Ontario Expert Commission on Pensions Commissioner Arthurs’ report “an iron fist in a velvet glove”

I finished reading last night the Ontario Expert Commission on Pensions Commissioner Arthurs’ report “A Fine Balance- Safe Pensions, Affordable Plans and Fair Rules” Reading the title of the report I got worried about its content, however when I finished reading it, I thought it was more like an “iron fist in a velvet glove” as he systematically enumerated everything that is broken in Canada’s(Ontario’s) pension system. This monumental work in breadth and depth on an extremely complex subject, and will be studied for years by forensic pension investigators (and hopefully very quickly by the Ontario and Federal governments, as time is running out for many pensioners). This is a thorough educational/historical source on Canada’s pension system, even aside of the far ranging recommendations.

The Commission certainly walks a “fine line” to try to strike a balance between the competing interests embedded in Ontario’s defined benefit pension plan. The two year effort, resulting in the thorough and well thought out 200+ page report (even the summary runs to 10 pages) with no less than 142 recommendations, certainly demonstrates beyond any doubt how thoroughly dysfunctional Ontario’s (and Canada’s) defined benefit system really is.

Perhaps because of the Commission’s mandate much of the focus of the Commission report is that of ”maintaining and encouraging the system of defined benefit pension plans in Ontario” the report spends a lot of time looking for the reasons of the decline of DB plans and how to reverse the decline. While the report recognizes that structural problems with plans and the ”perfect storm” that was/is faced by pension plans in this decade may have contributed, but DB plan decline is attributed to the diminished union density  and decreasing employment in sectors where DB pension plans were historically common”. I am not convinced; I suspect the structural flaws and reality of changed labor mobility alone may have been sufficient to kill DB plans.

The single biggest problem with the recommendations- SEPP Valuation Frequency

Let me zero in quickly on what I think is my biggest issue with the recommendations. The report recommends the maintenance of the current requirement of valuations only once every 3 years (unless some tests are violated), for all types of plans. Now the report spends a great deal of time explaining clearly and in detail (Section 4.5) the differences between SEPPs (Single Employer Pension Plans), MEPPs (Multiemployer Pension Plans) and JSPPs (Jointly Sponsored Pension Plans). The report went to a lot of trouble specifically listing reasons why SEPP members have the greatest exposure/risk associated with: sponsor insolvency, sponsor acting unilaterally, sponsor sole contributor, contractually fixed (accrued) benefit, private-sector sponsor, and often no union representation (in addition to the many other problems that plague the entire pension system). The report then correctly concluded no one size fits all solution is possible. Yet recommending the maintenance of the current once every 3 year valuation requirement for SEPPs is a serious problem, in the otherwise well balanced report. The problem is that for private sector SEPPs 3 years can be an eternity because single employer acts unilaterally and may go bankrupt with a significantly underfunded pension plan. And that in turn exposes beneficiaries as potential unsecured creditors in the bankruptcy court. For MEPPs and JSPPs plan members are exclusively or jointly responsible for plan governance, whereas for SEPPs the sponsor acts unilaterally.

(Before I continue, I need to declare my parochial interest on SEPPs because I am a member of one, and my plan sponsor was reported in today’s papers to be “seeking legal advice on exploring bankruptcy” and at the last valuation reflecting the situation almost two years ago a solvency funding level of 86% and a going concern funding level of 106% was claimed. No doubt, today’s the solvency funded status is much deteriorated.)

Report Highlights

It is impossible to do justice to the report with any granularity. I’ll try to share with you what I considered important highlights.

The report starts with historical background of Canada’s pension system and proceeds to describe the not just the declining participation but the shift from (bad) DB to (worse) DC pensions. Even worse, many plans have recently failed and many more are significantly underfunded and at risk of not meeting the promises made to pensioners. The report also point out that the limited extent and breadth of coverage and lack of portability have been known unaddressed issues for decades, and recently these were compounded by looming pension plan failures. (In reality it is somewhat of an oxymoron to call plans other than SEPPs “defined benefit” since as the report’s Section 4.5 explains, only SEPPs have “fixed” benefits, whereas MEPPs have target and JSPPs have adjustable benefits if plan is underfunded on wind-up.)

Next the Commission establishes a set of principles upon it bases its recommendations. Considering current realities of the day some may challenge the first two principles (which no doubt were at least in part due to the Commissions mandate) : (1)to maintain/encourage DB pension plans (not sure this is realistic in light of the mobility of the 21^st century workforce- which by the way is mentioned in the report as problem area) and (2) to have a voluntary system (while employer is not required to have a DB pension plan, DB plan participation is compulsory for employees; also  we seem to have legislated compulsory helmets for bikers, no smoking in public places, seatbelts for our protection, compulsory automobile insurance- so why not compulsory saving for retirement?)

