Bracing for the pension time bomb
- Subtitle: Cover Story
|Photo: Pierre Charbonneau|
During 2011 and 2012, Canada’s national airline was locked in bargaining and arbitration with its unions, which Headon, assistant general counsel, labour and
employment law, says “had a major pension component.”
The company sponsors a number of defined-benefit and defined-contribution pension plans, which were a major sticking point. Under a DB plan, the employer guarantees a set pension and is on the hook for any shortfall, making it riskier than a DC plan, where employees make investing decisions and their pension depends on the performance of those investments.
In the beginning of 2012, Air Canada’s 10 DB plans were running a $4.2-billion solvency deficit and the company was making past service catch-up payments
under federal regulations. It needed to deal with pension issues to move forward.
“Through that process, about three of us — on a pretty full-time basis — were involved in the bargaining given the role that pensions played. We were plugged into the discussion in a way that took up a fair bit of time.”
“It’s an area of law that not many of us studied or specialized in,” says Headon. “When you are in-house, you need to master it quite quickly.”
The legal department’s efforts paid off for the airline. “We secured approximately a $1-billion reduction in solvency liabilities [which at press time were subject to regulatory approval]. We have a template with the unions to get there.”
Headon is not alone in facing pension problems. Management is increasingly calling on in-house lawyers to help deal with pensions. It’s not just solvency issues that organizations and their in-house counsel face. Canada is undergoing an extraordinary round of pension reform at the provincial level, and almost every province has some sort of initiative underway. That, coupled with companies looking to reduce risk or possibly convert from DB to DC plans, has legal departments scrambling to keep up with the change and bring their boards up to speed on developments around pension risk.
Pension reform ‘tsunami’
“There’s a tsunami of pension reform that has been happening in the last couple of years,” says Melissa Kennedy, general counsel and senior vice president of corporate affairs at the Ontario Teachers’ Pension Plan.
As a result she is “being corralled”more and more by her general counsel colleagues and asked about pension reforms. “They are talking about pensions more than the general counsel community ever did.”
Elizabeth Boyd, a pension lawyer at Blake Cassels & Graydon LLP, agrees, adding “there has been a dizzying array of changes. It’s tough to keep up.”
Experts say there are three key areas general counsel and their legal teams need to consider when it comes to pensions: tackling solvency issues around DB plans, keeping abreast of pension law reform, and helping their company de-risk its pension obligations and mind its fiduciary duties.
Facing the solvency crunch
The biggest challenge organizations are grappling with is the growing deficits in their DB plans. At the end of 2011, 93 per cent of federally regulated DB plans were under-funded according to the Office of the Superintendent of Financial Institutions — a far cry from the early 1990s, when many ran surpluses. But that’s only part of the story — most DB plans are provincially governed and face similar problems. It’s not clear what the total liability is for underfunded DB plans in Canada. The Canadian Federation of Independent Business suggests public DB plans alone are $300-billion in deficit. Factor in billions more in red ink from private sector plans and the number starts to get very large, creating a ticking pension time bomb.
Pension deficits are not isolated to Canada. An August 2012 study by credit rating agency Dominion Bond Rating Service Limited looked at 451 major corporate DB plans in the U.S. and Canada, including 65 north of the border. It found funding deficits of US$389 billion. DBRS noted more than two-thirds of plans were “underfunded by a significant margin” and heading into a “danger zone,” the point at which reversing the deficit becomes difficult. It believes 80 per cent “is a reasonable funding threshold.”
The problem for organizations facing solvency deficits is they are required under pension law to make special funding payments to eliminate that shortfall over a tight time frame, in addition to making regular pension contributions. The money comes out of existing cash flow, which puts extra strain on balance sheets as the economy muddles along, and places companies at a disadvantage compared to competitors that do not have underfunded pension obligations.
It’s not just the private sector that’s impacted. Public pensions face the same solvency pressures. Take the Ontario Teachers’ Pension Plan, which pays out more than $4.5 billion a year to pensioners. It is considered one of the best, with more than $117-billion in assets under management, and invests around the world. In 2011, it returned 11.2 per cent, earning $11.7-billion, making it one of Canada’s most profitable entities. Its rate of return since 1990 has been 10 per cent.
Despite that performance, Teachers’ had a funding deficit in 2012 of $9.6-billion and currently its expected pensions costs over the next 70 years are growing faster than the projected value of pension assets. Teachers’ is not alone. OMERS, another big public plan, is expected to have a $9-billion deficit this year and many other public plans are in the same boat.
