In recent years, Canada’s largest companies have struggled with the inherent ups and downs of managing risk in their defined benefit pension plans. Two employer-sponsored pensions in particular — despite experiencing similar types of labour strife, government intervention and plan redesign — have so far embarked on very different investment strategies to suit their businesses and have seen diverging results.
On one side, Air Canada weathered the turbulence of the financial crisis, entered restructuring due to its pension deficit and has now landed with a decent surplus. Canada Post, meanwhile, took a different route, but faced with a growing pension deficit alongside a complete overhaul of its organization, it appears to now be taking some of Air Canada’s investment lessons to heart.
There are a number of similarities in some of the circumstances the two companies have faced around their pension plans, including a wave of labour difficulties a few years ago sparked in part over attempts to change the plan design. So how have their journeys differed and what lessons do they offer for pension plan sustainability?
Air Canada’s flight towards pension solvency
In 2003, Air Canada filed for bankruptcy protection under the Companies’ Creditors Arrangement Act, a move that effectively allowed the company to cease making contributions to fund its pension plans. Citing negative stock market returns and declining interest rates, it revealed a solvency deficit of $1.3 billion.
The airline’s solution was to close its defined benefit pension plan to new hires, but the unions fought back and won. Nearly a decade and a financial crisis later and facing a nearly $4-billion pension solvency deficit, the company returned to the unions with a proposal to address the shortfall. Its solution, once again, was to close the plan to new hires and open a defined contribution pension plan.
“That was June 2010, but when we went into bargaining in 2011, the shortfall was down to $2.1 billion and then it went to $2.7 billion in the summer,” says Jo-Ann Hannah, director of pensions and benefits at Unifor, a union that represents nearly 4,000 of the company’s employees. “Air Canada said it could live with a shortfall of $1 billion. We came up with a proposal that would reduce the liabilities for active members by 25 per cent and get Air Canada to its solvency shortfall of $1 billion if the company would be able to get the other unions on board to make the same changes.”
The union’s counter proposal included a change to retirement dates — from age 55 and 80 points (age plus service) to age 55 and 85 points — which Hannah says represented significant savings to the company. But the airline and its unions were unable to come to an agreement on the pension plan’s design.
Following a strike that was quickly quashed by the federal labour minister, negotiations went into final offer arbitration. Air Canada’s proposal for a defined contribution pension plan went up against the unions’ offer, a design they called “DB light.”
Still, neither side would budge. Eventually, they compromised with a hybrid plan. Effective July 27, 2011, the airline offered new hires a pension with both a defined benefit and a defined contribution component.
A representative from Air Canada says all of its workers used to participate in defined benefit plans, but new employees now join either a hybrid, defined contribution or multi-employer pension plan.
In the following years, the changes began to show in the plan’s shrinking deficit. By May 2015, it had improved its solvency position by more than $5 billion, reporting a $1.2-billion surplus. Preliminary estimates for this year project the aggregate solvency surplus in Air Canada’s domestic registered pension plans will be $1.3 billion. The airline says its final valuations will be complete in the first half of 2016.
But the plan redesign wasn’t the only contributing factor. According to a statement from Air Canada, the improvement was also a reflection of a new investment strategy, introduced in 2009, that created more than $3.5 billion in value.
Matching assets to liabilities
The new investment policy and risk-mitigation strategy included a move to immunize 75 per cent of pension liabilities with duration-matched fixed-income products. Through a strategy commonly known as matching assets to liabilities, the change significantly reduced the interest rate risk associated with the pension plan.
“If you’re going to make $100 million in benefit payments next year, you invest your assets so the cash that comes out is $100 million,” says Tom Levy, senior vice-president and chief actuary at the Segal Group Inc.
“That takes the reinvestment risk out altogether because you’re getting the cash just when you need to spend it. The process for the present values of the benefits and the present value of the cash flow from your fixed-income investments go up and down with the discount rate changing by the same amount. They move together. As interest rates go up, your assets go down and your liabilities go down and they do so by about the same amount.”
In January 2014, when Air Canada reported the elimination of its pension plan’s $3.7-billion deficit, it credited a 13.8-per-cent return on investment in 2013, the implementation of its plan design changes, $225 million in contributions made by the company and the application of an estimated prescribed discount rate of 3.9 per cent to calculate its future pension obligations.
The new discount rate, used from Jan. 1, 2014, was nearly a full percentage point higher than the three per cent used for its 2013 valuation. The airline said: “Every 10 basis points change in the discount rate would result in approximately a $150 million change to the solvency liabilities.”