The report then proceeds to dig into what’s wrong with the current system? Just about everything. Actuaries are determining valuations for regulatory reporting by mechanisms of considerable discretion. A blatant example is the use of out of date mortality tables that lead to intentional underestimation of liabilities and thus to underfunding of plans.

Federal/provincial constitutional and jurisdictional “complications” (federal, provincial, ministries responsible for income tax, bankruptcy/insolvency and provinces often are responsible for pensions). Income Tax Act limits pension registration to an overly restrictive definition of “employee”, thus excluding many potential pension plan participants. Income Tax Act rules and legal constraints limiting sponsors’ access to plan surplus, creating a strong deterrent to excess contributions in good times. And “Inherent structural flaws” and “the perfect storm”(falling interest rate pushing liabilities up coupled with falling equity values reducing assets values, aggravated by increasing longevity).

To top it all off, reading the report, I concluded that the SEPPs are probably in the worst condition since the employer is holding all the cards, act unilaterally, and intentionally or due to incompetence may not act in the best interest of the beneficiaries resulting in debilitating consequences to pensioners.

The Recommendations

The 142 recommendations of the Commission tackle: funding, impact of rapid economic change, plan failures, regulation and governance. Though not explicitly part of the Commissions’ mandate it also addresses innovative (transformational/revolutionary) pension (re)design at the end of the report. The need for 142 recommendations clearly indicates that the pension system in not just dysfunctional, but completely broken.

Funding recommendations include more actuarial “transparency and structured discretion”, regulatory over-ride when valuation “materially misrepresents” funding status, and stop practice of excluding the cost of benefits in valuations. Many other interesting and useful funding related recommendation are included; of particular interest may be some compulsory inflation adjustment in case of “inflation emergencies”, the use of “asset pledges and “irrevocable letters of credit” to secure shortfalls. Also included is a list of changes for the Federal government like increasing benefit and contribution levels under the Income Tax Act and removal of prohibition on certain investments. (No mention that going concern valuations under accounting and actuarial professional standards can vary dramatically due to discretionary actuarial discount rates, including the ludicrous situation whereby the more risk the plan portfolio takes the higher the discount rate that may be used for liabilities!?!)  Altogether there are 25 funding recommendations.

Recommendations associated with Changing Economy deal with extreme delays in regulatory approvals of transactions, establishment of an Ontario Pension Agency to receive funds of stranded pensions, remove impediments to plan transfers, permit phased retirements. (I found no mention of the fair treatment remaining plan members when commuted value of is calculated for a departing member in and a significantly underfunded plan. There are a total of 23 recommendations in this category.

In the When Plans Fail section the 19 recommendations include powers to the regulator to identify at risk plans and require more frequent valuations, additional payments or security (regulator certainly has not demonstrated ability to be able to do anything of this complexity/authority, in fact I doubt that regulator is even using the discretion available under current legislation to demand compliance), and the all important recommendation that the federal government should extend “priority to all special payments to fund both solvency deficiencies and unfunded liabilities owing to the plan by the sponsor at the time of insolvency”, increase the insurance under Pension Benefit Guarantee Fund maximum to $2,500 per month from current $1,000 (given the risks borne by SEPP members the maximum should be increased to at least $4,000).

While the other sections of the report clearly had punch, the Regulation and Governance sections were the ones that delivered the K.O. punches for me.

The Regulation section states that “As a result, the substantive rules of the regulatory system are almost incomprehensible to anyone who is not an expert in the field — including most especially employers who must honour the pension promise and workers who are its beneficiaries. Pension plans, and their sponsors and beneficiaries, must therefore invest heavily in legal, actuarial, accounting, investment and other professional advice.” A major rework of the Pension Benefit Act is recommended so the “PBA becomes the single, authoritative source of all substantive and procedural rules governing the field” by “both rules-based and principle-based approaches.” Also that “The government should accept ultimate responsibility for insuring that standards governing the conduct of professional and other participants in the pension system are appropriate and in the public interest” (clear indication that some of the professional bodies playing key roles in the outcome of pensions have failed in their roles and perhaps even succumbed to conflicts of interest which challenge the current relationships.)

