Relieve It or Not

With many defined benefit pension plans facing a funding crisis, how do we address the problem of solvency?

For the second time this decade, pension funding rules are broken. What was seen as a temporary problem in the perfect storm during the early part of the decade has now recurred with a vengeance. This time, the crisis is not simply a crisis of pension funding; it is a general economic crisis, characterized by a shrinking economy, job losses, falling profits, declining cash flows and a rising threat of widespread insolvencies. What, then, is the best approach to the funding problem?

Meeting Diverse Goals

Pension funding involves a balance between two objectives. First is retirement income security. If a pension is promised, it should be paid. Failure to provide a retirement income has serious implications for individuals and their families.

Second, a pension has to be affordable. There is little point to a plan if it means that the sponsoring enterprise will not be economically viable.

Any solution to the funding crisis needs to navigate between these two objectives and the twin failures they seek to avoid. In this highly politicized pension environment, any solution that addresses benefit security without considering affordability—or affordability without income security—is doomed to fail.

However, balancing these objectives in a general economic crisis poses extraordinary challenges. The underlying defined benefit (DB) funding model presumes that a reasonably steady contribution rate will result in sufficient wealth to make good on a plan’s retirement income commitments. But the current crisis has put asset returns into sharp reverse, triggering enormous losses. In the normal course, the DB funding model requires that plan sponsors make up these losses—losses that were triggered by high-equity, high-risk investment policies that led to the risks that are materializing today. However, the general economic crisis will make this difficult, if not impossible, for many firms.

Tackling the Problem

Two approaches have emerged to address the issue. The first implicitly assumes that the underlying funding model remains the right one, and that all we need is time and flexibility to overcome current circumstances. If we believe this, then we look at extensions of amortization periods and increased flexibility with regard to items such as smoothing and valuation dates. Then, we hope that the economy improves to the point where the traditional balance between affordability and benefit security can be restored.

If we focus on overcoming the short-term circumstances, then we must remember that pension funding is not supposed to be a “balancing item” in a firm’s financial situation. Pensioners are not risk-taking investors; they are recipients of a deferred wage for work done. A firm’s investors and creditors are supposed to be the risk-bearing parties, and any pension funding relief needs to be considered within the firm’s broader economic context.

Furthermore, in dealing with the short-term paradigm, it is important that the scale and duration of pension funding relief correspond to the depth of the firm’s financial problems. Affordability objectives aren’t met if relief is insufficient, and relief that is too great or lasts too long undermines retirement income security goals.

The alternative view is that the economic crisis is too severe and the DB funding model is no longer viable. If we believe that fundamental change is required, then we need to look outside the box. If we want to preserve secure private sector DB pensions but cannot afford to fund them, then we need to look at pension insurance or government-provided letters of credit. Properly insuring pension funding risks should be less expensive for the system as a whole than funding each plan against the worst contingencies.

If, on the other hand, the private pension system has simply become too burdensome or too volatile, then we need to look at new ways to provide retirement income, whether through an improved Canada Pension Plan, a provincially sponsored plan or some similar vehicle.

Ultimately, too much erosion of pension funding standards on too many occasions will amount to an admission that the private system cannot carry the retirement income load and will set the stage for more extensive reform.

Murray Gold is a partner with Koskie Minsky LLP in Toronto.

mgold@kmlaw.ca

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