What’s wrong with private sector defined benefit pension plans? Everything? …Problems and Solutions
(Originally posted October 27, 2008 re-hosted March 5, 2012)
A series of actions/circumstances, any one of which could be individually damaging to the welfare of pensioners, when taken together could threaten to destroy the retirement of millions of Canadians. The problems are numerous: (1) pension plan sponsors taking contribution holidays to reduce expenses and prevent pension plan overfunding, (2) plans are running with underfunded and unimmunized portfolios which have prescribed/contractual payouts, (3) pension plans are directed by administrators/trustees often challenged by potential conflicts of interest, (4) plan administrators are supported by professionals also often challenged by potential conflict of interest who may be recommending aggressive practices and (5) plans are overseen by ineffective regulation and regulators. Altogether this leads me to think that the private-sector pension plan member is significantly exposed. In fact, the condition of the pensioner, reminds me of story about the fellow who jumped out of the top of the Empire State building and, as he passed the 10th floor, said to himself: “So far, so good!”
I have little comfort to offer to those asking me if their private sector pensions are secure because of:
-disincentive to overfund and tendency to use (some would say inappropriately) aggressive pension portfolio asset allocations, no doubt encouraged by investment advisors clamoring to secure plan’s asset management business, instead of a prudent approach of asset-liability matched immunized portfolios
-infrequently and opaquely reported pension plan funded status is often based on very optimistic (actuarial) assumptions; valuation is done by actuaries hired/fired at the discretion of the plan sponsor; actuarial standards are subject to considerable discretion and in dire need of updating to current realities (some might even tempted to think that they have no fiduciary/professional responsibilities toward plan members/beneficiaries)
-plan administrator is often one and the same as the plan sponsor and the employer of the plan member with perceived short-term incentive to minimize contributions to the plan and take excessive risk with plan assets (even though the administrator has unquestionable fiduciary duty to plan members/beneficiaries)
-inadequate legislative protection to insure that pension benefits (which are deferred wages) are protected (inadequate regulatory requirements)
-regulators, while constrained by the existing inadequate regulations, often tend to apply a lenient interpretation of existing requirements
-and finally, if your sponsor goes into bankruptcy you may have to line up with other unsecured creditors to try to recover the any pension funding shortfall
In an earlier blog, “Is your (defined benefit) company pension safe?” , I explored some of the issues associated with the valuation mechanism used to establish the funding status of non-public pension plans in Canada and attempted to provide some rules of thumb that you may wish to use to adjust the funding status published by your employer/plan-sponsor. As previously indicated, while I am neither an actuary nor an accountant, I spent some more time reading up on the problems and the situation may be even more complicated and depressing than I thought. This is where my further reading has led me to:
- Discount rates– there are actually not two (as I mentioned previously) but three discount rates that are used for valuation of liabilities. This may sound to some a little bit like, “tell me what answer you would like” and the answer “depends who is asking”. The “solvency” discount rate (to be used assuming immediate wind-up of the plan) is related to the then available medium/ long-term government bond rates. The “going concern basis” discount rate (to be used assuming that the plan, and sponsor, continue indefinitely), I indicated earlier, is based on high quality (AA) long-term corporate bond rates (e.g. Towers-Perrin’s Global Capital Markets Update Q2’2008 ) . Well, this is only partly true; the accounting standards specify their use for calculation of long-term corporate pension liabilities. However the actuarial and regulatory standards/practices for “going concern valuation” funded status do not require the use of this AA corporate bond rate related discount rate for reporting status to pensioners and regulators . Instead, they often use a rate related to, believe it or not, the expected return on the plan’s assets?!? This is truly amazing, or perhaps ridiculous would be more appropriate description. What this means is that the more risk you take with the plan assets (and thus might expect a higher return) the higher the discount rate that you can then use for the calculation of the present value of the liabilities. This is alchemy! Discount rates used for accounting purposes should be required to be used for regulatory going concern valuation.