On the effectiveness of current Regulator(s) and Regulations, the Commission has recommendations in all areas: passive (insufficient and improperly organized data), active (too long to review/approve transactions and too much “informal” discussion), proactive (develop programs to detect sponsors/and plans at risk) and reactive (inadequate handling of enquiries/complaints); creation of a Complaints Office is recommended to deal with the latter. Recommendations are also tabled to increase the effectiveness of the FSCO and its Superintendent in the context of current powers, and to extend additional powers to them. In addition, the Regulator should institute thorough self-evaluation program and report the findings in a transparent fashion. Then the clincher is that the Commission in effect recommends the creation of a dedicated Ontario Pension Regulator with re-architected mission, structure and operation; not a surprise given the perceived lack of effectiveness with which the FSCO has been operating in the pension domain. While the Commission recommends significant increase in the quality and quantity of regulatory staff, it also recommends some simple improvements (sponsor creditworthiness and plan size) in its risk-based approach to the regulator’s function. Commission also recommends “rule-making” powers to the new Ontario Pension Regulator (OPR), similar to the SEC- since legislative time constants are too long. In effect the Commission covers the shortcomings of the FSCO in the pension domain quite thoroughly and then dispatches it appropriately out of existence. A total of 31 recommendations comprise the Regulation section.

Governance is my other favorite section of the report. Governance issues are particularly severe with SEPPs, which often suffer most from sponsor unilateralism and lack of transparency. The two-thirds of SEPPs which are not union represented essentially leave members at the mercy of the sponsor’s unilateral actions. Special regulatory vigilance is recommended for SEPPs, to protect members’ interests. The conflicts of interest in the current governance of plans (especially SEPPs) are rife; the Commission recommendations include specific actions to eliminate conflicts of interest (act in the best interest of the plan, representation by active and retired members and retaining arm’s length professional administrators). Not only the administrators are in a position of potential conflict of interest, but actuaries are in a particularly precarious position due to their “inherently conflicted role”. (The same can be said of investment managers who recommend and/or execute inappropriately aggressive investment strategies.) The current actuarial claim that they are just “provider of information” and the sponsor makes the final funding decision and that they demand written assurances that if sued, the client will compensate them for any awarded damages, are ludicrous (my, not the Commissioner’s, descriptor). The Commissioner recommends immediate consultations with professional governing bodies to insure that “members provide service in the pension context in a manner consistent with the good governance and proper regulation of pension plans” and the fiduciary responsibilities associated with those professional role (i.e. they are often NOT acting in that manner today!). Access to information is essential for all plan members (even SEPP members) and Commission recommends that the regulator provide access to all available (and hopefully appropriate information) to plan members in an understandable manner and plan administrator to provide an annual statement to plan members (including funded status of the plan). Other governance recommendations is the publication to members and regulator of plan’s “governance, funding and investment policies”, establishment of a Pension Advisory Committee for each plan (which includes active and retired members),  participation by retired members to the same extent as active members in governance of and information pertaining to the plan. This is wonderful chapter with 30 recommendations.

In the Innovation section you could call beyond DB or DC and it contains 5 recommendations. After discussing differences between DB and DC, the chapter on pension innovation opens the door on exploring options beyond the current models. Currently available alternative models are enumerated and the proposed Pension Champion is assigned the task of driving innovation in plan design. The advantages of size in running pension plans then leads the Commission to recommend consideration of CPP as a model with its inherent advantage of size and its implicit “target benefit” strategy (i.e. aiming for a DB-like pension outcome but with allowance for benefit reduction and/or plan participants’ increased contribution). Improvements to the CPP may include increasing the 25% benefit and increasing the maximum earnings to which the benefits accrue. The report then recommends a series of mechanisms that would allow aggregation of small plans into larger ones and open access even to individuals who do not otherwise have access to a pension.

In the final chapter the Commissioner looks at the future of Ontario’s DB pension system. The Commissioner has realistic expectations considering that Ontario’s pension system is “too complex, too convoluted and especially too conflicted”. And finally a key recommendation is for Ontario to identify an agency or unit of government as its Pension Champion driving change in the pension system and another one to initiate a drive toward harmonization and policy coordination across provinces and the federal government. The report then closes with a call for urgent action which is needed now!

Conclusion

As I indicated earlier, this is an impressive report. It is impressive in its depth, its breath, its perceptive insight into the flaws of the current system and (with very few exceptions) its recommendations. In some way, I would have preferred much fewer recommendations or even perhaps just a next generation pension plan architecture with a recommended transition plan from the current system. But much of the work of the Commission was driven by its mandate established over two years ago, and the world has changed dramatically since then. The ball is now in the court of the Ontario (and federal) government(s) which has signaled their intention to act promptly on the matter of pensions. I sure hope that they will have the wisdom to do quickly for the sake of many of us.

Feedback to the Ontario government is due before February 27, 2009

The Ontario government “is seeking feedback on the report from Ontarians, with a written comment period ending February 27, 2009, and is committed to introducing legislation.