That same year, the company also elected to opt out of the Air Canada pension plan funding regulations, with the change taking effect in 2015. Under the regulations, the airline had to make average solvency-deficit payments of $200 million each year over a seven-year period. However, the company said it believed it had largely eliminated the funding risk associated with the solvency of its pension plans.
Though it was part of a much wider approach, it’s clear Air Canada’s new investment strategy worked in its favour. But was it simply a matter of good timing?
“From what I can tell, Air Canada was saying it wasn’t going to try to time the market,” says Levy.
“It had all this matching done, so when interest rates went down, the assets went up. That could have been just, ‘We’re going to follow the bottom line, no volatility strategy.’ Or it could have been, ‘We think interest rates are going to go down,’ or it could be blind luck. But the net result was it was invested in a way where the net assets would go up if interest rates went down, and interest rates went down. It sure did help them.”
Unifor’s Hannah says a number of people warned the company that the new investment strategy was a dangerous one. “But [in January 2014], it had good investment returns, the discount rate improved, which reduced its liabilities, the benefit reduction certainly played an important part and Air Canada did make solvency contributions to the plan. I think all four of those things contributed.”
But will its investment strategy continue to be beneficial moving forward? “With the economy as it is, it’s still a good way to go because you are not taking excessive risk on your plan assets and you are offsetting the changes in your liabilities because bonds will move roughly in the same direction where the liabilities for the plan benefits will move,” says Dimitry Khmelnitsky, an investment analyst at Veritas Investment Research.
How Canada Post’s plan took a turn for the worse
As Air Canada’s pension plan took off, Canada Post’s pension plan has taken a different journey. The company established the plan on Oct. 1, 2000, when it assumed responsibility for it after separating from the public service plan.
But rather than carrying over all of the previous plan’s pension liabilities, it only took on about 55,000 active members who were still working for the company on Sept. 30, 2000. That makes it a fairly young plan and something that justifies a fairly risky and illiquid investment program, says pension consultant Bob Baldwin.
The funds accrued by these active employees were transferred from the government to Canada Post in a phased approach. “These funds will be invested according to the long-term asset-mix policy,” the company wrote in its first pension report published in May of that year.
While the postal service didn’t carry over all of the plan’s liabilities, it likely inherited whatever commitment the previous plan had in place to index pensions, says pension consultant Malcolm Hamilton. “Since most federal employee pension plans are fully indexed, I suspect the Canada Post plan is as well,” he adds.
“If your pensions are . . . indexed, you need to hedge your exposure to real interest rates. The only instruments we have in Canada that are well suited to this task are the government of Canada’s real-return bonds, which are horribly expensive at this time. The bottom line: It may not be feasible to hedge indexed pensions like unindexed pensions.”
Canada Post declined an interview request, so the information on what happened to the plan largely comes from annual public reports on its status with specific dates and figures confirmed by the company’s media relations department. By 2004, the plan had a total of 70,519 active and retired members as well as deferred pensioners and beneficiaries, according to its annual report. It also had a 10:1 ratio of active employees versus pensioners and noted that most plans of comparable size in Canada had been in existence for much longer and had ratios closer to 1:1.
The report also said the pension had a solvency deficit of $184 million using the asset-smoothing method and $509 million using the fair value of plan assets as of Dec. 31, 2003. Canada Post had contributed $129 million to the plan above and beyond its usual contribution of $281 million. “These additional contributions are in line with what other large pension plans are doing to offset short-term solvency deficits caused due to interest rates holding at historically low levels,” said a notice to members.
The report noted the company would be conducting a review of its investment structure relative to its pension liabilities and noted “the decline in certain benchmark interest rates witnessed in 2004 will mean that, although the [plan] is well funded on a longer term ‘going-concern’ basis, current accounting rules indicate that the plan continues to be under-funded on a ‘wind-up’ basis. A strategy to cure this under-funding will be implemented.”
The plan delivered a similar message in 2008, with a pension update to members once again citing declining real interest rates and flat financial market returns as reasons for the increase in the plan’s liabilities on a net present value basis. Indeed, in the wake of the upheaval in the financial markets, the company’s 2009 annual report showed a solvency deficit of approximately $3.4 billion on the basis of the fair value of plan assets.
“Because the plan had ended 2009 in a solvency deficit position, Canada Post began making special solvency payments in 2010 in accordance with federal pension legislation,” wrote Deepak Chopra, the company’s president and chief executive officer, in that year’s annual report. “Canada Post made a special solvency payment of $425 million to the plan in 2010, in addition to its $321 million regular contribution.”
The report also pointed to changes in the actuarial assumptions, through which the going-concern discount rate dropped to 5.8 per cent in 2010 from 6.2 per cent in 2009, that caused increases in the cost of providing pension benefits.
