These days, people are worried their pension plans are underfunded, yet need to support retirees who are living much longer than anyone anticipated 40 or 50 years ago. Add economic volatility and prolonged low interest rates to the mix, and there’s a valid concern there won’t be enough money in the pot to pay out pensions.
As a result, there’s been a lot of talk about pension reform and, in particular, de-risking strategies. These run the gamut from new plan designs that “share” the risk, to transferring risk to insurance companies through annuity buy ins and buyouts.
“De-risking used to be called risk management,” says Kathryn Bush, a partner with Blake Cassels & Graydon LLP involved in pension and employee benefits law.
De-risking isn’t a magic bullet, but it is putting pension reform in the spotlight and forcing organizations to at least start looking at their options.
For in-house counsel, that means a whole lot more paperwork. But it also means an opportunity to be involved with innovative pension reform strategies that will directly affect employees’ lives.
While transferring pension risk to an insurance company is not a new concept, it’s still relatively new in the Canadian market. But for the Canadian Wheat Board, it was the best option to help meet its benefit promises to retirees.
Last year, the CWB signed a $150-million deal to buy an annuity policy from Sun Life Financial Inc., which would transfer some of its pension risk to the insurer.
The CWB lost its government monopoly in 2012 and transitioned from 400-plus employees to an organization of 100. “The transition did not support the type of plan we were able to operate in the old environment,” says Dayna Spiring, general counsel and chief strategy officer for the CWB in Winnipeg.
The organization had to look at de-risking as it moved into a more competitive space against large grain companies, and the CWB didn’t want the risk and liability on its balance sheet. “We sought advice from all over the industry,” says Spiring. “Our primary concern was that we had made a commitment to these employees to maintain a certain level of benefits (so) our first priority was to find a solution that captured those benefits for them.”
With the annuity buy in, the CWB was able to transfer both the longevity risk (people living longer than expected) and investment risk in its DB plan over to Sun Life. The CWB also worked in an “inflation-linked” promise, so the benefit commitments increase with inflation.
Some of the CWB’s employees qualify for this plan; the rest are on a totally separate defined contribution plan.
The Office of the Superintendent of Financial Institutions still has to approve the termination of the original plan; after that, pensioners can convert the buy in to their own annuity buyout (from the group pension to an individual one).
Canadian companies have done this before, just not on this scale, adds Spiring.
So could we start seeing more of these types of arrangements in Canada?
The insurance companies think so. At the time of the announcement with the CWB, Sun Life’s Brent Simmons told the Financial Post de-risking transfers could add up to a $10-billion business in Canada by 2016.
Typically, organizations offer defined contribution or defined benefit pension plans. A DC plan involves fixed contributions from the employee and employer, and future benefits will fluctuate, depending on investment earnings. A DB plan, on the other hand, promises a monthly benefit on retirement based on the employee’s earnings and tenure.
With a DC plan, you don’t get to take advantage of average mortality rates because you’re not pooling that risk with anyone else, says Randy Bauslaugh, who leads McCarthy Tétrault LLP’s national pensions, benefits, and executive compensation practice.
That means, for example, you may live to 60 or to 105, but maybe you only have enough money to last until you’re 83 (which is the average age people are expected to live).
The issue with a DB plan, though, is employers have a top-up contribution risk; if they have to put more money into the plan, they have to account for that on their financial statements.
The state of today’s DB plans is not necessarily the result of economic volatility, though. In part, it has to do with accounting — and how the rules have changed. “It essentially turned 30-year obligations into something you had to quantify on the balance sheets every year,” says Bush. And, for many organizations, that’s not something they want to do.
With a DC plan, your accounting is easier, says Bauslaugh, but you’re not going to have a tool that will allow you to manipulate the workforce (say, to allow people to retire early).
There has to be some place on the spectrum between a DC and a DB plan with enough flexibility so it can bend when the economic or demographic winds blow strongly. “A lot of single-employer type plans are unbendable,” says Bauslaugh.
That place on the spectrum would be a target benefit plan, which takes attributes from both DC and DB plans and creates a new design that shares risk.
(Target benefits already exist in the multi-employer world, but not in the single-employer world.) Essentially, with this type of plan, you’re targeting a benefit, but not guaranteeing it.
The New Brunswick example
If you have an extremely young or mobile workforce, a DC plan might be the most appropriate option. For some, the DB plan is working, but many others are struggling with cost volatility and sustainability issues due to factors such as increased longevity, changing demographics, and low interest rates, says Jana Steele, a partner in Osler Hoskin & Harcourt LLP’s pensions and benefits group.
“Having a pension to be able to give to employees is a very good attraction and retention tool,” she says. “On the other side of the coin, it has to be affordable — there has to be some cost certainty or affordability from the plan sponsor’s point of view.”
