This year is shaping up to be a watershed year for solvency funding reform, with funding ratios on the decline and a growing clamour to revise the rules by which sponsors must keep their defined benefit pension plans in the black.
While a temporary spike in Canadian 10-year bond yields had arrested and reversed a previous slump in solvency ratios between 2011 and 2013, longterm bonds have since returned to all-time lows, and this time, nobody is pinning their hopes on a quick rise. Temporary solvency relief measures have also returned to the pension world, but experts say something more permanent could be in order.
Provincial governments have been stirring into action. At the turn of the year, Quebec took a step away from solvency funding as it embraced goingconcern valuations, while legislatures in Alberta and British Columbia have also moved to loosen the strictures plan sponsors say solvency funding rules place on them.
But Ian Edelist, a principal at Eckler Ltd. who’s a long-time doubter about the efficacy of solvency funding rules, knew something major was afoot once Ontario jumped on the bandwagon when it announced an expedited review last fall of its solvency funding framework.
“Ontario is one of the most conservative jurisdictions in terms of plan funding and security,” says Edelist, who leads Eckler’s pension practice in Toronto. “I didn’t even think they would take the step of looking at the solvency rules, so I don’t know how far they will go, but I’m cautiously optimistic.”
He adds: “When people cling on to these rules and say that we can’t change something that was created in 1987, I think it’s ludicrous. The insurance industry has responded, the banking industry has responded, so why shouldn’t the pensions industry?”
Any move, however, to abandon solvency funding altogether would meet resistance from plan members who worry that anything less than the solvency standard merely obscures the fact that a plan couldn’t meet its future obligations to its members should the sponsor unexpectedly disappear. For Bob Farmer, the president of the Canadian Federation of Pensioners, the spectre of Nortel Networks Corp. looms large over any discussion of pension plan funding.
“Eliminating solvency funding is not the way to go because it opens up the risk that a plan looks like it is fully funded, only for everyone to discover when the sponsor goes under that it wasn’t,” he says. “If pensioners had guarantees that an employer would never fail, that would be fine, but nobody can give that kind of guarantee. A couple of years before it was gone, Nortel looked great. I knew a lot of people there and they all took a big hit.”
Solvency ratios plunging
Defined benefit pension plan sponsors in most Canadian jurisdictions report their funding ratio once every three years on a solvency basis that values a plan’s assets as if it were to wind up on that date and then checks whether there’s enough in the pot to immediately pay out all of the liabilities already accumulated.
When the calculation shows a deficit, sponsors must make a special payment to cover the shortfall, typically over a maximum of five years.
A number of recent studies of pension funds showed a notable downward trend in solvency ratios. In January, Mercer reported that the median solvency ratio among its Canadian clients had reached 85 per cent, down from 88 per cent at the same time in 2015.
A survey of Aon Hewitt clients for the first quarter of the year reported similar results (although subsequent surveys showed a reversal of that trend, largely due to improving equity markets), while the Financial Services Commission of Ontario, which receives actuarial reports from all defined benefit pension plans registered in that province, produced its own report based on the data. At the end of 2015, the median solvency ratio of plans regulated by FSCO was 83 per cent, the lowest level since June 2013. The same report found just eight per cent of plans were fully funded, which was down from 28 per cent as recently as June 2014.
Ian Struthers, a partner and lead in Aon Hewitt’s investment consulting practice, says the special payments demanded by plans’ deficit positions put immediate pressure on the overall financial health of employers. “It means there is less cash available to invest in running the business,” he says.
Hugh Wright, chair of the board of directors at the Association of Canadian Pension Management, says the current rules make it easy for plans with sizable solvency deficits to get locked into a vicious cycle.
“A deficit in your pension can make it more difficult to access financing, which ironically means that those who offer more generous pensions actually find it more difficult than those with less generous ones,” says Wright, who’s also a Halifax-based pension lawyer at McInnes Cooper. “Ultimately, funding challenges for the pension plan aren’t good for either the employee or the sponsor.”
At the end of 2015, the Ontario government responded to the current difficulties facing plan sponsors by extending temporary measures provided in both 2009 and 2012 after previous crises in solvency funding deficits. The move allows companies to reamortize existing deficit payments and extends the maximum amortization period for new shortfall payments to 10 years from the current five-year limit.
For Manuel Monteiro, a partner and leader of Mercer’s financial strategy group, the persistent need for solvency funding relief is evidence of the inadequacy of the existing rules.
