No. 2 – Spring 2007
By Don Lee
Funding rules for employer-sponsored pensions keep re-emerging as a political issue. The economic issue at the core is always the same – maintaining the security of pensions when jobs are disappearing. In this latest round, public concern has been fueled by several high-profile cases of corporate restructuring in which job security has been on-the-line, and by a steady flow of alarmist opinion to the effect that unfunded pension liabilities are undermining Canada’s competitive position.
In this new chapter of pension funding issues, the concerns are coming, for the most part, from the corporate sector – the employer side of the bargaining table. The primary focus of complaints from companies and their pension consultants are the rules which impose increased contributions when a pension plan is running a solvency deficit.
An actuarial valuation on a solvency basis discloses what would happen if a pension plan were wound-up – would there be enough money to pay-out the full amount of benefits earned – or would there be a deficit? Even if the plan is ongoing, as most are, any such deficit must be made up within 5 years. If the plan is being wound-up, several jurisdictions now extend the same funding requirement to any corporate vestige of the plan sponsor which continues to operate in Canada.
This legal requirement gives considerable comfort to both active and retired workers in defined benefit pension plans. Their pension entitlements are not completely secure, but are only at risk in the event the employer goes bankrupt, leaving no one to pay down the solvency deficit on plan wind-up. In that unhappy case, both active and retired workers would see the amount of their pensions reduced in proportion to the available funds versus the wind-up value of their entitlements. Although there is a Pension Benefits Guarantee Fund in Ontario, that scheme only covers pensions up to a limit of $1,000 per month.
It is only a few short years ago that the pension issue of the day was control of surplus. That earlier chapter of the pension story exposed and created new dimensions to funding deficits, and specifically their treatment on plan wind-up. In Ontario and several other jurisdictions, the battle for control of surplus was tranquilized, at least in part, by new rules requiring that, on plan wind-up, surplus not be paid out without an agreement between the plan sponsor, the active members and the pensioners, or failing that, a court order.
The most controversial aspect of that requirement has been its application to partial plan wind-ups. The Ontario rules often resulted in a portion of surplus, from an otherwise ongoing plan, being distributed to plan members affected by the partial wind-up.
The corporate world resisted this aspect of the rules with all its fire-power, but ultimately lost the point when a case involving Monsanto went to the Supreme Court. The court confirmed the position of the Financial Services Commission of Ontario, namely, that the contested rules on surplus distribution also apply in the case of a partial wind-up.
The extent of surplus on plan wind-up is the result of a variety of factors and may even be affected by the wind-up itself. Laying out the complex interplay requires a little patience.
While a pension plan remains ongoing, active members of the plan expect that their pensions to move ahead in some fashion with future wage increases. In many cases, this “indexing-to-wages” is part of the plan formula – in a plan based on final average earnings. In other cases, it happens on an occasional or ad hoc basis as the result of employer discretion or collective bargaining – in a flat benefit or career earnings plan.
During the 1970’s and 1980’s, a comparable set of expectations and arrangements developed with respect to the adjustment of pensions for price inflation during retirement – the Pension COLA. In many cases, this “indexing-to-prices” became part of the formula. In other cases, it continues on an ad hoc basis.
When a person terminates employment and withdraws the commuted value (or lump-sum value) of their pension, the potential value of any future ad hoc adjustments is lost. And even if movement ahead with future wage growth is part of the formula and fully funded, in a plan based on final average earnings, the value of the “indexing-to-wages” is lost.
But an “indexing-to-prices” provision affecting pensions during retirement is not lost. The value of Pension COLA is reflected in the commuted value when it is part of the plan formula.
This imbalance between the treatment of indexing-to-wages and the treatment of indexing-to-prices, when calculating lump-sum values on termination of service, is even more disconcerting when we consider that an indexing-to-wages provision must be funded. The estimated liabilities for past service and the annual cost of future service include an assumed rate of future wage growth. As a result, when a larger group is terminated, surplus may increase because their benefits will no longer move ahead with future wage increases, as had been anticipated in the basis of funding.
Unlike an indexing-to-wages provision, an indexing-to-prices provision can be exempted from the funding rules and, these days, often is. As a result, a plan that appears to be in a surplus position might actually show a substantial deficit if the plan were wound-up. This can happen because the commuted values paid out are supposed to include the value of indexing-to-prices during the period of retirement, even if they have not been funded.
A similar circumstance applies to early retirement benefits. Under legislated rules, the prospective early retirement benefits of all plan members must be funded on the solvency basis. But the value of those same benefits is not reflected in the commuted value paid out to an individual plan member whose service is terminated. Thus a wave of terminations which does not lead to a partial wind-up may actually improve the funding position of pension plan – because of early retirement benefits which are funded but not paid out.
The notion that a pension plan might profit from a plant shutdown or mass lay-offs created an politically explosive issue in the 1980’s. The Ontario government and several others responded by improving lump-sum settlements in the case of pension wind-up or partial wind-up. The improvements included the vesting of early retirement provisions on the basis of prospective service – the “grow-in” rules – and the requirement for an agreement with affected plan members concerning the sharing of surplus.
These reforms clearly represent a significant set forward for employees affected by a plan wind-up, but it has never been clear why employees or pensioners, not directly affected by a partial wind-up, should not enjoy equivalent benefits.
In November 2006, the Ontario government appointed a new Expert Commission under the guidance of Harry Arthurs, a distinguished professor of labour law. The commission includes two experienced specialists from each of the labour side and the employer side. It will report on how to update the Pension Benefits Act by the summer of 2008, after consulting with pension plan stakeholders.
Employers and the pension industry will seize upon this opening to press for relief on the funding rules, and specifically, the five-year funding requirement for deficiencies on a solvency (or wind-up) basis. Organized labour may be persuaded to cede this point in favour of stronger guarantees for benefits undermined by an employer’s bankruptcy. But the unions and plan members at large could also be asking other questions.
In the complex interplay of issues surrounding surplus, inflation protection and plan wind-up, there is good cause for new solutions to several remaining problems:
q Plan sponsors are able to exempt themselves from funding indexing commitments to pensioners, leaving retired plan members vulnerable to funding shortfalls on plan wind-up caused by an employer’s bankruptcy.
q When indexing is excluded from pension liabilities in a valuation for funding purposes, the result may be an artificial surplus, which could be used to cover a contribution holiday for the employer, further aggravating the plan’s true position on wind-up.
q When members terminate their service (or are laid-off) the value of any “wage-indexing” is excluded from the lump-sum commuted value paid out, even though it may be fully funded.
q The value of early retirement provisions is not paid out to terminating members unless they are affected by a full or partial plan wind-up.
q There is no mechanism to ensure a fair distribution of surplus to members remaining in an ongoing plan affected by a partial wind-up.
If the new package of reform includes some stronger scheme of insurance against funding shortfalls, plan members will have more secure pensions. But without more coherent provisions on the funding of indexing and the basis of payouts on termination, some employers will inevitably be tempted to transfer their pension liabilities to the rest of us, as their own ship is going down.
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