and which was subsequently proven, to be a temporary situation,” controller Ian Sunderland told Canadian HR Reporter in an e-mail.
Sunderland said the company saw benefits for both members and the plan sponsor in seeking a letter of credit. The gain for members was the immediate guarantee provided by the letter of credit — an improvement over the amortization payments option, which would mean that the liability would only be funded at the end of five years.
The benefit for the company was “it would not be required to make contributions to the pension plan that are unnecessary under the going-concern valuation. Because of legal uncertainties regarding surplus ownership in Canada, it is doubtful that the company would be able to withdraw a solvency surplus when the causes of the original solvency deficit were shown to have disappeared,” he added.
The Superintendent of Pensions Financial Institutions Commission rejected this plan, prompting the company to turn to the courts. The British Columbia Supreme Court agreed with the superintendent.
“Assuming the letter of credit is an asset, it is an asset with a condition. That is to say, it is an asset which the plan may realize upon if, and only if, the plan is terminated,” wrote Justice R. Dean Wilson in Butler Brothers Supplies Ltd. v. British Columbia (Financial Institutions Commission). “I read the wording of the (Pension Benefits Standards) Act to mandate a current contribution of the plan, without conditions, upon the solvency deficiency being identified. To put it another way, the legislation proscribes the conditional funding of solvency deficiencies. It places the entire risk on the employer.”
Having also lost at the B.C. Court of Appeal, Butler Brothers sees no recourse. “We can only wait for the government to change the laws to allow letters of credit to be used to fund solvency deficits,” said Sunderland.