Steele recently drafted key pension documents based on the new shared-risk pension model adopted in New Brunswick. “There’s an inclination to kick the can down the road with things like pensions because politically they’re a bit of a hot potato,” says Steele. “It’s great to see New Brunswick tackle this issue and try to do something innovative on the pension front.”
The province has taken a shared-risk approach — its own variation of a target benefit plan — so there’s a narrow range in which contributions can go up or down. Essentially, it’s like a lever. “A shared-risk model is designed to adapt to changing economic circumstances,” says Steele.
In good years, when the plan is performing well, the extra funds can be used for contribution decreases or enhancing employee benefits. During a bad year, maybe you don’t pay cost of living adjustments; those become conditional in a shared-risk plan.
“What we did is looked all over the world to see who had the best pension plans in Commonwealth countries,” says Susan Rowland, a member of the Task Force on Protecting Pensions in New Brunswick. Rowland, a graduate of Osgoode Hall Law School, has focused her career on pension and benefits law, specializing in the restructuring and funding of pension plans.
“We knew about the Dutch (shared risk) model and how well it had performed,” she says. “We decided to Canadianize it and build on the principles established under the Dutch.” And the secret sauce, she said, is risk management.
“You want the focus to be forward in terms of the management of the plan — not retrospective,” says Rowland. “Right now pension plans in Canada have a retrospective look on which to base their goals for going forward. We have to plan for the future and manage for the future.”
Target benefit plans deal with problems if you get into a deficit, but don’t provide benefit security, says Rowland. What makes N.B.’s shared-risk model different from a target benefit plan is it provides that benefit security, she added. “What you want is benefit security on one side and deficit management on the other.”
The management of the assets in the plan has to meet a test of 97.5 per cent security on a go-forward basis, says Rowland, which provides a high level of benefit security. When you have a bull market, you may not have the returns you’d expect if you were heavily invested in equities, but you’re not focused on the performance of the assets in the plan — you’re focused on maintaining the security of the plan. “You’re not chasing returns — that’s a gamble,” says Rowland.
It’s about matching assets to liabilities; if your testing shows you’re going to have a deficit, the shared-risk model can force contributions from members and the original plan sponsor up to a cap. If that’s not enough, they can then look at ancillary benefits, such as not paying cost of living. Only as a last resort would they cut basic benefits.
Why would employees buy into this? The intention is to allow for the ongoing provision of sustainable benefits. After all, guarantees are only as good as the funding in the pension plan or the solvency of the employer. If the plan sponsor goes into bankruptcy, that guarantee isn’t going to mean much.
“The idea is it does allow for adjustments and some flexibility as you go along instead of without warning seeing a reduction [in your pension] by 40 per cent,” says Hugh Wright, a partner at McInnes Cooper in Halifax and group leader of the firm’s pensions and benefits practice.
“It’s the difference between shaving someone’s head and a haircut,” says Rowland. With a shared-risk plan, there is joint governance between employees and management — and it’s off the books of the employer. It’s a stand-alone entity in and of itself, she adds. And that has big appeal to a lot of employers.
“We’re all in the same boat,” she says. The plan is designed to weather heavy seas — and when the seas are calm you can let the sails out and just go for it.
“That’s the idea behind the plan — set money aside for future benefit increases and pay off any cuts that you might have had to make.”
The shared-risk model has been created as a design option in legislation (which other provinces could adopt). So far, it’s being rolled out by both public- and private-sector organizations in the province, in unionized and non-unionized environments.
It’s anticipated several provinces will bring the target or shared-risk model into force (with regulations) in the near future.
Quebec is introducing target benefits for the pulp and paper industry. Ontario is proposing changes — including some single-employer target benefit provisions — but those have not yet been enforced in regulations and are limited to the collective bargaining workforce. Nova Scotia, Alberta, and B.C. all have proposed legislation.
“It’s unclear what elements of shared-risk models will end up in other jurisdictions,” says Steele. What makes the N.B. model different, she added, is prescribed risk management. “Arguably some form of risk management is a good thing,” she says. “The question is how prescriptive should it be? That’s a policy decision.”
N.B. was way behind the eight ball on shared risk and then leapfrogged ahead, says Bauslaugh. But several provinces allow for jointly managed plans, done on a fiduciary basis (by a board that has a fiduciary obligation to consider all of the stakeholders in the plan).
“New Brunswick made a lot of noise, but it’s not that different really than jointly sponsored plans — they’re already shared risk,” says Bush. “In Ontario there are seven large jointly sponsored plans.” Nova Scotia also has a detailed funding policy, she added, so if they’re funding at a particular level, they reduce or increase benefits accordingly.
