Most Canadian DB pension plans have significant solvency deficits. Unless we experience a turnaround in financial market conditions over the next few years (i.e., equities perform well and/or long-term interest rates rise significantly), many DB plan sponsors will need to make large contributions—and for several years—to fund these solvency deficits.
One of the risks faced by plan sponsors with significant solvency deficits is that the contributions they make to fund today’s deficits can quickly turn into surplus in the future if market conditions improve. While at least some of a plan’s surplus can usually be used to take employer contribution holidays, it can be difficult to refund surplus to the plan sponsor without sharing some of it with plan members. Therefore, plan sponsors face the prospect that large and painful solvency contributions required during the next few years could become “trapped” surplus in future years.
Due to these concerns, many plan sponsors limit their pension contributions to the minimums required under pension legislation. The trouble with a funding policy that minimizes contributions is that it can cause considerable volatility in the sponsor’s minimum contribution requirements and also reduces the security of members’ pensions.
As discussed in a previous blog, a letter of credit is a tool that can be used to reduce the risk of developing trapped surplus. However, a letter of credit may not be available or appropriate in every circumstance, so it’s important that other tools are available to manage this risk.
Reducing the risk
One approach for alleviating the risk of developing trapped surplus is the establishment of a solvency reserve account (SRA). SRAs were recommended in 2008 by the Alberta and British Columbia Joint Expert Panel on Pension Standards. This year, B.C. amended its legislation to permit the use of SRAs, although the amendment will not come into force until detailed regulations have been issued.
The following diagram illustrates how a SRA fits into the funding regime of a DB pension plan.
Similar to the regular pension fund, an SRA is tax-sheltered, held separately from the plan sponsor’s assets, and protected from non-pension creditors.
The going concern valuations of the pension plan would not reflect the establishment of the SRA and contributions resulting from the going concern valuations would be made to the regular pension fund. Any surplus that develops in the regular pension fund would be subject to rules similar to those currently contained in minimum pension standards legislation (e.g., surplus could typically be used to reduce normal actuarial cost contributions in future years).
However, for the solvency valuations of the pension plan, both assets in the regular pension fund and assets in the SRA are recognized. Contributions required to fund solvency deficits and any discretionary contributions above the required minimums would be contributed to the SRA instead of the regular pension fund. If the plan develops a surplus on a solvency basis, the sponsor can withdraw the surplus, possibly reduced by a buffer for conservatism, from the SRA without the need to share the withdrawal with plan members.
If the plan is wound up, the regular fund would be used first to settle the pension benefits accrued under the plan. If assets in the regular fund are not sufficient, the SRA would also become available to settle members’ pensions. If all of the members’ pensions are settled and assets remain in the SRA, the remaining assets would be refunded to the plan sponsor.
Benefits of SRAs
- The use and ownership of pension surplus have been controversial issues in Canada. A funding regime that includes SRAs provides the flexibility to establish rules that maintain an appropriate balance between the surplus ownership rights of plans sponsors and plan members for the assets contained in the regular pension fund (i.e., the assets which have been set aside to ensure the long-term viability of the plan).
- In contrast to contributions required due to a going concern valuation, contributions to fund a solvency deficit are not intended to ensure the long-term viability of the pension plan. The purpose of solvency funding is to protect plan members’ pensions against the short-term risk of a plan wind up at the same time that the plan sponsor is bankrupt and therefore unable to fund a wind up deficit. This means that the large solvency contributions being made today are providing plan members with protection for an event that in most cases is highly unlikely to occur. Given the purpose of solvency funding, it only makes sense that if solvency contributions made to a plan are no longer required due to the development of a solvency surplus, the sponsor should be able to withdraw the excess payments. SRAs provide a mechanism for facilitating such withdrawals.
- Since the risk of trapped surplus would become less of a concern, plan sponsors would be more willing to make discretionary contributions above the required minimums during times when they have the available cash. By making such contributions, and thus creating a buffer during good times, a sponsor would be able to reduce the volatility of contributions during bad times. Discretionary contributions would also provide additional protection to plan members.
SRAs provide an innovative approach for mitigating the risk of a trapped surplus , while continuing to provide protection to plan members. British Columbia understands the importance of addressing this risk and is turning the concept of SRAs into a reality. Other jurisdictions would do well to consider following British Columbia’s lead.