“When governments in Ontario and elsewhere keep granting relief, it’s clear to me that the rules aren’t really working in the long term,” he says.
According to Edelist, temporary relief measures are almost inevitable under the current solvency rules due to their “pro-cyclical” nature.
“When the economy is going well, plans generally don’t put in a lot of money or they take contribution holidays if there is no deficit, which means there’s no reserve built up for the times when the economy is not going well,” he says. “Temporary measures have been a good Band-Aid, but I’d like to see some permanent rules.”
In any case, Edelist says that in practice, solvency rules don’t protect employees as well as they might expect. After reviewing the plans of 151 companies that went out of business in Ontario between 2000 and 2013, he found that almost half went bust with a solvency ratio in their pensions of less than 70 per cent, despite the funding rules in force.
“There’s a false sense of security around solvency and, I think, with some education, members will realize it’s not everything they hoped it would be,” he says.
Farmer acknowledges there are holes in the solvency funding rules but he has no doubt things “would be worse” for pensioners if bankrupted companies hadn’t been funding according to solvency ratios. He says he’d be happy to see temporary measures extended until sponsors have a clearer view of the longterm outlook for interest rates.
“It still exposes pensioners to more risk but not an unreasonable amount,” he says. “I have sympathy for the pressure sponsors are under.”
Even if interest rates do eventually rise, that will create its own problems for employers, according to Wright, since sponsors have no way to recover previous deficit payments once plans return to surplus.
“Maybe the solvency rules made sense in an era of high interest rates, but funding demands have become so volatile that they are defeating the purpose for which they were originally set up,” says Wright.
Legislators in Alberta and British Columbia have tackled the problem of trapped capital by creating solvency reserve accounts to receive deficit payments. Employers can withdraw the money under certain circumstances if they no longer need it to fund the deficit, which would remove the incentive for sponsors to underfund their plans, says Jana Steele, a partner and pensions lawyer at Osler Hoskin & Harcourt LLP in Toronto.
Ontario should consider a similar mechanism as part of its review of the funding rules, she says.
“I like the approach because it still deals with benefit security by ensuring the money is there if needed,” says Steele.
Quebec, meanwhile, has moved away from solvency funding in favour of going-concern valuations that assume a plan will continue indefinitely and help smooth short-term fluctuations in market conditions.
“Clearly, going concern is better for companies because pension contributions are not as high, but it does mean that benefits are not as secure,” says Monteiro. “But maybe that’s a more realistic approach to funding pension plans.”
Julien Ranger, a partner and pensions lawyer in Osler’s Montreal office, says a stabilization reserve designed to provide a cushion for plans in times of economic turmoil will moderate the scale of the transformation in Quebec. The measure was a concession to union demands in return for ending solvency requirements.
“If you compare what they had to pay before and under the new regime, the amounts aren’t that far apart,” he says. “Right now, everyone seems satisfied, but it will be hard to tell if either party has achieved their objectives for another few years.”
But even with a cushion, Farmer remains suspicious of going-concern valuations and says he hopes Ontario sticks with solvency funding.
“If they’re funding to 115 per cent, there’s no guarantee that’s enough because solvency ratios tend to really lag behind going concern,” he says.
A look at the funding ratios for Alberta’s public service pension plan illustrates Farmer’s worry. In its 2014 actuarial report, the plan’s going-concern ratio was 84 per cent. While it’s exempt from solvency funding rules, the plan still disclosed its solvency ratio for the same year, which stood at 54 per cent. Another fund with a solvency funding exemption, the Colleges of Applied Arts and Technology pension plan in Ontario, showed a fully funded ratio of 110.4 per cent on a going-concern basis in January. However, its solvency ratio, released at the same time, stood at just 80 per cent.
Wright sees promise in the Quebec changes because they mark a significant move away from what he says are “arbitrary” solvency funding rules. He’d like to see Ontario do the same, preferably with the support of labour groups as happened in Quebec.
“At the end of the day, the best long-term guarantee of a defined benefit pension plan, in my view, is a prosperous and thriving pension plan sponsor,” he says. “If you impose financial requirements that are debilitating, you may well end up with a few years of extra funding, but the effect on the sponsor in terms of long-term competitiveness and productivity can be punishing.”
Michael McKiernan is a freelance writer.
Get a PDF of the full article.
Alternatively, get a PDF of the 2016 Top 100 Pension Funds.