Too little, too late- A 50% interim CV payment would be more appropriate than the proposed 69%!
You may have missed the story not mentioned in the title of Bert Hill’s Ottawa Citizen article “Court names Toronto law firm to represent Nortel pensioners” unless you actually read the article itself, is Nortel’s request for permission of the Court to reduce the CV (commuted value) payments from 86% to 69% (corresponding to the just disclosed estimated Transfer Ratio of 69% for the plan at the end of 2008) for future payments. (Not sure why this Mercer supplied number is an estimate? Is it because they were done on the back of an envelope or the assumptions used were not quite appropriate? Who knows?) You can read for yourself by going to the CCAA Monitor website to get the details behind the proposal. The arguments below are based on my understanding of the situation with the Non-negotiated plan, but I suspect the same would apply to the negotiated plan. This turns out to be good news, bad news and even worse news.
The good news is that this will reduce the haemorrhaging of the already seriously underfunded pension assets in anticipation of the ramp-up of further Nortel downsizing in Canada. For those who argue that reducing CV payouts may be unfair, I couldn’t resist quoting from comments in a Nortel pension group discussion by a retired actuary Dan Anderson that “We are talking here about determining holdbacks, where underpayments can be corrected and where overpayments are not recoverable. It seems strange to argue that pension plan administrators, under threat of legal action by Canadian regulators (or terminating employees?), had no choice but to continue to knowingly pay out excessive non-recoverable commuted value overpayments.” And on that note we can move next to the bad news.
The bad news is that this should have been but wasn’t done not just immediately, but even before bankruptcy protection (CCAA process) was begun. Surely, the fact that the pension plan was not even close to have been funded at the 86% level on January 14th, must have been well known to Nortel and its advisors. In fact there were numerous reports that pension plan underfunding was one of the key drivers for seeking bankruptcy protection at that time. Up to April 24 during the CCAA process, Nortel has permitted $45M to be paid from the Ontario Non-negotiated pension plan assuming plan funded level at 86%, depleting the plan assets by (at least) $9M in excess or the corresponding reduction in liabilities, had the 69% figure been used. That resulted average of overpayment of $45,000 for each of the 197 individuals taking commuted value from the already underfunded plan. (Some even suggest that Nortel used the CV overpayments from pensioners’ funds to dull the pain and compensate fired employees for no severance under the CCAA process.) Of course many more 10s or perhaps 100s of millions were drained by excessive CV payments even before the CCAA process was begun by using the 86% Transfer Ratio assumption.
The even worse news is that the 69% proposed going forward payout is still based on an estimate which in turn is based on overly aggressive assumptions of what the final annuity based haircut pensioners would have to take upon windup, assuming no further injection of funds. Therefore a 50% interim payout would be a safer (and certainly fairer) number to proceed with until the actual outcome is better understood.
So why do I say that 69% is too high? Keeping in mind that I am not an actuary, you’ll have to add your judgement of the facts to my interpretation of the Mercer (the actuaries) estimate tabled by Nortel. There are at least the following three reasons why the Transfer Ratio, and thus the proposed future payments, is still too high at 69%:
- 1. Many would consider the assumptions used in calculation of the provided “estimate” in Appendix A (p.139 in Nortel’s motion documents) as being aggressive and thus resulting in a high estimate of the funded status of the plan. Included the following assumptions:
Lump sum: (discount rate) 4.2% for 10 years, 5.7% thereafter (Comment: Is it reasonable/consistent to assume that if, as indicated in the inflation assumption below, inflation for the next 10 years is 1.34% and after 10 years it is 1.95% i.e. 0.61% increase in inflation rates, yet the discount rates (related to long-term government bond rates will increase from 4.2% to 5.7%% or 1.5% increase? And by the way, while the 4.2% number may(?) be an FSCO specified number, it is still higher than the Bank of Canada website 2008 year-end or average rates for 10 year rates (YE=2.69% and AVG=3.58%), and the 5.7% after 10 years is also higher than the 2008 long-term government bond rates(YE=3.45% and AVG=4.05%)- again perhaps at least a less than conservative assumption on discount rates.)
