Lies, Damn Lies, And Canada’s Private Pensions Funding Crisis
By: Greg Hurst
While most commentators blame factors such as poor equity market returns and low interest rates for the pension funding crisis, Greg Hurst, of Heath Benefits Consulting Inc., has a different take on the causes.
There’s little doubt the funding of Defined Benefit (DB) pension plans in Canada is in a crisis situation. Concerns over DB pension funding were first publicly raised as far back as 1999 when the federal Office of the Superintendent of Financial Institutions (OSFI) issued a warning memorandum in respect of ‘negotiated cost’ (union-sponsored) DB plans.
These concerns grew in succeeding years until by May 2003, OSFI said 60 of the 370 DB plans it supervised were on a ‘watch list’ due to funding concerns. ‘Stress-testing’ revealed 177 of these plans were under-funded. The same month an Association of Canadian Pension Management study estimated the shortfall in private DB pension plan funding was $225 billion.
In June 2004, the Certified General Accountants published an in-depth report showing that 59 per cent of DB plans in Canada were in a deficit position at December 31, 2003. In their November 2005 update, they found that the relative number of plans in deficit at December 31, 2004, had held steady at 59 per cent, but the magnitude of those deficits had increased from $160 billion to $190 billion.
To begin to address the situation, we need a better understanding of how DB pension funding got to where it currently is. Most commentators on this subject blame:
- Poor equity market returns
- Low interest rates
- The Income Tax Act 10 per cent/20 per cent surplus ceiling on contributions
- The legal framework (pension standards legislation, regulators, and the courts)
If I can be forgiven for not mincing words, these are simply ‘rubbish.’ The real cause of the pension crisis is the lack of appropriate and rational behavioural adjustments to these factors. Let us look at each of these factors.
Myth #1 – Poor Equity Market Returns
Poor equity market returns from 2000 to 2002 were the first factor to be blamed when the alarm bells began ringing in 2003. However, regulators were beginning to raise concerns over pension funding in the latter part of the 1990s.
An unpublished study in 1997 of 17 pension plans of a particular industry regulated under the BC Pension Benefits Standards Act concluded that 50 per cent of these plans covering 75 per cent of the members had significant funding risks. That same year, in BC, there were three plans that were required to cut pensions due to funding shortfalls.
Lets look at some facts about equity market returns. In Chart 1, a historical graph of Dow Jones Industrial Average Returns (which may be utilized as a reasonable proxy of Canadian equity market returns which are reflective of the U.S. markets) we see:
- Stock market returns have always been volatile.
- 1982 to1999 was the longest bull market of the past 100+ years, three times longer than the next longest period, 1947 to1956.
- The 2000 to 2002 bear market was of modest magnitude, but relatively lengthy.
- Most interesting is that 20-year compound returns at the end of 2002 were higher than any similar period prior to 1997.
Myth #2 – Low Interest Rates
Chart 2 illustrates that low interest rates, as represented by Canada long bonds, are not a new phenomenon in the history of pensions. Here we find:
- For the 45-year period from 1919 to 1964, Canada long bond rates averaged 4.05 per cent per year.
- For the five-year periods ending December 31, 2004, and October 31, 2005, Canada long bond rates averaged 5.62 per cent per year and 5.31 per cent per year respectively.
This suggests that the current, and apparently stable, low interest environment represents a return to normal interest rate cycles and the current environment cannot be reasonably regarded as a surprise. As well, there cannot be a reasonable expectation for any change to significantly higher rates in the short or medium term.
Myth #3 - Surplus Ceiling On Contributions
The Income Tax Act limits taxdeductible employer contributions to a registered pension plan if surplus assets exceed the greater of
- 10 per cent of actuarial liabilities
- The lesser of:
- two times the actuarial ‘normal cost’
- 20 per cent of actuarial liabilities
Citing these limits as a cause of the pension crisis shows either ignorance of basic actuarial principles or are a purposeful intent to misdirect or obfuscate pension funding issues. Actual limits are a function of actuarial liabilities. ‘Surplus’ could, in most cases, have been ‘spent’ by using more conservative economic assumptions. A one per cent reduction in the discount rate assumption results in a 15 per cent to 20 per cent increase in actuarial liabilities, eliminating the application of the ceiling in most cases.
Myth #4 – The Legal Framework
There is a collection of complaints about the legal framework, including jurists don’t understand pensions (Monsanto).
