The 5 key components of a DB pension funding regime

The interest in pension funding rules is as great as ever, with changes taking effect in Quebec in 2016 and a review of funding rules in Ontario currently underway. For plan sponsors, members and other interested parties that would like to have a better understanding of how defined benefit pension funding rules work, it’s useful to consider the following key components.

1. Funding targets

The most important element of a funding regime is the liability (or multiple types of liabilities) that a plan sponsor must target when determining the minimum level of pension contributions. The specific targets, which typically depend on the purposes of the funding regime, are so important because they dictate the short-term volatility of contribution requirements. For example, a solvency liability target can result in considerable contribution volatility. The specific targets are also important because they affect the total amount and timing of contributions that will need to be made over the long term.

Read: Eliminating solvency funding on the table as Ontario reviews DB rules

Read: A look at Quebec’s solvency changes one year on

Traditionally, funding rules have targeted both the going concern and solvency liabilities of a plan. However, in order to reduce contribution volatility, Quebec brought in legislation that now requires only an enhanced going-concern liability for private sector pension plans. (The enhanced liability is the going-concern liability increased by a stabilization margin that is prescribed by Quebec funding rules.) So the solvency liability of a pension plan is no longer a funding target in the province. As part of its funding review, Ontario is considering the Quebec approach. As an alternative, a combination of the going-concern liability and a portion of the solvency liability (i.e., 80 per cent) is being considered as future funding targets.

2. Assets below targets

There must be rules to address situations where plan assets fall below the funding targets. The reasons assets might fall below a funding target include unfavourable experience (i.e., investment returns on plan assets are below expectations) or an increase in the target liability caused by a change to the valuation assumptions or an improvement made to the plan benefits.

Read: 2016 Top 100 Pension Funds Report: Solvency reform on the agenda

The key issue that needs to be addressed when assets are below target is how quickly the shortfall can be eliminated. Usually, a going-concern shortfall must be funded over 15 years and a solvency shortfall must be funded over five years. If the period for eliminating a shortfall is too short, pension funding can become a financial burden for the plan sponsor. However, if the period is too long, the security of plan members’ pensions may be jeopardized. A related issue is how previously established special payment schedules are treated when there is a new funding shortfall.

3. Assets exceed targets

What options are available to a plan sponsor when the funded position of a plan improves? In this situation, a funding regime must specify how any special payment schedules established in previous valuations to fund prior shortfalls can be reduced or eliminated.

Also, when plan assets exceed the funding targets (i.e., a surplus develops), the following questions arise:

  • When can a surplus be used for purposes of a contribution holiday?
  • Under what conditions can surplus assets be distributed to plan members?
  • Under what conditions can surplus assets be withdrawn by the plan sponsor?

Ideally, when addressing the above questions, there will be a balance between the desire to enable a plan sponsor to benefit from a surplus (i.e., through a contribution holiday or surplus withdrawal) and the desire to protect plan members’ pension benefits. Pension benefits are often protected by requiring a surplus buffer before a contribution holiday or surplus withdrawal is permitted.

Read: A refresher on the purposes of pension plan funding

The rules concerning surplus withdrawals must also address the thorny issue of the relative rights of plan sponsors and plan members to benefit from surplus assets.

4. Permitted funding vehicles

Historically, pension funding has required cash contributions to a fund held by a third party, generally a trustee or an insurance company. However, funding rules are evolving to provide more flexibility with respect to permitted vehicles for securing the obligations of a pension plan.

For instance, in Alberta and British Columbia, plan sponsors can now direct special payments that are made to fund a solvency shortfall into a solvency reserve account. A solvency reserve account provides clear entitlement for a plan sponsor to withdraw a portion of any surplus assets that may emerge in the future.

Read: B.C. takes first step to resolve pension solvency funding challenge

Most Canadian jurisdictions have amended their funding rules in the past several years to permit the use of a letter of credit, in lieu of cash contributions, to secure a portion of a plan’s solvency obligations.

Additional funding vehicles are welcome news to plan sponsors, as they both secure the benefits of plan members and provide additional flexibility to plan sponsors that may be struggling to manage pension risk.

5. Guarantees provided by public programs

A public program can provide a level of insurance to a pension plan’s members in the event of plan sponsor insolvency. Such a program may be an efficient vehicle for pooling the pension risks associated with the insolvency. However, financially secure companies often view the required fees paid to such a program as an additional tax and unnecessary plan expense.

The Pension Benefits Guarantee Fund provides Ontario members of certain defined benefit pension plans with a guaranteed minimum pension in the event of a plan windup when an insolvent plan sponsor is not able to fund a shortfall. However, Ontario is the only jurisdiction in Canada that has implemented this type of program, which highlights the fact that there is no current consensus on the overall benefits of such a program.

Read: Canadian DB pension solvency reaches highest level in two years: survey

A key challenge when establishing or updating a funding regime is to balance the interests of plan members, plan sponsors and other stakeholders. At the same time, it’s important to remember that if one component of a funding regime is changed to achieve certain objectives, other components of the regime will be affected and may need adjustments to ensure that the various components of the regime continue to function well together. In addition, transparency and simplicity of the funding rules should be important considerations when making any revisions.

As Ontario and other jurisdictions review their pension funding regimes now and into the future, it will be interesting to see how Canada’s funding regimes evolve over time.