We may be witnessing the most significant changes to the funding rules of Canadian defined benefit pension plans in more than 25 years.
First, since Quebec’s Bill 57 came into effect at the beginning of 2016, minimum funding requirements for private sector plans registered in the province are now based on an enhanced going-concern valuation. The funding of deficits on a solvency basis is no longer required. Ontario is currently reviewing the funding rules for Ontario-registered pension plans, including considering the merits of the Quebec approach that eliminates solvency funding.
When considering what a defined benefit funding regime should look like, it’s worthwhile to step back and consider the purposes of pension funding (i.e., what a funding regime should be trying to achieve) in the first place. Agreeing on the purposes of a funding regime is important, as it provides a basis for establishing the characteristics of the regime.
Cash management versus bankruptcy protection
Experts typically point to the following two potential purposes for pension funding:
1. Cash management. By putting cash aside as active members render service and accrue benefits in the pension plan, assets are accumulated in an orderly manner to pay promised benefits from the plan when they become due. Thus, funding reduces the risk of cash-flow pressures emerging when previously active plan members retire and begin to draw their pension.
This long-term cash management view of the purpose of funding tends to lead to a preference for using the going-concern liabilities of the plan as the funding target. This is because going-concern liabilities are premised on the pension plan continuing indefinitely and are based on the plan actuary’s long-term assumptions. The long-term assumptions selected by the actuary typically include items such as future increases in price inflation, the rate of plan members’ future salary increases, the expected investment return on the plan’s assets, and the future incidence of member withdrawal, retirement and death.
2. Bankruptcy protection. Through funding, assets are deposited in a trust that’s set apart from the plan sponsor’s other assets and are shielded from the plan sponsor’s creditors. This protects the accrued benefits of plan members in the event the plan sponsor becomes bankrupt and is therefore not able to pay promised benefits from the plan.
The bankruptcy protection school of thought with respect to the purpose of funding tends to lead to a preference for using the solvency liabilities of the plan as a funding target. The reason for preferring solvency liabilities is that employer bankruptcy usually leads to the windup of the plan, and solvency liabilities are based on an estimate of the cost of settling the benefits of the plan in the event of windup.
Since the late 1980s, pension funding rules have incorporated both the cash management and bankruptcy protection views of the purpose of funding. The financial position of a pension plan is measured on both a going-concern and a solvency basis. A funding deficiency under either of these two bases needs to be funded by the plan sponsor, usually over 15 years for a going-concern deficit and five years for a solvency deficit.
Finding the right balance
The traditional approach to pension funding has been under pressure for a number of years. The trend of declining long-term bond yields has caused a significant increase in pension solvency liabilities, which are very sensitive to the level of long bond yields. At the same time, equity markets continue to be volatile.
This has resulted in large and volatile solvency deficit contribution requirements for many plan sponsors. These sponsors have had to divert a significant amount of capital away from their core business for the purpose of providing protection for pension plan members under an employer bankruptcy scenario, a scenario which is highly unlikely for the vast majority of employers at any point in time. In some cases, solvency contribution requirements have even jeopardized the viability of the sponsor’s core business. These challenges have led to Quebec’s move to its enhanced going-concern funding approach.
The traditional funding approach does need to be modified so contribution requirements are more affordable and less volatile for plan sponsors. However, providing security for members’ pensions still serves a valid purpose, since pension plan sponsors do occasionally go bankrupt. In other words, both purposes of funding outlined above are important.
The challenge for legislators is to create funding regimes that strike the best possible balance between the two key purposes of funding: enabling plan sponsors to manage their pension cash outlays such that their pension plans are affordable, predictable and sustainable, while providing an appropriate level of protection to plan members. Striking an optimal balance between these objectives is by no means easy, which makes the outcome of Ontario’s current funding review and any future similar reviews in other jurisdictions important for all pension stakeholders.