Originally published in Blakes Bulletin on Pension and Employee Benefits, August 2007
Canadian pension legislation has typically provided a five-year period for funding any solvency deficiencies under defined benefit plans. In the face of large pension plan deficits, governments in Canada, the U.S. and the U.K. are taking proactive steps to provide funding relief.
The issue of funding deficiencies has been highlighted in Canada by several recent high-profile corporate insolvencies with significant pension funding shortfalls, including Air Canada and Stelco. The problem is, of course, more widespread. For example, the Office of the Superintendent of Financial Institutions (OSFI) estimated that as of December 31, 2005, 78 per cent of federally-regulated defined benefit pension plans had a solvency deficit.
What is a Solvency Deficit?
Pension standards legislation in every jurisdiction includes minimum funding rules for defined benefit plans. The purpose of these rules is to provide assurance that adequate funds will exist to pay for all defined benefits promised, with due regard to stability of contribution levels and the possibility of unfavourable outcomes now and in the future.
Going-concern funding rules use assumptions consistent with the plan continuing in operation. A going-concern valuation provides a mechanism by which employers and employees can understand the influence of future demographic and economic factors on the expected size and time pattern of the ongoing financial commitment needed to secure the defined benefit promise.
A solvency valuation basically aims to determine whether a defined benefit pension plan is sufficiently funded to meet its liabilities on wind-up as of the date of valuation. Any deficiency of assets over liabilities is a solvency deficit. The determination of assets and liabilities for this purpose varies somewhat among the different jurisdictions. However, since the determination is based in part on changing market conditions and any deficit must be funded over a relatively short period (generally, five years as compared to 15 years for a going-concern deficit), there can be significant variations in the contributions required from year to year.
This volatility may create a financial concern for plan sponsors. As well, it may result in a stranded surplus if market conditions or company employment patterns change significantly. A longer amortization period gives time for good plan experience to improve the funded status of the plan.
Specific Provincial Measures
Solvency Funding Exemptions or Extensions for Specific Types of Plans.A number of provinces – including Newfoundland and Labrador, Nova Scotia, New Brunswick, Québec and Manitoba – have put in place special funding measures for defined benefit plans sponsored by universities and municipalities that exempt them from special payments. In Alberta, regulations proclaimed in force on August 10, 2006 permit the Superintendent to exempt public sector plans from the solvency funding requirements provided the participating employers contractually agree to pay any solvency deficiency that exists at the time of plan termination.
Multi-Employer Negotiated Cost Plans.Multi-employer negotiated cost plans exhibit characteristics of both defined contribution and defined benefit plans. Under such plans, target levels of benefits are defined from time to time and communicated as such on the basis of available funding resulting from the negotiated rate of contributions. However, benefits are generally variable, since they depend on the agreed or negotiated rate of contribution. If funds are insufficient and contributors – employees and employers – are unable or unwilling to adjust contributions, benefits must be adjusted.
Arguments have been made that such adjustments should be required only where there is a going-concern deficiency, not in the case of a solvency deficiency. Unlike single employer defined benefit plans, the risk of employer insolvency on full or partial plan wind up in a multi-employer plan is usually mitigated by the number of unrelated employers in the plan. This suggests a long-term view is appropriate when deciding whether action must be taken to address a current deficit.
As noted below, the relief provided under the federal regulations, other than the letter of credit option, applies to multi-employer plans. Under the Québec permanent measures below, letters of credit arrangements may not be used in connection with multi-employer plans. New Alberta regulations provide solvency relief to Specified Multi-Employer Pension Plans. Up to three years of solvency funding relief is available on several conditions, including: amortization of unfunded liabilities over a period of not more than 10 years; annual filing of valuations; and no benefit improvements while the deficiency exists.
Temporary Measures.New Brunswick and Québec have provided temporary funding relief by extending the amortization period to 10 years in Québec and up to 15 years in New Brunswick, where certain conditions are met.
