Today, most Canadian single employer DB pension plans have large solvency deficits, and there continues to be significant focus on the large minimum contributions required to fund these deficits. What has received little attention in recent years is that there is also a cap, prescribed in the Income Tax Act, on contributions that can be made to a registered pension plan. Thus, there is typically a contribution range—between the minimum required and maximum permissible contributions—in which an employer can choose to contribute.

Despite the contribution range available to employers, most employers fund at the minimum required levels. Given the large solvency deficits that exist, even minimum required contributions can create cash flow challenges for many employers. Therefore, it’s not a surprise that employers are currently funding at minimum levels. However, even when they can afford to contribute more, most employers tend to continue a minimum funding strategy.

One of the key reasons for a minimum contribution strategy is that employers perceive Canadian pension funding rules for single employer DB plans as asymmetrical. Employers are responsible for funding pension deficits but are typically severely constrained in their ability to withdraw any surpluses that may emerge. Therefore, they are reluctant to make discretionary contributions that could, in the future, become “trapped surplus.”

While the desire by employers to avoid developing trapped surplus in their pension plans is understandable, there are potential advantages to making discretionary contributions above minimum levels.

  1. Discretionary contributions may reduce future year-to-year contribution volatility, thereby facilitating cash flow management. For example, excess contributions made to an Ontario-registered pension plan can typically be used to create a prepaid contribution balance, which can then be applied to reduce contribution requirements in future years.
  2. A number of employers would like to reduce the risk in their pension plans. For certain de-risking strategies, such as the purchase of a buyout annuity from an insurance company, pension legislation may require additional funding in order to implement the strategy for an underfunded plan. Contributing above minimum levels can be used to facilitate such de-risking actions.
  3. For plans with Ontario employees, additional contributions may reduce the Pension Benefits Guarantee Fund assessment fees.
  4. For plans registered in certain jurisdictions, additional contributions may avoid the need to file annual valuations with the pension regulator. For example, the need for annual valuation filings can typically be avoided for an Ontario-registered plan if the solvency funded ratio disclosed in the most recently filed valuation report is at or above 85%. Avoiding annual valuation filings facilitates cash flow planning and stability.
  5. The additional contributions to the plans are tax-deductible to the employer.
  6. Additional contributions may reduce any “reputational risk” associated with poorly funded pension plans. For example, incremental contributions may reduce employee concerns about the security of their pensions.

Despite the above-mentioned potential advantages of making incremental contributions, there are important considerations for an employer considering such a strategy.

  1. The employer should assess the advantages of additional pension contributions compared to the potential value derived from other uses of the cash (e.g., the potential return from investing the cash in the employer’s business).
  2. Prior to making the contributions, there should be a clear strategy in place with respect to the manner in which the additional contributions will be deployed (e.g., whether or not the contributions will be used to facilitate a pension de-risking strategy).
  3. The risk that additional contributions could become trapped surplus in future years should be addressed. However, depending on the circumstances, this risk may be manageable.
    • Since many plans have significant solvency deficits, it may be possible to contribute incremental amounts without materially increasing the trapped surplus risk. This is particularly the case for employers that frequently monitor the funded status of their plans and should be in a position to take action before a significant risk of trapped surplus develops.
    • If the employer plans to implement a de-risking strategy, the risk that future surpluses will emerge is reduced (i.e., a de-risking strategy typically reduces both the risks of future deficits and surpluses emerging).
    • The decision by British Columbia and Alberta to implement solvency reserve accounts will reduce the trapped surplus risk for plans registered in these provinces.
  4. It is important that the employer understands the pension funding rules that affect the manner in which incremental contributions can be deployed, including any restrictions on the use of these contributions. These rules can be complex and differ depending on the jurisdiction in which the pension plan is registered.
  5. If the pension plan benefits are collectively bargained, an improved funded status resulting from additional contributions may encourage the union to demand improvements to the pension benefits.

Employers should carefully consider their pension funding strategy, which is one of the key tools available to manage pension risk. Any review of a pension funding strategy should include an assessment of whether a minimum funding strategy is truly optimal or whether a strategy that allows for discretionary contributions—made at the appropriate times—is more in line with the employer’s risk management objectives.

Gavin Benjamin is senior director of retirement at Willis Towers Watson. He has worked in the industry for more than 20 years. These are the views of the author and not necessarily those of Benefits Canada or the author’s employer.
Copyright © 2018 Transcontinental Media G.P. Originally published on benefitscanada.com

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