In fact, Manuel Monteiro, a partner at pension consulting company Mercer’s financial strategy group, estimates only one in 20 DB plans are fully funded on a solvency basis, which is a stress test pension regulators impose on plans.
He said pension deficits are not a big deal for healthy companies. “If a plan is in a deficit position, the company is required to fund that deficit. It’s not a big deal if the company you are working for is strong. If you work for a weak company that has a deficit you have to question if you will get a pension.” Take Nortel, which sought creditor protection in 2009 — a deficit in the plan means pensioners receive reduced payments.
Yves Desjardins-Siciliano, chief legal and corporate affairs officer at VIA Rail, which oversees a $1.7-billion DB pension plan that has a deficit, notes solvency is “an actuarial calculation and not an impending threat. It is an area that requires serious management attention, even at the board level.” Like many companies, he says VIA is looking at ways to address its deficit.
Low interest rates a problem
Experts say the deficit problem is twofold. First, low interest rates are the biggest contributor. Plans simply can’t keep up with the growing liabilities, because fixed-income investments — the lion’s share of most plan assets — are generating such low returns. The DBRS report notes the discount rate, which pension plans use to calculate the present value of future pension obligations, has been plummeting since 2008 and are unlikely to rise anytime soon — though they are bottoming out.
DBRS estimates if the discount rate rises by 2 per cent, the funding gap of almost US$400 billion would be eliminated. It’s certainly achievable given the average discount rate in 2011 was 4.84 per cent compared with 6.27 per cent in 2008.
Since companies cannot control interest rates, it means they must fund shortfalls using voluntary payments, such as BCE did in late 2012, dropping $750-million into its plan. Corporate Canada has an estimated $600-billion sitting on its balance sheet, but the reality is few companies have the luxury of writing a billion-dollar cheque like BCE did.
In fact, experts say companies are reluctant to kick extra money into pension plans because the expectation is interest rates will soon start to rise and much of the funding problem will vanish. Many simply rely on letters of credit to satisfy regulators’ concerns about shortfalls. Monteiro says, “The problem with pension plans is that once you put it in, you can’t get it back easily.”
There are also companies required by pension regulators to make catch up payments and some of those are seeking relief. Take Air Canada. It made $433 million in pension plan funding payments in 2012, which included a special past service catch-up payment of $173 million. For the last three years, Air Canada, whose pensions are federally regulated, has been making catch-up payments under special three-year pension relief regulations passed by the federal government following the credit crisis.
Air Canada projects another past service payment of $221-million in 2013. However, its Q4 financial statement notes the three-year regulation is set to expire in 2014 so Air Canada, with the agreement of five labour groups, is now asking the federal government to cap the past service payment at “acceptable levels” over the next decade or until the plans are no longer in deficit.
Under the recent negotiations with its labour groups, Air Canada secured amendments to existing plans that will reduce liabilities and will put in place a hybrid
pension regime for new employees consisting of both a defined-benefit and defined-contribution component, putting the airline at the forefront of pension reform that is bubbling through corporate Canada.
“We had an awful lot of learning to do,” says Headon. “Issues coming out of pension reform touch a large number of stakeholders.” That meant making sure the large team, which included non-lawyers such as actuaries, tax experts, and managers, were kept up to speed on negotiations.
“Lawyers are in a very good position to play a role to make sure the team has the information they need and are pulling in the same direction.”
Companies seek pension relief
Air Canada is not alone in seeking relief from hefty catch up payments. A group of six Canadian companies — which include telcos, railways, and some former Crown corporations — have long lobbied the federal government for greater solvency relief including the way calculations are made to assess pension solvency and an extension in the amount of time companies can fund their deficits. Michel Benoit, a lawyer at Osler Hoskin & Harcourt LLP who has worked with them, says, “They didn’t get what they wanted. It’s a dead issue right now.”
Canada is at a competitive disadvantage on that front. The U.S. recently modified its rules to allow a 25-year average for calculating the discount rate, rather than confining it to the past few years, which has been artificially low and leads to higher pension obligations. Some European countries are doing the same as the U.S.
Companies seem to have more luck seeking relief from provincial regulators. For example, in Ontario employers can seek to spread deficit funding out over 10 years if employees agree, so a number of companies have recently sought co-operation of their unions to take advantage of that. Some have been successful, others haven’t.
Plan design needs to change
The second primary issue driving deficits is age. Many plans were designed three or four decades ago, when the life span of Canadians was much shorter than it is
today. The only way around this is to address the structure of the plan and that could mean hiking retirement ages or looking to move to a DC plan.