Annuities: 4.85% for immediate annuity, 4.45% for deferred annuity(Comment: I am not sure how these were arrived at and why the 0.4% lower deferred annuity rates, but neither of these numbers gives me a warm and fuzzy feeling with respect to the 5.7% discount rate used for CV calculation after 10 years.)
Mortality: 1994 tables (Comment: A 2003 TIAA-CREF research paperindicates that “age 65 life expectancy (has been) increasing at about 1.5-2% every five years”. We are in 2009, in the past 15 years the life expectancy may have increased 4.5-6% leading to 3-5+ years longer life expectancy which may add as much as 5-10% increase in pension plan liabilities (hopefully less if the 1994 tables already may have included the forecasted increasing longevity trend that was much clearer in the 2003 report and even clearer in 2009.)
Inflation:1.34% for 10 years, 1.95% thereafter(Comment: I won’t argue whether the proposed inflation rates are to low or high on macroeconomic basis- I’ll let you be the judge. However, if the 5.7% discount rate assumption used after 10 years (relative to the 4.2% assumption for the first 10 years) is correct, then the inflation increase of only 0.61% may perhaps be too low- again perhaps a lack of conservatism, if not inconsistency, in assumptions)
(You can also read about how the assumptions used in actuarial calculations can affect the valuations (or is it “estimates” now) that are then used to make CV payments and current-year/make-up payment calculations, in my last year’s blog entitled “Is your (defined benefit) company pension safe?”)
- 2. On plan wind-up the cost of purchasing annuities would be significantly higher than resulting from the assumptions used in the results presented because: (i) Canadian annuity market is very shallow (non-competitive) it would be difficult to find insurance company (or companies to digest such a large plan and (ii) the insurance company would likely want to include a safety factor to protect itself (some estimate about 10%). To support this view, consider the following (discomforting) quotes from Mercer in the 2006 Nortel non-negotiated plan valuation report:
“…it may not be possible to settle the liabilities at any reasonable cost through the purchase of annuities due to the size of the plan, the size of the annuity market in Canada and the current lack of competitive market for indexed annuities in Canada.”
And calculation of inflation impact is likely too low as “we expect that if an insurance company were to take these obligations…they would demand a significantly higher price.”
- 3. In a related article, in the Financial Times, entitled “UK Pension transfers seen as potential marker for future M&A activity” it discusses a significant increase in competition among insurance companies and that they are now prepared to assume responsibility for pension plans at about 10% above the outstanding liabilities of the plan. Given the likely significantly lower level of competition in Canada among insurance companies (and financial services in general), as compared to the UK or the US, the 10% premium over fair values may turn out to be even low.
So the 69% Transfer Ratio on windup may end up closer to 50% than 70%.
As to Nortel’s motion (#56 in the Factum) asking the Court for declaration that:
“The duties of NNL and any associated persons, including the officers, directors and members of the pension plan committees of NNL and Northern Trust Company, Canada, in conduct of the administration of the Plans and determination of commuted value transfer payments have been discharged by the application of such Transfer Ratio”
Clearly it would be completely inappropriate for Nortel to receive such a sweeping endorsement from the Court that their conduct in plan administration and determination of Transfer Ratio have been discharged; the most you could say is that Nortel has not failed to discharge its duty toward those taking interim CV payouts at the proposed 69% (instead of 89%) or even at 50%. I am very doubtful that Nortel “and any associated persons” have discharged their duties to any of the pension plan beneficiaries (including those taking CVs) given that the likely over-estimated funding level of the plan is 69% and the company is in bankruptcy protection- see my earlier blog Systemic Failure in Canada’s Private Pensions: Who could have prevented it? What could be done now? .
The bottom line is, as I mentioned in May 22, 2009 Hot Off the Web, is that given the expected additional significant demand for CV payments in the next few months by the likely ramp-up of terminations, it is essential to set unrecoverable but only interim CV payments on the low side, until the final actual Transfer Ratio becomes known if and when wind-up should occur. A 50% interim CV payment would be more appropriate than the proposed 69%!