- Commuted (or Cash) Value (CV) – Upon retirement or when a pension plan member leaves the employment of the plan sponsor, she has the option to take the CV and transfer it into an individual locked in retirement plan. The bad news is that for underfunded plans, the departing member may be given an unfair share of the available assets on the assumption that the remaining members will receive their pensions anyway. While this may be true so long that the company stays solvent, however should the company declare bankruptcy all bets are off; in effect when somebody takes the CV, she may be aggravating the underfunded status of the plan for the remaining members. The Canadian Institute of Actuaries is looking at adjusting (increasing) the discount rate used for CV calculation (the present value of future received payments) for pension plans with and without an inflation adjustment component, and to using more accurate mortality expectations. . If adopted this would be an improvement but would not fully address the CV issue of underfunded plans.
- Bankruptcy protection– The situation has gotten a little better this past summer, with changes in the bankruptcy laws, current year payments due to a pension plan are now at the same priority as outstanding wages (ahead of other creditors). This is an improvement, but does not deal with the existing underfunding of the plan even though pensions are nothing more than deferred wages (Is that not what employees are told- pensions are part of the compensation cost?). Additional legislation is urgently required to protect 100% of the pensions with either giving pension deficits the same priority as wages in case of bankruptcy or mechanism are required for insuring against shortfall.
- Reporting frequency – The FSCO (the Ontario regulator of pensions) has recently tightened the rules for calculating transfer ratio (a solvency measure- the ratio of assets-to-liabilities upon immediate wind-up) to require inclusion of the effect of inflation on plan liabilities (previously it was optional). This would be a positive step, however the criteria for the use of the resulting ratio was then relaxed. Previously is the ratio was between 0.8-0.9 (i.e. 10-20% underfunded plan) then an annual valuation report was required by the FSCO. However, when inflation requirement was added to the calculation, the annual reporting requirement was relaxed. (So, let’s measure the underfunding more accurately, but if the indication is that the plan is in trouble, you don’t have to do anything about it- not even report it more frequently!) Over three years the funding status could easily deteriorate from 100% to under 70% funded and the sponsor/employer’s credit rating may drop dramatically or sponsor may even be on the verge of bankruptcy. Once every three years valuation reporting requirement is completely inadequate. Annual pension plan valuation should be a requirement for regulatory purposes just as it is a requirement for account purposes.
- Governance and Standards required of pension trustees and administrators imply fiduciary responsibility toward plan beneficiaries “Standards required of pension plan and pension fund trustees in Canada” and “FSCO: Administrator” (Similarly actuaries and investment managers are accountable for professional best practice standards and Codes of Conduct, and probably implicit fiduciary responsibility as well.) A good place to start may be to read the Code of Conduct for Members of a Pension Scheme Governing Body tabled by the CFA Institute Centre for Financial Market Integrity and a working group of global pension experts, described in “Who is managing your retirement income” . I suspect it must be quite a challenge to operate without a conflict of interest given the current incestuous relationship between administrator, trustee, actuary, investment manager, etc and multiple roles often played by the same person or delegated to hired/dependent professional, while regulators are standing by without demanding appropriate checks and balances; yet there must be no letting down one’s guard to insure that legal and ethical responsibilities owed to plan members stay intact.
- Class action suits– In “Pension Plans Under Attack” Craig Ferris quotes: “Mr. Justice Winkler of the Ontario Superior Court of Justice, who has dealt with many class action cases, writing extra-judicially, made the following observation: “…that pension and benefit class actions are the way of the future should serve as a warning to these individuals that the previous barriers surrounding this type of litigation no longer exist. The bottom line is that trustees, plan administrators, advisors, professional, among others, should assume that if they do not fulfill their fiduciary and other duties or do not do their jobs properly, they will be sued. The days of being insulated by cost and psychological barriers that previously affected plaintiffs are gone”.” An example of a class action suit is in the case of shortfall on plan wind-up (or sponsor bankruptcy). In the previously referred to paper, various other class action suits are described against trustees, Board of Directors (as an entity and as individuals) and officers of the company, actuaries and investment managers for assorted failures to perform fiduciary or professional duties, to protect plan members and beneficiaries. (I haven’t come across examples of actions against regulators for failure to do due diligence and oversight of the pension fund within the law of the land; let me know if any of you have.)