Effective Jan. 1, 2010, the company closed its defined benefit pension plan to non-unionized employees and added a defined contribution component. All defined benefit pension plan members on Dec. 31, 2009, remained in the plan. According to Canada Post, negotiations led to the introduction of a defined contribution component for new unionized employees represented by the Public Service Alliance of Canada as of June 1, 2014, and the Association of Postal Officials of Canada as of March 1, 2015. But it dropped a proposal to introduce a defined contribution plan for new employees who were members of the Canadian Union of Postal Workers amid a 2011 labour dispute.
Canada Post takes action
The change was a tourniquet but it didn’t stop the bleeding. By Dec. 31, 2012, the plan’s solvency deficit had increased to $6.5 billion. In 2013, in an attempt to realign postal services with changes in the business environment, Canada Post published a five-point action plan that included “addressing the cost of labour.”
The company increased the age at which new employees would qualify for an unreduced pension to age 64 (or 60 with 30 years of service) from age 60 (or 55 with 30 years of service) following negotiations with the Canadian Union of Postal Workers. The change was applicable to new employees represented by the union who joined the plan on or after Dec. 12, 2012.
The company also increased employee pension contributions as it moved to a 50/50 cost-sharing approach effective Jan. 1, 2013.
In February 2014, the federal government introduced the Canada Post Corp. pension plan funding regulations. They provided Canada Post with temporary relief from making special payments, including solvency payments, from 2014-17. The company is expected to resume special payments in 2018.
In its October 2014 pension newsletter to members, the Union of Postal Communications Employees said the “pension crisis” was in large part due to the decision by the senior leadership to take the temporary relief.
“That money was never transferred to the fund, which resulted in a missed opportunity to invest with better rates of return,” it said.
“These solvency payments would have been re-invested which would have resulted in a healthier fund.”
At its latest actuarial valuation in 2015, Canada Post reported a $6.9-billion solvency deficit, based on the market value of assets. Douglas Greaves, the company’s vice-president, pension fund, and chief investment officer, said that the fund’s investment strategy was helping to “cushion the plan from capital market volatility.”
The plan had added to its alternative assets through investment in real estate, private equity and infrastructure. “Private equity investments increased significantly in 2014 due to market gains and additional funding,” said Greaves in a report. “Private equity and infrastructure assets were two of the best performing asset classes for the plan in 2014.”
Canada Post completed an asset-liability study in 2015 and updated the statement of investment policies and procedures for the defined benefit component of the plan in November 2015.
According to the statement, the company is turning to a liability-driven strategy in which the plan’s asset mix better matches its liabilities with the interest rate risk reduced over time.
“In addition, the plan’s funded status volatility will decline,” said the document.
“The first step entails an increase in bond holdings and the extension of bond duration. This will lead to a better match of the assets to the liabilities. Furthermore, alternative investments will increase gradually depending on investment opportunities.”
An asset-liability study is a common move by an organization of this size, says Andrew Kitchen, managing director and senior client portfolio manager for SEI Investments Co.’s institutional group.
“[An asset-liability] study demonstrates the risk and reward of whether [an organization] meets its objectives. Whether one appears right or wrong is not the question to worry about, more that they have to make sure to [align the decision] with their objectives, risk tolerance and organization demands. Even when they do that, it doesn’t always mean it works out perfectly,” he says.
“Ultimately, the true goal for most of these DB promises is that there is no real benefit to leaving risk on any longer than you need to, and that doesn’t mean that all risk needs to be eliminated immediately because there are many sponsors out there that need to produce returns. But the moment they get to a point where they don’t need to leave that risk on, take it away, match more assets with liabilities, and lock it down, get to that safe haven.”
Strategies for defined benefit pension investment
The journeys of these plans are just two examples of the range of options available to employers, including plan redesigns and new investment strategies, particularly in the face of continued market volatility and declining bond yields.
In the third quarter of 2015, according to a survey by Aon Hewitt, the health of Canadian pension plans declined sharply, with the median solvency ratio at 87.6 per cent on Sept. 24. That represented a 5.4-percentage-point decrease from the previous quarter.
While the markets aren’t co-operating, at least the mindsets of plan sponsors are looking up, and not just at Air Canada and Canada Post. Another survey by Aon Hewitt at the end of 2015 found that 93 per cent of defined benefit pension plan sponsors polled now have a long-term objective to their approach to risk in an effort to better cope with volatility. That compares to 50 per cent in 2009.
With Air Canada’s actions over the last few years and Canada Post now looking to take similar steps, it would appear the airline and postal service are two such plans revising their approach to risk.
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Jennifer Paterson is managing editor of Benefits Canada: firstname.lastname@example.org.