The Supreme Court of Canada decision in the Monsanto case resulted in a flood of comments on the lack of understanding of the Canadian judiciary on pension issues. Criticisms included:
- “What people have difficulty understanding is that true surplus only materializes once the plan is fully wound up,” – Michael Beswick, former chair, Association of Canadian Pension Management
- “The Court was not persuaded by arguments that employers bear the risk and responsibility for Defined Benefit plans and that surplus distributions, in the context of partial plan terminations, disproportionately favour the interests of employees over those of the employer.” – Mercer Human Resources Consulting
The real story is that in the end, 13 jurists, from three levels of courts, were unanimous in their decisions. In fact, the SCC commented that these arguments were “unpersuasive.”
The question is do plan sponsors unfairly bear all the risks of DB pension funding? A November 2004 Watson Wyatt ‘Special Memorandum’ argued “Even prior to Monsanto, there was already a significant imbalance (asymmetry) between funding risks and rewards for DB plan sponsors. This asymmetry arises from the fact that for most single employer DB plans, the employer is responsible for paying off deficits, but often cannot access plan surpluses that may develop as a result of conservative funding policies that incorporate a safety margin in the amounts contributed to a pension plan.”
The real story is that risk exposures change over time and employer interests represents the ‘weighted side of the fulcrum’ relative to employee interests. In fact, plan sponsors routinely access surplus via contribution holidays and the plan sponsor has full controls over the risk management ‘levers’ of funding and investment policies.
So we then need to determine if pension solvency standards are too onerous for multi-employer industry wide pension plans.
The Canadian Institute of Actuaries (CIA) ‘Report of the Task Force on Multi-employer Pension Plans,’ recognizes that “use of going concern funding only, is not in agreement with CAPSA’s position or with current laws in many jurisdictions. To the extent that regulators believe that stronger funding of MEPPs is required, the task force is prepared to support stronger going concern requirements as preferable to solvency funding. An example might be 10-year amortization of benefit improvements and five-year amortization of actuarial losses on a going concern basis.”
The real story, though, can be found in the OSFI memorandum, which stated “The distinctiveness of these plans does not warrant more lenient funding requirements, in our opinion. Members of NCDB plans should be given the same level of protection as that requested from sponsors of other Defined Benefit plans. In particular, declining memberships and the need to maintain intergenerational equity argues in favour of solvency standards for these plans.”
The one complaint that does have validity is that of non-responsive regulators. These are not off the mark. Unfortunately, they do not reflect an accurate understanding of the role of the regulator, which is to administer legislation. It simply does not provide for a more pro-active role for regulators in formulating pension policy. Regulators are not responsive to the interests of plan sponsors in a manner that would promote growth of pension coverage.
The Real Cause
All of these are mythical as causes of the pension funding crisis in Canada because they don’t explain, or even justify, the behavioural nature at the roots of the real cause. The real, behavioural, causes of Canada’s pension funding crisis are aggressive actuarial assumptions and the behavioural influence of accounting disclosure requirements.
Aggressive Actuarial Assumptions
Chart 3 shows a mapping of actuarial discount rate assumptions, in a ‘traditional comfort zone,’ onto a five-year moving average of Canada long bond rates. The red and green lines represent arbitrary theoretical upper and lower bounds for actuarial discount rates if they were to be determined relative to the five-year moving average bond yield. The ‘comfort zone’ for the period 1978 through 2001 represents the author’s experience in the pension industry, with the slight declines for 2002, 2003, and 2004 based on ‘a priori’ ranges set in the August 2005 Canadian Institute of Actuaries Pension Review Project Report. The report also revealed:
- Discount rates utilized in 52 per cent of reviewed valuations were in excess of the ‘a priori’ ranges established by the review team with 36 per cent in excess between 0.25 per cent and 0.50 per cent per annum and six per cent in excess greater than 0.50 per cent per annum.
- Salary scale/discount rate spreads were in excess of three per cent per annum for 32 of 50 reports.
- 33 per cent of valuations utilized asset values of more than 100 per cent of market value of assets.
Before 1999, it is unlikely that actuarial discount rate assumptions ever exceeded long bond yields. To the extent that actuarial assumptions exceed long bond yields, they implicitly anticipate additional pension funding from the higher yields from equities. Such a requirement represents a mismatch between the nature of the liabilities (which is ultimately fixed and, therefore, bond-like) and funding requirements. This adds very significant levels of risk to pension funding outcomes.