Some believe the N.B. model is too rigid, says Bauslaugh. “On the other hand, at least in that risk management spectrum, it’s going to be a benchmark to judge fiduciary decision-making in other provinces.” The other thing it provides is a clear path for converting from an existing DB plan to a shared-risk plan, he added.
The province has provided rules on how to convert existing pension arrangements into these new shared-risk arrangements, whether in a single-employer or multi-employer context. And that, he says, is brilliant. “That’s where New Brunswick has really moved ahead of the pack.”
The N.B. model is based on the Dutch model, which is based on intergenerational equity — that no one generation should pay unduly for the pension benefits of another generation. In other words, if there are adverse economic circumstances, it shouldn’t be the current generation that has to pay for the presently retired generation that didn’t contribute enough to their funds.
The traditional Canadian model, on the other hand, is based on the protection of vested rights — that a promise is to be kept no matter what.
“It’s more a matter of what seems to work for a particular plan or jurisdiction — protecting earned interests or intergenerational interests,” says Wright. “It comes down to financial mathematics. If current employees have to fund retirees to the point where it takes away from the current business, is that the right thing? But should people who work their whole careers [have their pensions reduced]?”
Many private-sector employers offer defined contribution plans (and aren’t willing to undertake the risk of a defined benefit plan), so employees can take their money with them if they leave and move it into an account administered by a financial institution; all risk is on the employee.
“The reality in the private sector is most of the benefit plans are legacy plans,” says Wright.
Shared risk could work in the private sector but it’s not common yet, says Jeremy Forgie, a partner specializing in pension and employee benefits law at Blakes.
But, if an employer has a large enough plan, it could create efficiencies and adjust benefits to be sustainable in the long run.
The New Brunswick model was designed to allow members to decide if they want to stay in the plan if they leave the organization. If they stay in the plan, they reap all the benefits with increasing interest, but they’re treated as deferred members, says Rowland. Or they can transfer the money out to an RRSP.
“The beauty is they get access to sophisticated financial planning of their pension,” says Rowland. “When you’ve got a 2.5 per cent interest rate environment, the only person making money off it is the fund manager.”
Making sure it’s sustainable
The ultimate challenge for employers these days is offering a pension plan in a competitive marketplace to attract and retain employees, but also being efficient so the dollars they’re putting into these plans are translating into value for employees. “It’s more a matter of trying to capture that proper value and ensure their businesses are sustainable,” says Wright.
While shared risk is one way of “de-risking” that has more to do with the design of the plan itself, there are other ways to de-risk.
One is risk management, where organizations look at investment strategies that better match liabilities. “If we ever get to the happy days of interest rates going up, we’d see more movement there,” says Forgie.
We’re seeing more thought going into the development of investment policy, and lawyers may get more involved in looking at policies and working with actuaries to develop those.
Another area is risk transfer strategies, dealing with longevity risk through options such as buy-in annuities. We’re seeing variations on that being developed in Canada, though it’s not as developed as other countries, such as the U.K.
This involves transferring pension risk to private insurance companies, so you would take assets from the pension fund and purchase group annuities (there’s also the option of longevity swaps with a financial institution instead of an insurance company).
A buy in transfers the pension liability funding risk to an insurer, but the responsibility for administering the benefits remains with the employer. A buyout also transfers risk to an insurer, but the sponsor may be responsible if the insurer defaults on annuity payments.
“The real problem with these savings arrangements is the cost of them,” says Bauslaugh. “A one-per-cent management expense ratio over 40 years will eat up about one-third of your savings.”
Some larger clients have a DC plan through an insurance company, and have managed to lower those management expense ratios. But, that begs the question, is that really pension reform?
“We’ve already got group RRSPs that can replicate what PRPPs do,” says Bauslaugh.
No matter which de-risking strategy is taken, pension reform will likely drive legal work for in-house counsel. “We’re going to see a lot of contracts being reviewed with respect to a number of issues,” said Bush. This could be anything from regulatory compliance to longevity hedges to annuity buy ins.
And there’s much to consider: If the organization has had a defined benefit plan for the past 50 years, one issue is whether that can be converted into a target benefit plan or if the organization has to run two separate pension plans. “If I stop a plan now, I have to run that plan until the last retiree dies,” says Bush. “So it’s hopeful the government says ‘this is how you convert.’”
Canada’s unionization has also decreased. With a shared-risk model in the private sector, one issue to consider is the mechanics of picking representation from a non-unionized workforce. (N.B.’s shared-risk model was developed hand-in-hand with unions.)
Pensions used to be the domain of human resources or finance. Increasingly, in-house counsel are being brought in, says Bauslaugh, and in some cases organizations are hiring in-house counsel that have some pension knowledge, particularly where pension obligations exceed the value of the enterprise.
“In-house counsel shouldn’t shy away from this,” says Bauslaugh. “They have a lot of value they can add to the management of the pension plan.”