© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the August 2005 edition of BENEFITS CANADA magazine.
The Law: Give them credit
Using letters of credit to provide solvency relief for plan sponsors of defined benefit plans is an idea whose time has come.
By Paul Litner

THE FUNDING CRISIS FACING DEFINED BENEFIT(DB)PENSION plans has been well documented. And one of the key factors fueling this crisis are the current solvency rules. For that reason, any tool that can help manage volatility in contributions without sacrificing benefit ecurity—-such as a letter of credit(LC)—is welcome.

Plan funding is measured on two bases: going concern and solvency. Going concern is a long-term measure intended to fairly balance the competing objectives of price predictability and benefit security. The solvency measure, on the other hand, is more short-term in nature, and is intended to ensure that benefits can be paid in the event of plan termination and plan sponsor insolvency.

The solvency measure has proven to be quite volatile. For instance, our current environment of low interest rates has resulted in a significant increase in contributions for many DB plan sponsors.

Increased contributions, which are not ultimately required to pay for benefits, are problematic. When long-term interest rates rise or equity markets once again perform favourably over a sustained period, the result is that large solvency contributions today quickly turn into “runaway” surpluses tomorrow. And given the uncertain legal environment over the use of surplus, there is a large disincentive for plan sponsors to overfund DB plans.

For a fee, a bank will issue a LC as part of a plan sponsor’s credit facility. The holder of the LC is entitled to call on it at any time and receive payment from the bank in an amount up to the “face amount” of the LC. In concept, LCs can be used for DB plan funding as a backstop or guarantee of the sponsor’s solvency contributions to a plan, substituting the bank’s credit for that of the sponsor’s.

There are several variations on how this concept could work. One method employed in the Air Canada insolvency case, for example, is the following: the sponsor is granted an extended period over which to make solvency contributions(e.g. from five to 15 years)provided that an LC is purchased from a bank to cover the amount of the solvency deficit, or the foregone solvency payments.

Another possibility is to allow sponsors to arrange for an LC to be held by the trustee and to be called upon in the event of sponsor deafult, in lieu of all or some solvency payments. The LC would be counted as a plan asset only for solvency valuation purposes.

LCs have been used for some time to help to provide benefit security in supplemental pension plans(through the use of a retirement compensation arrangement trust), but not for registered pension plans. If this is such a good concept, why hasn’t this been done before? The short answer is that current pension standards legislation and regulations arguably do not permit plans to use LCs in this manner. An ongoing case illustrates the legal difficulties with the LC. In Butler Brothers Supplies Ltd. v. British Columbia(Financial Institutions Commission), the Superintendent objected to the employer’s use of an LC as a plan asset in determining its solvency contributions. While the lower court was sympathetic to the sponsor, it ultimately agreed with the Superintendent that the pension legislation did not support the LC as a plan asset. The court of appeal upheld this ruling but did not share the lower court’s empathy for the LC funding concepts.

If LCs are not currently permitted under pension legislation, then governments need to take steps to ensure they can be used as a tool in managing solvency deficits. Quebec has already taken steps in this regard. In Bill 102, which passed into law on June 17, 2005, the use of LCs is contemplated as one way of qualifying for solvency relief.

The use of LCs as a tool in managing solvency funding is not a panacea for all of the problems facing DB pension plans. But it is clearly a step in the right direction.

Paul Litner is a partner in the pension and benefits department at Osler, Hoskin & Harcourt LLP in Toronto. plitner@osler.com