Behavioural Influence Of Accounting Disclosure Requirements
The pension accounting requirements of the Canadian Institute of Chartered Accountants have been in effect since 1987. From that time and through 1999, pension funds delivered ‘profit’ to corporate financials as surpluses measured in accordance with accounting principles grew in value. Consequently, a view developed that DB pension plans provided added benefit to companies as ‘cash flow management tools,’ with benefits primarily realized via ‘contribution holidays.’
However, viewing DB pension plans as cash flow management tools runs contrary to the purposes for which tax incentives to fund pensions are provided, and it conflicts directly with the employer’s fiduciary duties to the pension plan. Unfortunately, this view has a strong hold on actuaries and corporate finance professionals and lies at the heart of the ‘asymmetry’ arguments that plan sponsors unfairly bear all the risks of pension funding.
Accountability For DB Funding Shortfalls
Who might be held accountable for the DB pension funding crisis? The answers will vary upon circumstances of each plan, but a couple of general observations may be made.
In trusteed negotiated cost DB plans, members will bear the burden of funding shortfalls because, under common law, trustees have a duty to mitigate that limits liability of actuaries and other advisors, even if such duty results in the reduction of benefits payable to plan members.
For other DB plans, the employer bears the burden of funding shortfalls.
Future Developments In The DB Pension Funding Crisis
In the absence of any regulatory change, it is likely that there will be a gradual move to more conservative actuarial funding assumptions.
There is, however, a possibility that regulatory change may occur. The ACPM and a number of large actuarial firms have commenced an aggressive lobbying campaign aimed at relaxing pension funding regulations. What they are suggesting would provide more flexibility to employers to utilize pension funds as ‘cash flow management tools.’ However, this would further weaken DB pension funding by moving it away from Income Tax Act requirement that pension funds are to be utilized exclusively to provide pensions.
In its ‘Back from the Brink’ paper, the ACPM calls upon legislators to over-ride the application of classic trust principles to trusteed pension plans and deem them to be business contracts. If this were to come to pass, legislators would also have to apply a prudential regulatory regime similar to that imposed upon the insurance industry in respect of insurance contracts since DB pension plans provide ‘self-insured’ forms of life insurance. This regulatory regime would likely be more onerous than the current one.
Another suggestion is the use of letters of credit to secure solvency deficiencies in DB pension plans. The problem, as articulated in a recent court decision, is that a letter of credit does not represent actual funding. It is a contingent guarantee for payment that has no asset value unless the contingency event is realized. This simply layers another element of risk on pension funding, akin to invoking a debt obligation in order to meet another debt obligation.
These wrong-headed lobbying efforts will not improve DB pension funding, in the short or long term. At best, these measures will mask the underlying pension funding issues in hopes the passage of time may grant relief through increased interest rates or higher equity returns. At worst, they will hasten the demise of DB plans as members begin to recognize higher risk levels in their benefit security and demand the consistent funding levels of Defined Contribution pension plans.
Three Simple Recommendations For Private Pension Reform
On balance, Canada’s pension system, including the regulatory framework, is actually quite effective and efficient. In respect of pension surplus, plan sponsors have full control over its use in ongoing plans through the setting of funding policies and the availability of contribution holidays, with employer surplus rights on plan termination dependent on classic trust legal principles which are well-established in common law.
There are, however, serious issues to address, including reversing the decline in numbers of Canadians participating in pension plans and securing funding of DB pensions. Such outcomes could be achieved by: u Increasing maximum pension limits imposed by the Income Tax Act by 50 per cent, while maintaining current RRSP limits, with limitations placed on participation of highly paid employees unless pension coverage is provided also to regular employees. This would stimulate demand by both management and regular employees for employersponsored pension plans and would likely reverse the decline in pension plan participation. This approach parallels that of certain other countries (most notably the U.S.). u Improve actuaries’accountability by separating the valuation function from consulting functions in a fashion similar to post-Enron practices where the accounting profession separated the audit function from consulting functions. As well, impose and/or enforce a fiduciary role on the pension valuation actuary. u Revise accounting standards to recognize surplus ownership by plan members.
At the end of the day there are no ‘magic bullets’ that will end the DB pension funding crisis. The fact is that in today’s economic environment, pensions simply require higher levels of contributions. Until we in the pension industry are prepared to come to grips with this basic fact, the hand wringing and whining about the current state of DB pensions in Canada remains, as noted by the justices of the Supreme Court in their Monsanto decision, “unpersuasive.”
Greg Hurst is the national pensions practice leader of Heath Benefits Consulting Inc.
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