Québec Permanent Measures.In Québec, permanent measures are being introduced as part of Bill 30. The following are expected to be in effect on January 1, 2010:
- Reserve Fund. A reserve fund must be established (i.e., assets of the plan to exceed solvency liabilities) equal to the lesser of the surplus and an amount to be calculated in accordance with regulations which have not yet been adopted. The amount of the reserve required will vary depending on the risk profile and investment policy of the plan. This change will reduce the amount of surplus available for contribution holidays and for funding benefit improvements.
- Funding of Amendments. There is a restriction on benefit improvements in underfunded plans. If the actuarial valuation prepared in connection with an amendment shows that the solvency ratio of the plan is less than 90 per cent, there must be immediate funding to bring the solvency ratio to at least 90 per cent or funding equal to the cost of the amendment, whichever is less.
- Letter of Credit. All or part of the solvency deficit special payments may be suspended where a letter of credit is provided by the employer. The letter of credit forms part of the assets of the plan for the purpose of determining its solvency (but not for the purpose of determining a going-concern deficiency). The amount of the letter of credit cannot exceed 15 per cent of the solvency liabilities of the plan. This arrangement may not be used in connection with multi-employer pension plans.
- Amortization Period. The amortization of solvency deficits over a period of 10 years (permitted under the temporary measures) will no longer be permitted. The maximum amortization period for solvency deficiencies will be five-years.
British Columbia.The B.C. Ministry of Finance has launched a policy review of the solvency rules for defined benefit pension plans under the Pension Benefits Standards Act. The Ministry asked this spring for input from stakeholders on various issues, including whether relief should be temporary or permanent, whether letters of credit have an appropriate role and if so whether there should be a cap on the amount of letters of credit used by any one plan, whether the solvency amortization period should be extended and whether solvency rules for multi-employer plans should be different.
Alberta.Draft regulations and a consultation paper were released in 2005. The Act and Regulations have since been amended to provide relief with respect to public sector plans and specified multi-employer plans. However, the broader reaching solvency relief proposals, such as the proposed letter of credit regulations, have not yet been implemented. We understand new pension solvency funding regulations are likely to be released shortly.
Ontario.The Expert Commission on Pensions was established in late 2006. Its areas of focus include defined benefit plan funding. The Commission report is expected in the summer of 2008.
Temporary Federal Solvency Funding Relief
In November 2006, the federal Solvency Funding Relief Regulations were introduced. These are temporary measures that apply only to the first valuation between December 30, 2005 and January 2, 2008. The measures are only available to employers who are up-to-date in required contributions and to plans established before 2006 or after such date as the result of a merger or division. The regulations allow for funding relief through one of three options (and a fourth applicable only to Crown corporations):
Smoothing Payments.Plan sponsors may choose to consolidate solvency payment schedules and amortize the entire solvency deficit over a new five-year period. This would have the effect of extending previously established solvency payment schedules over the next five years thereby reducing the payments required in the first years after the valuation. There is a notification form that must be filed with OSFI that includes a statement that payments are up-to-date and that the employer and the administrator have complied with the regulations. For multi-employer plans, the form includes a statement that the annual amount required to be paid or remitted to the pension fund is no less than the aggregate amounts required to be so paid under all collective agreements.
10-Year Amortization Period with Buy-In.Solvency funding payments may be made over a period of up to 10 years, instead of five, on the condition plan members are fully informed and no more than one-third of the active members and one-third of former members and beneficiaries object. A union or court-appointed representative may object for each person the union or representative represents. Also, for multi-employer plans, the annual contribution amounts cannot be lower than those required to be paid under all collective agreements.
- Notice Requirements. The Regulations contain detailed requirements about the information that the notice to members, former members and beneficiaries must contain. If members are represented by a union or court appointed representatives, the notice may be provided to the representative only. These requirements include:
- Solvency ratio of the plan and amount of the initial solvency deficiency
- Description of the extent to which benefits under the plan would be reduced if the plan wound up with the initial solvency deficiency
- Statement that annual valuations will be filed during the 10-year amortization period
- Statement that benefit improvements will be restricted during the first five-years of the 10-year amortization period
- Directions on the effect of an objection and how to object including the deadline for objecting which cannot be earlier than 30 days from the date the Notice is sent (objections are sent to the administrator not the Superintendent).
