In 2022, the typical defined benefit pension plan achieved an investment return of roughly negative 12 per cent.
However, due to dramatic increases in bond yields and a subsequent decrease in pension liabilities, many pension plans ended 2022 with the same — or better — solvency funded level that they had at the beginning of the year.
In fact, many pension plans are better funded on a solvency basis than they’ve been in decades and no small number of plans have moved from a deficit to surplus position. For example, the Financial Services Regulatory Authority of Ontario estimated that, as of Dec. 31, 2022, the median solvency funded ratio of Ontario DB pension plans was 112 per cent and 81 per cent of these plans had a solvency ratio greater than 100 per cent.
Many pension plan sponsors are now in the enviable position of having a surplus, but this raises the question as to what plan sponsors should do with this surplus. It should also be noted that, due to restrictions imposed by the Income Tax Act on excess surplus, plan sponsors will sometimes be forced to use at least a portion of the surplus.
Here are a few ways that a pension surplus can be used:
- Contribution holiday
One option is to apply a portion of the surplus to reduce employer and/or employee current service contributions. If the pension plan has both a DB and defined contribution component, it may be possible to apply the surplus to reduce both DB and DC service contributions.
The rules for taking a contribution holiday depend on the jurisdiction in which the pension plan is registered and the provisions of the plan. Many jurisdictions only permit surplus above defined thresholds to be used for a contribution holiday in order to increase the likelihood that some surplus will remain after the contribution holiday has ended. Some jurisdictions may also require plan sponsors to provide a notice of a contribution holiday to plan members and any unions representing those members.
- Improve plan benefits
Surplus can also be used to improve the benefits provided by a pension plan. For example, a cost-of-living increase could be provided to retirees who are in receipt of a fixed pension, as the recent increase in inflation will have eroded the purchasing power of their monthly pension.
- Risk management
Financial markets remain volatile and the funded position of a pension plan with significant embedded risk can deteriorate quickly if markets move in the wrong direction. Some plan sponsors may want to keep surplus in the plan as a reserve to protect the plan from future adverse experience.
Well funded plans are often ideally positioned for de-risking through a change in the asset mix or the transfer of risk to an insurance company via a group annuity purchase. Plan sponsors considering an annuity purchase may also use some of the surplus to fund activities, such as data cleansing, that will increase the likelihood of a successful annuity transaction.
Decisions regarding the use of surplus should reflect a number of considerations, including:
- Plan member benefit security and ensuring the sustainability of the plan;
- The plan sponsor’s ultimate objectives with respect to the pension plan — for example, maintaining the plan over the long term or settling obligations;
- The plan sponsor’s risk tolerance;
- The trade-off between the benefit the plan sponsor can derive from growing the surplus further and the risk to the plan sponsor were the surplus to erode and the plan move to a deficit position; and
- The implications of the use of surplus on intergenerational equity between plan members.
Plan sponsors can make optimal decisions on pension surplus by understanding pension plan risk through proactive monitoring of the plan’s funded status and conducting financial stress testing. If they haven’t done so already, it would be wise for plan sponsors to establish a surplus management policy for their plans since a policy will increase the likelihood that both short-term and long-term value can be derived from pension surpluses.