© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the March 2005 edition of BENEFITS CANADA magazine.
What is the next step for pension plan sponsors and regulators, now that they have to contend with potential design changes in the wake of the Monsanto decision on surplus distribution?

Many of the questions and concerns voiced in the aftermath of the Supreme Court of Canada’s decision in Monsanto have related to the impact on previously-declared partial pension plan wind-ups. However, once the dust settles in this arena, plan sponsors must consider the decision’s impact going forward, particularly in relation to pension plan design. Through attention to design, pension plans can be developed that address the issues of surplus accumulation and risk and reward sharing. One place to look: the Régie des Rentes du Québec(Régie), which has introduced new plan designs that may be of assistance to plan sponsors.

The growing importance of plan design in today’s pension environment was highlighted in the November 2004 report by Watson Wyatt Worldwide and the Conference Board of Canada: Is There a Pension Crisis? The Perspectives, Reactions and Strategies of Canadian CFOs. While the majority of respondents considered the current pension crisis(i.e., liability and asset issues, from both a present cost and a future cost-volatility perspective) to be cyclical, the report has led them to examine their pension plan strategies and design options. Many of the CFOs surveyed also believe regulatory change is necessary to allow plan sponsors to contribute more than the current legislative maximums and address the risk-reward asymmetry between defined benefit(DB) plan sponsors and members.

Pension plan design is an important consideration for plan sponsors who wish to minimize the possibility that surplus ownership conflicts will exist on a full or partial wind-up. A fully-funded pension plan that offers benefits calculated on a final-average-earnings basis, automatic indexing, or early retirement subsidies such as bridging benefits is much more likely to develop a surplus (or deficit)than one that does not. Going-concern funding assumptions must make provisions for early retirement subsidies, future salary increases, and the cost of providing indexing of increased future benefits. But on full or partial wind-up, a surplus will often develop because the projected cost of some benefits no longer has to be taken into account for terminating members. However, plans without these guaranteed benefits could offer them on an ad hoc basis to use up any surplus that does emerge.

Some pension plan designs are less likely to have surplus when there is a full or partial wind-up, even if the long-term cost of the plan and the value of benefits accruing to employees each year are similar to designs that are more likely to develop a significant surplus on full or partial wind-up. There are, however, examples of plan design features that can offer a lower likelihood or magnitude of potential surplus. While they all exist as designs within the pension world, the first two are the most common.

They include: a career-average-earnings benefit formula with ad hoc upgrades; a flat-benefit formula with negotiated or ad hoc benefit increases; hybrid benefits based on the greater of a defined contribution(DC)and a DB accrual; employer contributions capped to a fixed percentage of pay; and providing minimum DB accrual, and sharing investment gains with employees through enhancements that are granted only once the gain has materialized. Other options include a fixed-cost plan with a variable-benefit formula providing past service upgrades when fund performance is good and reducing the current service accrual if fund performance is poor; a basic DB formula fully funded by the employer, with ancillary benefits purchased at the employee’s option (a “flexible pension plan”); a contributory plan that varies both employer and employee contributions according to the funded status of the plan(“shared-cost plan”); and finally, ad hoc as opposed to automatic indexing.

Despite the plan design changes that can be made to help deal with the after-effects of Monsanto, the ability of them to safeguard a plan sponsor from surplus and payouts in a partial wind-up will depend on the particulars of each plan’s design.

All retirement income plan designs allocate risks and rewards in some manner. Risk falls on shareholders and bondholders, current and future employees and their heirs, pensioners, and governments(due to the loss of tax revenue from various sources if retirement income plans under-perform).

DC plans are at one end of the risk/reward continuum, as the plan sponsor bears no funding risk once contributions have been made to the plan. Monsanto can be relevant to DC plans, particularly those that were converted from DB to DC(see December 2004 issue of BENEFITS CANADA).

At the other end of the risk/reward continuum are noncontributory single-employer DB plans. The plan sponsor must contribute all amounts required to fund promised benefits, irrespective of fund performance. Although contribution holidays may be taken if the plan has a surplus, the sponsor’s upside is limited because surplus funds usually cannot be withdrawn. On the other hand, there is no opportunity to share downside risk with retirees, and the opportunity to share downside risk with current and future employees through benefit reductions may be limited by competitive pressures. In addition, the Monsanto requirement to distribute surplus on partial wind-up increases the overall risks and costs of funding the plan, because it reduces the sponsor’s ability—and motivation—to carry surplus in the plan that could offset losses in years when the fund experiences poor investment returns.

Some plan designs fall midway on the risk/reward continuum between non-contributory DB plans and DC plans, a good example being shared-cost public sector plans. In a shared-cost plan, both employer and employee contributions increase when the plan has a deficiency. Contributions decrease when the plan’s funded status improves. If the plan has a surplus, both the employer and employees may take contribution holidays. Alternatively, a surplus can be applied to provide benefit increases.