- Benefit Improvement Restrictions. In the first five years of the 10-year amortization period, no benefit improvements may be made unless the improvements do not worsen the solvency ratio of the plan. This requirement could be met by immediate funding of the benefit improvements (at least to the extent necessary to preserve the solvency ratio). Alternatively, improvements could be made if the plan sponsor returns to the normal five-year funding schedule.
- Other Requirements. The administrator must file the following with OSFI:
- A board resolution approving the extended payment schedule
- Actuarial report
- Written statement that the initial solvency deficiency will be funded in accordance with these regulations and that a notice with the required information has been sent. OSFI has Notification Forms for this purpose that also require a representation that plan payments are up-to-date, that the employer and the administrator have complied with the Regulations and that the information required under the Regulations has been provided to the beneficiaries and that less than one-third of the members and less than one-third of the other beneficiaries have objected.
The difference between the payments on the 10-year amortization schedule and the five-year amortization schedule are subject to a deemed trust for all members and other plan beneficiaries. If the plan is terminated, this amount becomes due and payable to the plan by the employer (except in the case of multi-employer pension plans).
10-Year Amortization Period with Letters of Credit. Solvency funding payments may be made in equal annual instalments over 10 years if the difference between the five-year and 10-year payment levels is secured by letters of credit. If the financial position of the plan improves, the amount of the letters of credit can be reduced or eliminated. No notice to plan members is required and plan members have no opportunity or right to object. It should be noted that amounts secured by a letter of credit are not considered plan assets for purposes of the actuarial valuations, plan financial statements or solvency ratio.
- Letter of Credit Requirements. The letter of credit must be held by a trustee pursuant to a trust agreement and must meet the following requirements:
- Payable only in Canadian currency
- In accordance with the rules of International Standby Practices 1998 as amended from time to time
- Issued or confirmed by a bank or co-operative credit society: (i) that is not the employer or affiliated with the employer within the meaning of the Canada Business Corporations Act; (ii) that is a member of the Canadian Payments Association; and (iii) that has an acceptable credit rating as defined in the Regulations (generally an "A" rating);
- Provides the issuer will pay the face amount to the holder on demand
- Is irrevocable, expires on the plan’s year-end and is automatically renewed for further one-year periods at that time for the first five-years unless certain conditions are met
- Provides that bankruptcy of the employer shall have no effect on the rights and obligations of the issuer and the holder
- May not be amended during its term or assigned except to another trustee.
- Trust Agreement Requirements. The Regulations also specify certain requirements for the trust agreement including:
- The trustee may be the same trustee holding other plan assets or a different one. However, the trustee must be a trust company that is licensed to carry on business in Canada. Therefore, where plan assets are held by another type of custodian, such as an insurance company, a new trust agreement with a trust company would be required.
- Where the employer is not the plan administrator, both the employer and the administrator must be parties to the trust agreement.
- The trust agreement under which pension fund assets are held may be amended to provide for the letter of credit arrangement or a new separate trust agreement may be executed for this purpose. In practice, it may be more convenient to execute a new trust agreement so that further amendments to the main funding agreement are not required when the arrangement is no longer in place. However, to simplify the drafting of the new trust agreement care should be taken to ensure that it is clear that any funds received under the letter of credit will be deposited in the main trust for the plan as soon as practicable. In addition, care should be taken to ensure that it is clear that any funds received under the letter of credit are held for the purposes of the plan and that the (indirect) beneficiaries of the new trust are the beneficiaries under the terms of the plan including the plan sponsor, if applicable. In addition, the liability and indemnity provisions should generally parallel those in the main funding agreement.
