DB shortfall could hit $190 billion

The Certified General Accountants and the Bank of Canada governor defend defined benefit plans

The Bank of Canada governor has added his voice to the call for pension system reform to halt the decline of defined benefit pension plans.

His comments were echoed by the Certified General Accountants Association of Canada, which released a review of 784 defined benefit (DB) pension plans in Canada showing a funding shortfall of about $8.6 billion. With these representing about three in 10 DB plans, the overall shortfall in the DB market is expected to be $29 billion before indexing. With indexation, the funding gap is around $190 billion.

Rock Lefebvre, vice-president of research and standards of CGA Canada, said one of the reasons behind the deficit is that sponsors took contribution holidays in the early 2000s, including some plans that were already under-funded.

“We would like to see some legislation that would prohibit contribution holidays for plans that are not fully funded,” said Lefebvre.

“Everyone has to recognize that any form of pension contribution is in fact deferred compensation. You should not be able to mitigate these obligations any differently than the payroll that you have to process at the end of the week. You have the obligation to meet that promise because it’s one of the conditions of employment. To walk away from that 20 or 30 years into the future would be no different from not meeting payroll.”

Pointing to the example of Air Canada getting permission to amortize existing pension deficiencies over 10 years instead of the five years provided by law, Lefebvre urged for existing rules to be enforced more tightly and cautioned against making too many exceptions.

“Every situation has to be evaluated on its own merit, but we have to be careful that we don’t apply that too liberally, because we could always make the defence that this will bankrupt the company and allow the company to abscond from current liabilities. My concern is in the long haul everyone will see the benefit of pleading what Air Canada and Stelco have — not that it’s not legitimate in their case — but it can be abused.”

CGA Canada also recommended easier rules for converting DB plans to hybrid plans, more frequent actuarial valuations, which are currently required every three years, as well as stricter accounting standards so that obligations show up on the corporate balance sheet.

In projecting an overall $190-billion deficit for all DB plans, the CGA Canada assumed a five-per-cent interest rate, which corresponds to the yields on long-term government bonds. The indexation relied on the assumption that the plans providing indexation after retirement — 17 per cent of all 2003 plans — would continue to do so, and the rest index at one per cent per year.

A similar call to policy-makers to “rebalance the incentives” for sponsors to operate DB plans came from Bank of Canada governor David Dodge. In a speech delivered to the association of Quebec MBAs, Dodge offered several ways to halt the decline of DB plans.

First, legislators would have to modify pension laws so that sponsors of DB plans assume “all residual risks to the pension plan — both outcomes that lead to deficits and outcomes that lead to surpluses.” He noted that in many pension funds, sponsors include both employers and employees.

Second, governments would have to eliminate tax rules that prohibit employers from making contributions to funds in surplus. Currently, most employers are not allowed to deduct contributions if the valuation of the plan is more than 110 per cent of expected liabilities. “This has certainly added to the bias against sponsors allowing surpluses to build up in their pension plans.”

In making his argument for rescuing DB plans, Dodge said that too much risk would be transferred to individual investors otherwise. He also highlighted DB plans’ contribution to the efficiency of the capital market.

Individual investors making decisions with registered retirement savings plans or with defined contribution plan assets tend to be more risk averse, said Dodge.

Citing research in the United States, he said people making investments with their individual retirement accounts tend to “invest too much in investment-grade bonds, money market instruments, and large-cap equities relative to the portfolio that would maximize their expected pension.”

In contrast, DB pension funds, particularly the large ones, tend to be managed by “sophisticated asset managers,” who make investments “over very long time horizons, so they can finance large investment projects at competitive rates of return. All of this contributes significantly to economic efficiency by transferring risk to those investors who are best able to bear it.”

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