“Like other companies have done, we are going to look at changing the design of the plan,” which could mean moving to some type of hybrid plan or a defined contribution plan, says VIA’s Desjardins-Siciliano.
“We are looking at re-designing the plan for new employees going forward in a way that not only preserves or makes it more financially viable, but reflects the reality of the new workforce.”
He notes that while VIA has many employees with 35 or 40 years of service, the average tenure at a Canadian company today is between four to seven years and a defined-benefit plan doesn’t have the draw it did when they were set up in the 1960s and 1970s.
In fact, DB plans are declining in the private sector, largely because of the risk they entail. In a November 2012 pre-budget consultation document presented to the Senate of Canada, lobby group Fair Pensions for All points out that 57 per cent of the Canadian workforce is not covered by pensions. Defined-benefit membership coverage is declining in the private sector, dropping to 1.5 million in 2011 from 2.2 million in 2001, while in the public sector it increased over the same period to 2.9 million from 2.3 million.
Are DB plans dead?
Kennedy, for one, believes in the DB Plan, and says there are “a number of ways of dealing with the solvency issues without throwing the baby out with the bathwater” and moving to a DC plan.
She notes states like Rhode Island and provinces like New Brunswick are developing new plans that aim to provide the upside of a DB plan while limiting exposure, known as shared-risk or targeted plans.
“I think that’s the key. There needs to be shared risk.” To address its deficit issue, Teachers’ has raised contribution rates and lowered benefits and continues to look for ways to address the deficit and provide sustainable pensions.
While studies show DB plans are being shunned and DBRS even predicts their demise in 40 years, Kennedy says DB plans have advantages. “They are a lot cheaper… because you are pooling the risk.” As well, she says, a DC plan puts the risk “totally on the employees” and that may have negative long-term social policy issues if DC plans fail to provide adequate retirement resources. “You’re going to have to pay the piper at some point — if it’s not today, it’s tomorrow.”
Shared risk plans
The key, she says, is building flexibility into the plan. The low-interest rate environment and underfunding is prompting more discussions around creating hybrid plans. New Brunswick, for example, which has had a negative experience with DB plans that have gone belly up leaving pensioners with a shortfall, has introduced shared risk pension plans which attempt to combine the best features of a DB and DC plan.
They remove absolute guarantees, such as indexing, and require both employers and employees to share in the risk, as opposed to the employer assuming all the risk for shortfalls. The plans provide basic benefits, and contributions can increase or decrease depending on the performance of the plan. Additional benefits, such as indexing, depend on whether the plan meets or exceeds expectations. In a stress test of more than 1,000 scenarios, basic benefits under an SRRP were achieved in 97.5 per cent of cases and the average indexation reached at least 75 per cent of CPI. Contributions were also stable, requiring no increases above 1 per cent of payroll.
Currently, some New Brunswick public pensions are converting to the SRPPs. The age for retiring without a reduction in pension will bump from 60 to 65.
Pension law reforms
In terms of provincially governed plans, there are a number of minefields awaiting in-house counsel. Many provinces are introducing changes to their provincial
pension laws. As well, the Canadian Association of Pension Supervisory Authorities has introduced an agreement respecting multi-jurisdictional plans, which Quebec and Ontario have signed. The goal is to simplify the administration of plans that operate in more than one jurisdiction and reduce oversight red tape. Blake Cassels’ Boyd says, “We’re only now starting to understand some of the implications of what they have agreed to.” She explains the “tricky thing” with pension plans is the home jurisdiction for regulating them depends on plurality of members in a plan. That can change as the business grows and acquires or divests operations. There are also hitches in provincial laws when it comes to meeting family law obligations in a separation or divorce.
Grow in rights
Boyd says another thing to watch for in Ontario is “grow in rights,” which are contained in recent Ontario pension reforms. Now, a pension automatically vests once a person joins a plan, as opposed to after two years. As well, if a person who has accrued 55 points (age and service exceed 55) is involuntarily terminated, then they must be allowed to “grow in” to a plan’s early retirement subsidies, which Boyd says can significantly increase the cost of a plan. She adds it’s not clear what happens if someone is fired for willful misconduct. There are also issues to be determined around a voluntary versus involuntary dismissal.
