In November of last year, as part of its 2015 Economic Outlook and Fiscal Review, the Ontario government announced its plans to review the current solvency funding rules for defined benefit (DB) pension plans. The expedited review was to focus on plan sustainability, affordability and benefit security.
On July 26, 2016, Ontario released the results of that review, a consultation paper entitled Review of Ontario’s Solvency Funding Framework for Defined Benefit Pension Plans. The Consultation Paper proposes options for reform of the funding rules for DB single employer pension plans (SEPPs).
What Precipitated the Ontario Government’s Review of the Solvency Funding Rules?
The last significant update to the funding rules for DB plans in Ontario was in 1992 and, at that time, the long-term government of Canada bond yields were at about 9%. Since 1992, bond yields have fallen precipitously and have remained low for many years now. At the end of July 2016, the long-term government of Canada bond yield was just 1.60%. In addition to lower bond yields, since 1992, there have been several updates to the mortality tables required to be used for solvency valuations in order to reflect that retirees are now living much longer. The much lower interest rates, coupled with the increased longevity of retirees, has resulted in solvency valuations becoming the driving force in determining the minimum required funding contributions for most DB plans. Volatile equity market returns have further exacerbated the funding challenges that DB plan sponsors face.
As a result of these challenges, Ontario implemented three rounds of temporary solvency relief in 2009, 2012 and 2015. These temporary solvency relief measures allowed plan sponsors to spread the funding of their solvency deficiencies over longer periods of time. Despite these measures, the existing solvency funding regime continues to create challenges for DB plan sponsors. As a result, the Ontario government initiated a review of the solvency funding rules and has started this process by seeking input from various stakeholders on its Consultation Paper by September 30, 2016.
The Background: Plan Sponsor Concerns
As part of its review, Ontario acknowledged that DB plan sponsors have raised the following concerns:
- Contribution Volatility – many DB plan sponsors are invested in assets that do not closely track the changes in the value of their plan liabilities. The falling bond yields and volatile equity market returns have resulted in contribution volatility, making it difficult for companies to budget for contributions.
- Procyclical Contribution Requirements – The lower bond yields and equity market losses often occur at the same time that companies are facing economic challenges and, as a result, increased contribution requirements typically occur when companies have less available cash flow.
- High Cost of Benefit Security – Solvency funding assumes that a plan is wound up on the valuation date and some are of the view that this results in excessive funds being allocated to their plans instead of being invested in their businesses.
- Complexity and Lack of Transparency– The current funding rules are complex and difficult to understand for most DB plan beneficiaries.
- