Solvency rules can change, but employers need to give a little too
Many private organizations that still offer defined benefit (DB) pension plans are concerned the current funding rules are too onerous and will lead to the companies that offer them being less competitive.
Seven major Canadian organizations voiced concerns to the federal government earlier this year and made recommendations to amend the Pension Benefits Standards Act (PBSA). The solvency rules, unless changed, would see these corporations pour an additional $2.5 billion of corporate cash into DB plans in 2009 and beyond — a financial burden they say they cannot bear.
In a joint submission, the CFOs of these organizations asked for meaningful, permanent changes to the solvency funding rules for DB plans, including that the government:
• increase the solvency deficit amortization period from five to 10 years, without any conditions
• move to the AA corporate bond rate as the solvency valuation discount rate for liabilities
• maintain asset smoothing to mitigate contribution volatility
• exclude inflation-indexing provisions in solvency liability calculations
• allow use of letters of credit in lieu of solvency funding at the corporation’s discretion
• give no provisions for adverse deviations (such as required balance sheet risk buffers) unless a corporation has clear title and access to surplus assets.
Will these requested changes really save corporate DB plans and, if so, should the PBSA be amended as requested? One must first look at the nature of these plans.
Corporate DB plans have both legal and financial dimensions. The legal one recognizes a corporate DB plan is a contractual arrangement between an employer and current and former employees. The financial dimension recognizes pension accruals are a form of corporate debt secured by a segregated trust fund.
However, the reality is not as clear-cut. First, DB pension contracts are seldom fully spelled out. Examples include fuzziness about surplus ownership, the ranking of accrued pension debt in corporate reorganizations, maximum allowable DB balance sheet mismatch risk and inflation indexation rules.
Second, corporations attempt to earn a risk premium with pension assets. If the only purpose of a pension fund was to secure pension promises, it would always be fully funded and fully immunized, with assets matching liabilities. This is clearly not the case. Instead, corporations expose DB balance sheets to mismatch risk in the hope of earning a risk premium on pension assets. Earning such a risk premium means not having to pay the full economic cost of the pension promise.
These realities took shape over a long period of time during which voluntary, informal pension “gratuities” morphed into arrangements with some contract-like features. Ironically, the formalization of DB pension arrangements in the 1980s and 1990s through pension legislation coincided with extended periods of high interest rates and rising equity prices, which made generous pension promises (often collectively bargained) seem affordable with only modest contribution rates.
All this came to a jarring end in the current decade, with its toxic mix of maturing plan memberships, falling interest rates, falling equity prices and the advent of “fair value” disclosure principles. In this new, difficult environment, both of the noted realities have negative consequences. The “incomplete contract” reality sets up situations of potential conflict between various stakeholder groups, each trying to interpret fuzzy pension deal options in their own favour.
Similarly, the earning-a-risk-premium reality means, without change, DB balance sheets will continue to be subjected to material mismatch risk, which in turn means there will continue to be periods of material DB balance sheet surpluses — and of material asset shortfalls. When the incomplete contract and asset shortfall realities coincide with a corporate reorganization, a messy material reduction in current and future pension benefits results.
Bigger picture
The joint submission’s recommendations should be studied in a broader retirement income system reform context.
The broader pension reform question is whether it is good public policy to facilitate corporations running risky, not-fully-defined pension arrangements, when research confirms there are superior alternatives such as target benefit plans that maintain clear property rights. Such plans, in which corporations no longer have a direct financial stake, could be managed by the employer or through one of a number of collective arms-length pension institutions designed specifically for the purpose.
Basis of a ‘win-win’ deal
Is there a basis for a win-win deal here between the seven corporations and the federal government? Yes, but it will be challenging. On the corporations’ side, there is no doubt about the urgency of the situation. They can ill-afford to part with billions of dollars in the midst of the largest financial and economic crisis since the 1930s. Further, future pensions already earned are more likely to be paid by going-concern employers than by employers forced to cease operations.
The federal government should, therefore, change the solvency funding rules along the lines set out in the submission (though some specific features might need to be modified). However, that should only be one side of the deal.
In return, the corporations should be asked to commit to reshaping retirement income arrangements to be consistent with the following three principles:
First principle: Establish a target pension and articulate a clear corporate commitment to help fund that target pension. A target benefit pension design fosters well-managed risk-bearing by younger workers through personal pension accounts and guarantees pensions to retirees through an immunized annuity balance sheet. Target benefit pension plans automate investment decisions and, as workers age, a deferred annuity purchase program is initiated, leading to a guaranteed stream of pension payments when workers retire.
The corporate commitment could take the form of an affordable target percentage-of-pay contribution rate, with the expectation workers would also make affordable target percentage-of-pay contributions.
Second principle: Create a pension design that ensures employees and retirees have clear title to their pension property in the form of assets in a personal pension account or claims on a fully funded and immunized annuity balance sheet, or some combination of two.
Third principle: Ensure the institutional mechanism through which the pension arrangement is managed is arms-length, expert and has sufficient scale to operate cost-effectively.
Finally, each corporation should lay out a transition plan for how, and over what time period, it will move from the old to the new. Such plans might range all the way from slow, multi-decade transitions for financially strong corporations to near-term reorganizations for weak ones.
Alternative proposition
An alternative solution is for the Office of Superintendent of Financial Institutions to start regulating corporate DB plans the same way it regulates banks and insurance companies. The basic regulatory principle here is mismatch risk on bank and insurance company balance sheets must be covered by a risk buffer, with the size of that buffer determined by the amount of mismatch risk.
Given that corporations subject DB plan balance sheets to material mismatch risk (easily 20 per cent of the balance sheet), permanent sizable balance sheet surpluses would be required by current regulations. Under this approach, pension deals must be fully defined, including corporate ownership of the risk buffer.
Circumstances have created a defining moment for corporate DB plans in Canada. The “old” model has shown itself to be seriously flawed by not fully defining property rights and permitting plan sponsors to substitute risk for full-cost contributions. The time has come for a new, more sustainable pension model faithful to the three principles. Let’s get on with it.
Keith Ambachtsheer is director of the Rotman International Centre for Pension Management at the University of Toronto. He is also president of KPA Advisory Services in Toronto. He can be reached at (416) 925-7525 or visit www.kpa-advisory.com for more information.