- Under the terms of the trust agreement, the employer must immediately notify the trustee and the Superintendent in writing immediately upon becoming aware of a default. A default occurs in various situations including the termination of the plan, the bankruptcy or insolvency of the employer, the failure of the employer to comply with a direction of the Superintendent or the non-renewal of the letter of credit for the full face amount except where permitted under the Regulations.
- On receipt of the notice of default from the employer or the administrator, the trustee must immediately make a demand on the letter of credit. Others may also notify the trustee of a default but in such circumstances the trustee’s duty is to notify the employer, the administrator and the Superintendent and to make a demand for payment only if the administrator fails to provide a written notice to the trustee within 30 days that the default has not occurred.
- In the consultations preceding the introduction of the Regulations, certain trust companies had expressed some concerns. Most defined benefit plans are funded through custodial trust arrangements under which the trustees typically act on the direction of the plan sponsor or an investment advisor and have no responsibility for the collection of contributions. The original proposals introduced an element of trustee discretion and, therefore, potentially of liability. In particular, the trustees were concerned about having enough information to fulfill any obligation to call the letter of credit. The federal Regulations have been drafted so that the trustee acts on receiving a notice of default and does not have an independent obligation to learn whether an event of default has occurred.
Other Requirements.The filing requirements for the letter of credit option are similar to those outlined above with respect to the member buy-in option including filing the actuarial report, the board resolution approving the arrangement and the Notification Form which includes various representations. In this case, those representations include a statement that the letters of credit comply with the Regulation. As well, a copy of each letter of credit and the trust agreement under which the letter is held must be filed. The annual statement to members must include information on the amount of the solvency deficiency, the fact that the deficiency is to be funded over a period not exceeding 10 years and the aggregate face amount of the letters of credit held in respect of the plan.
Advantages And Disadvantages
The buy-in option requires detailed communications with members and may not be a viable option in certain workplaces such as where union opposition is likely. Alternatively, it may require the plan sponsor to make other concessions to obtain the requisite support. Owing to the restrictions on increasing benefits under the plan when this option is used, it may not be possible in the circumstances to provide benefit increases in return for support. There is also a cost associated with providing the notices.
The letter of credit option involves the costs of negotiating a new trust agreement or changes to the current trust agreement, trustee fees and letter of credit fees. Letter of credit fees vary depending, in part, on the credit worthiness of the plan sponsor. These fees are properly characterized as an employer expense, not a plan administration expense and, therefore, should not be paid from the plan fund. There are detailed requirements for the agreement and the letters of credit which must be satisfied.
Other plan documents such as the statement of investment policies and procedures and plan governance documents such as the terms of reference for the pension committee must be reviewed and changes made to reflect the new arrangements. As well, the letter of credit decreases the plan sponsor’s credit available for other business purposes.
Income Tax Issues
When the use of letters of credit to provide security for the funding of solvency deficiencies was first discussed, there was a question as to how any payment by the issuer in accordance with the terms of the letter would be treated for tax purposes. Subsection 147.2(7) was added to the Income Tax Act (Canada) effective 2006 to ensure that the use of letters of credit does not cause adverse tax consequences.
If there is a call on the letter of credit, the amount paid by the issuer to the plan will be deemed to be an eligible contribution to the plan as long as the letter of credit arrangement was permitted under pension standards legislation and the amount would have been an eligible contribution under the Act if it had been paid to the plan by the employer. This means the amount paid to the fund will be considered a deductible pension contribution of the employer and that the plan will not become a revocable plan as a result of the contribution.
The concern over pension fund solvency deficiencies has resulted in many consultations (Federal, British Columbia, Alberta, Québec and Ontario) and legislative changes. The changes are a first step in promoting flexibility in funding and the sustainability of defined benefit plans. However, there is a concern, especially among labour groups, that the legislation could lead to lower plan funding and therefore less security for benefits. As well, the federal measures are only temporary. Hopefully, more permanent measures will be introduced, as in Québec, and consideration given to introducing more general measures to encourage less conservative funding of pension benefits.
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.