Canada: Head Above Water

By David Vincent and Scott Bomhof

Published in Benefits Canada, March 2004.

During the 1990s, pension surplus was perhaps the most contentious issue facing many Canadian pension plan administrators. The issues of whether surplus could be withdrawn, used to reduce employer-required pension contributions or even whether surplus could be used to finance benefit improvements for different subsets of pension plan members (for example, to provide an early retirement window) were often so contentious that they resulted in litigation. Now, the most contentious issue is pension solvency, along with related issues such as pension accounting, investment policy, plan design and regulation requirements.

Pension surplus has been used to increase corporate earnings in financial statements. What is included as pension expense on the income statement of a pension plan sponsor is not the annual cash contribution to the pension plan but rather an amount comprised of three key components:

1. Service cost: Corporations annually report a service cost to reflect an incremental year of service by pension plan members, which entitles the members to more future benefits payments and increases the company’s pension obligation.
2. Interest cost: This reflects the growing time value of the future payments owed to pension plan members.
3. Expected return on plan assets (ROA): Pension funds are invested in a combination of equities and bonds, anticipating markets will provide returns that increase the size of the asset pool enough to meet future obligations to employees; if so, it reduces or eliminates future employer contribution obligations.

The above three components are combined to arrive at a pension expense or pension income that appears on the corporation’s income statement. If the combined service cost and interest cost is larger than the expected ROA, the corporation will report a pension expense. If not, the corporation reports pension income. Pension income does not legally belong to a corporation’s

shareholders, nor does it contribute to corporate cash flow, but it will improve corporate earnings. This combination of attributes has attracted controversy, especially after Enron and other recent accounting scandals in the United States. A study of the 27 largest Canadian corporations revealed that in fiscal years ending in 2000, 11 of these companies reported pension income rather than pension expense, and for these companies, pension income represented an average of 5% of operating earnings. Examples were Maple Leaf Foods Inc., with pension income accounting for 11.8% of its operating income, Hudson’s Bay Company, with 9.4%, Dofasco Inc., with 8.6% and BCE Inc. with 6.3%.

Many Canadian defined benefit (DB) pension plans allocate 60% or more of their assets to equities. The heavy equity weighting had the effect of increasing pension fund investment returns while stock markets were buoyant during the 1980s and 1990s. However, many pension funds did not reduce their equity allocations at or before the peak of the stock market indices in 2000.

The years since 2000 have not been kind to DB pension plans. Substantial erosion of pension assets has occurred due to adverse equity returns. ROA assumptions have been reduced. Declining long-term interest rates have greatly increased pension liabilities. Malcolm Hamilton, a prominent actuary with Mercer Human Resource Consulting in Toronto, stated recently: "The last three years have provided a wake-up call. For the first time in 20 years, the cost of pension plan sponsorship is evident and painful."

Some pundits have gone so far as to challenge the accepted wisdom that investment returns from equities will beat fixed income over the long term and have suggested it is unwise for corporations to allocate pension funds to any equity investments. Pension obligations are much like longterm bond obligations. It has been suggested that investing a pension fund in stocks is like borrowing long-term corporate debt on the bond market and investing the debt proceeds in the stock market. In effect, the shareholders of the pension plan sponsor are forced to accept the risk associated with a pension fund stock portfolio, in addition to the risk of the business in which they have invested.

Instead of pension surpluses being used to rescue insolvent companies, massive pension deficits have recently become a predominant reason why some large Canadian employers like Algoma Steel Inc., Air Canada and, very recently, Stelco Inc., have been forced to seek protection from their creditors under the Companies’ Creditors Arrangement Act. According to press reports, Ontario’s Pension Benefits Guarantee Fund (PBGF)—a statutory pension insurance scheme administered by Ontario’s Superintendent of Financial Services and financed by employer assessments— could face claims in excess of $1 billion as the result of the Algoma and Stelco insolvencies. Yet, the PBGF presently has assets of only about $200 million.

While many DB single-employer pension plans face massive deficits, pension plan members are usually still protected as long as their employer is solvent. Canadian law prohibits the reduction of accrued pension benefits and the cost of funding DB pension deficits is usually still borne by the employer, not plan members. In Ontario, DB plan members have the additional protection of the PBGF, underfunded though it is.