- Appropriate pension portfolio– Despite the fact that it’s well known that the appropriate portfolio for a pension plan is one that matches assets to (the bond-like) liabilities (called an immunized portfolio using asset-liability matching), plan sponsors have become increasingly aggressive in the use of a high proportion of equities in pension portfolios. Sponsors have been chasing returns in the hope of reducing required pension contributions. In “Pension Tensions” there is an extensive overview of how we got here. The resulting impact is that many plan having larger pension liabilities than the sponsoring company’s market value, and in fact there are some pension plans which have funding shortfall significantly larger than sponsor’s market value! Interestingly, the authors Por and Jannucci indicate that “even if a plan earns a premium return on equities, generates value added by its managers and thus lowers its costs and increases its contribution to the company’s bottom line, it will not necessarily enhance shareholder value. The reduction in costs and increase in corporate earnings will be accompanied by a higher volatility of those earnings and thus will increase the company’s financial risk, with little or no impact in share price. If anything, the impact on share price will be negative, as the increase in risks is likely to be greater than the potential rewards of investing in equities, given the restrictions that pension regulators typically place on the use of surplus. The company’s shareholders are not compensated for bearing this additional risk.” So reckless use of risky pension portfolios provides illusory value to shareholder and ends up increasing the risk to many pensioners.
Conclusion- What should be done by party in this crisis?
Pensioner or pension plan member:
-look at reported funded status and discount it if assumptions are not realistic and request action from administrator to eliminate funding shortfall
-if you think that there is near-term risk of the sponsor becoming insolvent, consider if you could live with 80% or 70% or 60% of your expected defined benefit pension plan (i.e. do you have other assets you could tap, or could you secure part time work to get additional income or could you reduce/adjust your lifestyle accordingly?)
-write to Federal and Provincial legislators and regulators and about the state of the pension system and your plan in particular
– write to the Board of Directors of you sponsor/employer expressing your concerns about your pension plan transparency and underfunding
Members of the sponsor’s Board of Directors, officers, pension plan trustees/administrators, in order to fulfill their duty to secure the pension obligation to plan members and to reduce personal exposure to class action litigation, they must insure that they are acting in the best interest of plan members and beneficiaries (not the plan sponsor). In fact, a good place to start would be to read the Code of Conduct for Members of a Pension Scheme Governing Body tabled by the CFA Institute Centre for Financial Market Integrity and a working group of global pension experts, described in “Who is managing your retirement income”
Legislators must introduce requirements to insure that significant pension shortfalls cannot happen and must specify reporting requirements which insure transparency and timely disclosure of funded status of pensions (The Ontario Expert Commission on Pensions is expected to table its recommendations before the end of the year.)
Regulator, pending improved legislation, must bring to bear the strictest interpretation of the existing regulation to maximize protection of pension plan members/beneficiaries
Actuaries, as the expert professionals in this complex subject, must take a leadership role by reforming standards of practice and recommending necessary legislation to protect pension plan members/beneficiaries
Investment managers for the pension plans has responsibility to educate those with fiduciary responsibility about the appropriate asset mix corresponding to pension liabilities and the risk of exposing pension assets to undue volatility, and insure that resulting implementation is consistent with what a pension plan’s objectives
The Bottom Line on Pensions- Immediate action is required to:
- 1. protect accrued benefits of millions of private-sector pensioners with defined benefit plans (as described above)
- 2. start work on a re-architected next generation pension plan for our children and grandchildren. A good place to start would be to look at a new Pillar 3 of the pension system (Pillar 1 is OAS, Pillar 2 is CPP) for the still working and next generation of Canadians based on a recent proposal tabled by the C.D. Howe Institute CSSP- Canada Supplementary Pension Plan (similar plans were recently introduced in Australia, Holland and New Zealand).