Back to basics on the provision for adverse deviation

Defined benefit plan sponsors can’t predict the future — but with a provision for adverse deviation, they can at least plan for it.

“Given the work that actuaries do, where it’s all about quantifying risks and all these unknowns, it’s always best to be conservative,” says Andrew Gillies, partner and consultant at Robertson, Eadie & Associates. “Adding a provision for adverse deviation . . . is adding a level of conservatism because you don’t know the future.”

The provision, known as PfAD, is a percentage or dollar amount above the best estimate of a plan’s liabilities, which must be contributed to the plan on top of regular service costs. Plan sponsors must make PfAD contributions until reaching the plan’s going-concern funded requirements plus the added buffer. For example, a plan with a 10 per cent PfAD and a 100 per cent going-concern requirement wouldn’t be able to take a contribution holiday until reaching a 110 per cent funded status on a going-concern basis.

Read: PIAC calling for tighter link to asset allocation for PfAD in B.C. solvency funding framework

“It’s kind of like a target funding ratio — it’s the dollar amount of the best estimate at which point you should be fairly safe and the funded status should be fairly stable,” says Todd Saulnier, chair of the Association of Canadian Pension Management’s national policy committee. “That way, if you have a bad year . . . it shouldn’t throw the plan underwater.”

British Columbia, Ontario, Quebec and Nova Scotia have made the PfAD part of their pension solvency reforms, which have reduced solvency funding requirements and commensurately amped up their going-concern funding standards.

Provincial policies

However, the provinces have taken slightly different approaches to calculating the PfAD. In Ontario and Quebec, the provision is connected to a plan’s asset mix, with higher-risk investments such as equities resulting in a higher PfAD and fixed income serving to help reduce the provision cost.

Alternative investments have been trickier to factor into PfAD calculations, says Saulnier, noting most regulators have concluded that the risk for alternative assets falls somewhere between public equities and bonds when calculating the PfAD.

Timeline of Canadian funding reforms

2016 Quebec becomes the first Canadian jurisdiction to shift to going-concern obligations for funding evaluations and introduce PfADs.

2018 Ontario implements reforms that require enhanced going-concern funding and introduce the PfAD.

January 2020 B.C.’s funding reforms take effect, introducing stricter going-concern
funding rules and implementing a counter-cyclical PfAD.

April 2020 N.S. implements a PfAD as part of its funding reforms.

“A lot of alternatives would typically have at least observably less volatility than listed equities. If you’re investing in a building or real estate or infrastructure — toll roads or hospitals — then the value of those assets aren’t going to fluctuate as wildly as the stock market . . . [but] they may give you a similar rate of return as equities or a higher rate of return than equities.”

Read: Ontario’s new DB funding rules should base PfAD on plan’s asset mix: ACPM

Ontario’s PfAD calculation also takes into consideration whether a DB plan is opened or closed and the return assumptions of the actuary, with more aggressive assumptions requiring a higher provision. “The issue is, it’s still based upon current interest rates to an extent and as interest rates go down the PfADs for companies are going up,” says Gillies.

B.C. has taken a different approach, calculating its PfAD by multiplying the long-term bond rate by five.

“B.C. is actually counter-cyclical, so it’s a little bit better in that, if the interest rates are higher, plan liabilities are then at a lower amount but the PfADs are higher,” says Gillies. “In that scenario, it makes sense, because if the plan is well-funded because interest rates are higher, the company should be in a position to put more money into the plan for a rainy day fund. Now conversely, if the interest rates are low, liabilities are higher and the PfAD is lower, because they realize that maybe a plan sponsor isn’t in the position [to put in more money].”

Meanwhile, N.S. has implemented a PfAD calculation of a flat five per cent combined with a percentage based on the pension plan’s combined target asset allocation for non-fixed income assets.

Read: PIAC calling for changes to PfAD calculation, solvency reserve accounts in N.S.

In a July letter, the Pension Investment Association of Canada called for tweaks to the calculation, arguing the regulations don’t seem to give credit where a plan has a better alignment of its fixed income portfolio duration with liability duration, but do give credit to asset classes “not particularly well-aligned with liability characteristics,” such as venture capital and resource investments.

The letter also suggested the Canadian Association of Pension Supervisory Authorities review the variety of provincial approaches and recommend a more standardized measure, given the widespread adoption of PfADs in other provinces.

In 2019, the CAPSA published recommendations related to pension funding, which provided options for policy-makers and governments to take into account in order to promote new, consistent rules, including the inclusion of a PfAD.

“Governments across Canada have taken different approaches to PfAD requirements when developing their legislative provisions,” wrote the CAPSA in a statement to Benefits Canada. “CAPSA will soon begin discussing issues and initiatives for its 2022-2025 strategic plan. As part of that planning, CAPSA will review existing publications to determine if any updates are warranted. It is possible that CAPSA could consider undertaking a project to refine the recommendations for PfADs as presented in the [2019] recommendations.”

Kelsey Rolfe is a former associate editor at Benefits Canada.