Members of multi-employer pension plans (MEPPs) aren’t so lucky. Many are more poorly funded than singleemployer pension plans, in part due to vague, uncertain and unique funding rules applicable only to MEPPs in jurisdictions like Ontario. In most Canadian provinces (except Quebec), it is legally permissible to reduce accrued benefits in a MEPP if there are insufficient assets to provide the promised benefits. But two factors stand in the way—influencing boards of trustees to hide the problems in MEPPs and postponing the inevitable reduction of benefits that is all but certain to occur. The adverse public relations implications associated with reducing previously promised pension benefits are one factor. The other is the reluctance of employers who participate in MEPPs to increase pension contribution amounts above levels negotiated in collective bargaining.

In the recent high-profile case of the Participating Cooperatives of Ontario Trusteed Pension Plan, the board of trustees—whose assets are valued at only half its liabilities— was sued in a class action lawsuit after deciding to terminate the plan. The board had realized there was virtually no hope the plan’s funding problems could be solved. Stay tuned for more bad news about MEPPs.

How can employers best deal with these burdensome issues? One solution, which is currently attracting headlines, is to replace existing DB pension plans with defined contribution (DC) or other capital accumulation plan arrangements, thereby attempting to shift both investment risk and responsibility for ensuring adequate future retirement income away from the pension plan sponsor and onto pension plan members. Hong Kong-based Trinity Time Investment, the equity investor chosen as Air Canada’s saviour, has proposed replacing Air Canada’s DB pension plans with new DC pension schemes, while grandfathering certain existing DB members. Air Canada’s unions have protested and it is too early to tell how this battle will be resolved. But the trend away from DB pension plan design and toward DC plan design has been well established in the U.S. and more recently in Canada and it will continue.

Another measure of pension relief that Air Canada has requested is a change in the current legal requirement to fund its pension solvency deficit over five years. The Office of the Superintendent of Financial Institutions (OSFI), the federal pension regulator with jurisdiction over Air Canada’s pension plans, has signaled its willingness to support a request to the federal government to provide this relief, which would mirror similar pension regulation concessions proposed for airlines and other struggling industries in the U.S. If this reprieve is granted, it is possible a similar one will also be granted to a wider group of pension plan sponsors than Air Canada.

Another change to look for will be to the current pension accounting rules. Demands for increased transparency will force corporations to recognize in their financial statements pension fund investment losses and pension deficits much more quickly than in the past.

Because actuarial reports for DB plans are only required, in most cases, every three years, many corporations have not yet had to face the consequences of the adverse experience over the last three years. Air Canada’s most recently filed actuarial reports for many of its several pension plans revealed surpluses; for this reason, the airline was not making contributions to most of its pension plans. That was until OSFI took the unusual step in early 2003 of ordering Air Canada to resume making contributions to its pension plans prior to the expiry of the triennial actuarial valuation period. Based on OSFI’s own analysis, the pension surplus had disappeared.

As the triennial valuation periods expire and pension accounting rules are tightened, corporations will be faced with substantially increased pension cash contribution requirements and higher pension expense charges on their income statements. This will in turn cause them to seek changes to their pension plans to reduce these increased costs and charges. In addition to conversions of DB plans to DC plans, expect various design changes to existing DB plans such as reduced early retirement incentives, reduction or elimination of ad hoc improvements, increased member contribution requirements and other cost-saving measures. Many in the pension community also believe that pressure must be brought to bear on governments to change pension laws to ease the current rules in most jurisdictions requiring amortization of solvency deficits over five years.

In extreme cases, corporations facing insolvency will be forced to deal with their pension fund problems through insolvency restructuring procedures. For insolvent plan sponsors whose underfunded pension plans are registered in Ontario, the possibility of PBGF funding of pension deficits provides, in effect, an additional source of financing to support a restructuring. Any claims made by currently insolvent sponsors may portend more of such PBGF claims in cases where corporations are being restructured in Companies’ Creditors Arrangement Act proceedings. Increased employer PBGF assessments, or other more drastic PBGF changes, are likely to be forthcoming as a result.

Change is inevitable. And the pension problems described here will cause hardship for many. However, pension obligations are increasing in importance as our population grows more wealthy and ages. For too long, governments, unions and pension plan sponsors have ignored the need for change. Perhaps years from now we will look upon the current events as the motivating force that caused those in the position to effect change to recognize the problems and address them by accomplishing the necessary legal, funding and accounting changes. BC

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.