Companies look to de-risk
Ian McSweeney, a pension lawyer at Osler Hoskin & Harcourt, says there is a “spectrum of possibilities,” when it comes to de-risking pension plans. At one end is managing risk through investment and making sure the investment strategy aligns with the execution and matches liabilities. In the middle is the plan design and issues such as whether a DB plan is still feasible or should a company convert to a DC. He says “conversions gets you there over time, but you still have a legacy deficit.” At the other end of the specturm is getting rid of the risk entirely through lump sum payments or annuities.
Desjardins-Siciliano says achieving better pension results can be as simple as reigning in plan costs. VIA started by applying “rigorous management oversight” of expenses related to managing the fund and it reduced cost to 30 basis points from 50, a big savings when you are managing millions of dollars. VIA is also requiring employees to contribute more of their earnings to the pension fund. Employee contribution was 30 per cent and will move to a 40-60 split.
Beware of fiduciary duties
One area where Desjardins-Siciliano says “lawyers really have to be careful and diligent is on the issue of governance.” There is a fiduciary duty on the part of the company to make sure the plan is properly managed. He says in-house lawyers have to limit the risk of conflict when it comes to hiring fund managers or plan administrators. “The obligation is one that requires lawyers at the board level to be very diligent in making sure that all the steps are taken so that — especially in a deficiency or insolvency environment — if you should, god forbid, run out of money, no one can go back and say you are negligent.” It’s the same with things like making decisions on taking contribution holidays.
Larry Swartz has seen both ends of the pension challenge. He is counsel to Morneau Shepell and a principal at the HR consulting firm, which provide pension and benefit administration services. As a lawyer, he is involved in advising his firm on its DC and DB plans and providng clients with advice on theirs.
He says one of the biggest challenges for companies is communicating with employees about their pension options in DC plans in a way that meets the
employer’s obligations as a fiduciary. The role of the lawyer in pensions, he says, is helping the company manage risk. For DC plans, that risk can be in deciding how far a company goes in communicating about investment options for its employees. “You need an understanding of trust laws and fiduciary duties so that you can help realize it’s not just company money, you are providing a service for the company that is ultimately for the benefit of the employees.
“It’s an area where the more financial knowledge a general counsel has, the better they can be serving their client.”
It’s taken a while for the economy and corporate Canada to dig the current pension hole and the problem won’t be solved overnight, especially if interest rates don’t start climbing soon. Air Canada’s Headon says while there is light at the end of the tunnel, “pensions are going to remain a pretty significant part of our time for a few years yet.”
Indalex ruling clears air on priority
Employers and financiers can breathe a sigh of relief following a ruling by the Supreme Court of Canada that restores order over debtor-in-possession loans in restructurings. Normally under a CCAA application, a DIP financier is granted a super priority over other creditors, meaning they are first in line to get repaid before secured and unsecured creditors.
By granting that priority, it ensures DIP financiers will get paid, which encourages lenders to loan the much needed money to keep companies operating while buyers are pursued or to re-float financially impaired companies. Without that guarantee, lenders would be reluctant to loan money or would only do so at a higher interest rate to offset the risk they might not be repaid, notes Osler Hoskin & Harcourt LLP lawyer Ian McSweeney. “No one will lend money unless they are certain they will get it back.”
However, an Ontario Court of Appeal threw the traditional view about priorities out the window in Sun Indalex Finance LLC v. United Steelworkers and held company pensioners had priority to repayments of the DIP money by the employer.
The Appeal Court ruled Ontario’s pension laws created a deemed trust for pension shortfalls on a wind-up and there was a constructive trust, which put pensioners at the front of the line when it comes to payback. “The Court of Appeal changed the way everyone thought and the pension legislation concept of a deemed trust,” McSweeney says.
That ruling raised eyebrows among corporate and insolvency lawyers, who were waiting for the Supreme Court of Canada to weigh in. The court did that in early February in a 160-page ruling.
In a complex 5-2 decision — the judges were all over the map on some of the issues — they overturned the Ontario Appeal Court and sided with the financiers over the pensioners. McSweeney says the SCC resolved the case by ruling that a judge appointed under the federal CCAA “can make a super priority charge that trumps out the provincial deemed trust.”
McSweeney notes the case also discusses important issues, such as when an employer who acts as a plan administrator is facing a conflict of interest between the corporate interests and the fiduciary duties it owes to the employees, when a wind-up deficiency is subject to a deemed trust and discussion around constructive trusts. “There is something for everybody in that case,” McSweeney says. “[The judges] cross-agreed with each other on various points.”
— Jim Middlemiss
Published in InHouse Cover Story