In a public sector shared-cost plan, responsibility for plan governance is generally also shared. Although shared governance reduces the employer’s control over the plan, it can have important spin-off benefits. Members of such plans tend to have a greater understanding of their pension plan because they pay more attention to plan provisions and have a larger interest in ensuring it is properly funded and managed. Plan members also have more realistic expectations regarding what benefits the plan can provide.

Private sector employers can also sponsor shared-cost plans, which may or may not involve governance sharing. Such plans can allow an equitable allocation of funding risks and rewards between the sponsor and members by means of a surplus-sharing agreement in which members are explicitly entitled to a pro rata share of surplus based on their liability for plan funding. In addition, both member and sponsor contributions can vary with the funded status of the plan, subject to the general requirement of pension standards legislation that the employer fund at least 50% of the value of the member’s pension benefits.

While a formula to share funding obligations and entitlement to surplus will not reduce the likelihood of a partial wind-up occurring, it can somewhat reduce the possibility that a surplus will develop which must be distributed on partial wind-up. It can also minimize the likelihood of disputes over the use of such surplus because there will be a pre-determined formula for sharing it. As long as surplus entitlement and funding risks are allocated in a manner that appears equitable and consistent with regulatory requirements, courts are unlikely to interfere with such arrangements. If benefit and contribution changes are regarded as the outcome of risksharing, they may not be perceived as a change in total compensation, as compared to how they would be perceived in a traditional DB plan.

For sponsors, the benefits of cost sharing are clear. Exposure to pension fund investment risks is reduced accordingly, and there is a clear entitlement to at least part of a surplus. As compared to a DC pension plan, a shared-cost plan can be substantially better for members because the amount of pension benefits payable at retirement, although potentially subject to some volatility if upgrades depend on investment performance, will be much more predictable, in view of pooling of investment volatility risk.

Finally, the risk-sharing offered by a shared-cost DB plan can actually be leveraged to reduce both the sponsor’s and members’ costs of funding pension benefits over time, as compared to a traditional DB plan or a DC plan. The existence of the agreement creates an environment where the administrator may be more willing to hold investments that are likely to provide a higher long-term rate of return, even though they may have a greater degree of short-term volatility.

In a non-contributory DB plan, in which the sponsor bears all the funding risk, a sponsor that is averse to cost volatility may be more likely to adopt a more conservative investment mix that offers a lower long-term rate of return. Similarly, in a DC plan, older members, in particular, may hesitate to hold volatile, high-yielding investments that may provide a higher rate of return—and ultimately increased benefits—because of the individual risk of loss of value over a short time horizon.

Pension regulators have a role to play in reducing the uncertainties of pension funding. They can do this by allowing new plan designs to be registered which allow for funding risk and surplus entitlement to be clearly and explicitly allocated between the employer and employees at the inception of the plan.

For example, due to concerns about an aging population and declining private-sector pension plan coverage, the Régie has introduced proposals for new plan designs to make it easier and less costly for employers to establish pension plans.

On Oct. 6, 2004, it released a draft regulation that would allow employers and employees to jointly agree to register a “member-funded” DB pension plan in which employer contributions would be fixed, either as a particular amount per member or as percentage of salary. Active plan members would be required to make all additional contributions required to fully fund the plan and would have full entitlement to any plan surplus. As a consequence, costly disputes are unlikely to arise between the employer and employees about pension plan surpluses.

The proposed new member-funded plan could not have a final average earnings benefit formula. Member-funded plans would not have to comply with several provisions of provincial pension legislation, including the 50% rule.

The policy goal of the proposed regulation is to make a new pension plan option available in order to promote increased pension coverage of private sector employees and reduce eventual dependence by retirees on public benefits. While Quebec’s proposed member-funded pension plans will not fit the needs of all employers, the new regulation demonstrates that pension regulators can develop practical solutions to the problems of pension funding and, as a result, increase the affordability and availability of private-sector pension plan coverage.

Even though the Canadian Association of Pension Supervisory Authorities(CAPSA)has proposed a model pension law for Canada, it contains no innovative design options that address the problems posed by Monsanto, and it is doubtful the model law will be enacted. Nevertheless, Quebec has its member-funded plan, and CAPSA may want to seek creative solutions from that province’s legislation.

In the meantime, plan sponsors and members will need to address their next step in dealing with the Monsanto case. An examination of design options, including those intended to control surplus accumulation and more equitably share risk and rewards between sponsors and members, as well as Quebec’s member-funded plan, should form an important part of any discussion on the future of pension plans in a post-Monsanto world.

Karen DeBortoli is a lawyer with Watson Wyatt Worldwide’s Canadian Research and Information Centre in Toronto. karen.debortoli@watsonwyatt.com

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