Should letters of credit be part of your pension funding policy?

Contribution requirements for many DB pension plans are being driven by the plans’ solvency position. The financial crisis of 2008 and early 2009, along with a deterioration in financial market conditions during 2011, left many plans with large solvency deficits.

And unless equities perform better than expected and/or interest rates rise significantly over the next few years, sponsors face the prospect of large pension contributions required to fund these deficits. What’s more, contributions to fund solvency deficits may fluctuate significantly from year to year, causing cash flow strains and planning challenges for plan sponsors.

An additional concern is that large contributions made today to fund solvency deficits can turn into surplus in the future if market conditions improve (i.e., equities perform well and/or long-term interest rates rise significantly). While at least some of a plan’s surplus can usually be used to take employer contribution holidays, in many cases, 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.

Letters of credit
To address such funding challenges, many stakeholders have sought the ability to use a letter of credit (LoC) to secure a portion of a pension plan’s solvency obligations in lieu of making cash contributions. A number of jurisdictions have responded to these requests, and it is now possible to use an LoC to secure a portion (generally limited to 15%) of the solvency liabilities of a plan registered in Alberta, British Columbia, Manitoba or Quebec or under federal jurisdiction. Ontario and Nova Scotia also intend to permit the use of LoCs as part of their pension reforms.

What is a letter of credit?
An LoC is a promise by a financial institution, such as a bank, to pay a specified amount into a pension fund should a predefined “trigger event” occur. Trigger events are events that may jeopardize the security of plan members’ benefits, such as failure to renew the LoC prior to its expiration date (without the plan being fully funded or replacing the LoC with actual contributions to the plan) or failure of the plan sponsor to fund a deficit upon plan windup. In exchange for this promise, the sponsor pays the bank a standby fee for each year that the LoC is in place.

If a trigger event occurs and an LoC is called, the bank becomes a creditor of the plan sponsor in respect of the amount the bank deposited into the pension fund. Therefore, an LoC typically reduces the sponsor’s available line of credit.

How can an LoC help a pension plan sponsor?
There are a number of reasons why a pension plan sponsor may want to use an LoC in lieu of making solvency contributions to the plan:

  • an LoC can be used to help with cash flow management (i.e., by reducing required contributions to the pension plan when cash may be in short supply);
  • an LoC may be attractive to a plan sponsor that believes that a greater net rate of return can be achieved by investing cash in the sponsor’s business versus contributing the cash to the pension fund; and
  • since an LoC reduces the amount of required solvency deficit contributions, it can significantly reduce the risk of developing trapped surplus in the event that equity markets take off and/or long-term interest rates rise in the future.

Considerations when deciding whether to establish an LoC
There are a number of questions a pension plan sponsor should ask when assessing whether an LoC is appropriate for its circumstances.

  • Does the plan sponsor have the credit capacity needed to establish an LoC?
  • How likely is it that the plan could develop trapped surplus in the future?
  • How does the expected return on pension assets compare to the expected return on investment in the business? A sponsor should take into account the cost of the LoC standby fee and the tax implications when conducting this assessment.
  • How much is the LoC standby fee that will be charged by the bank? How does the amount of the standby fee compare to the cost of borrowing cash in order to make actual solvency deficit contributions to the plan? What are the tax implications of establishing an LoC versus borrowing to contribute to the plan?
  • Has the sponsor considered its exit strategy? If the sponsor no longer wishes to secure a portion of the solvency obligations with an LoC, the LoC will need to be replaced with cash contributions to the plan, or the sponsor will need to demonstrate that the plan is sufficiently funded without the LoC.
  • How will use of an LoC affect pension expense and, thereby, affect the plan sponsor’s income statement?
  • A number of plan sponsors are implementing (or considering implementing) a reduction in pension financial risk using a phased (or “journey plan”) approach. Is an LoC appropriate where a journey plan has been established? If an LoC is still considered appropriate, are any changes to the journey plan objectives and implementation approach warranted?

LoCs are welcome additions to the financial risk management tools available to pension plan sponsors. They can be used for cash flow management, to mitigate the risk of developing trapped surplus and to facilitate the deployment of cash to a sponsor’s business, without jeopardizing the security of plan members’ pensions. While LoCs will not be appropriate in all situations, plan sponsors should consider whether an LoC can be used to help manage their pension funding challenges.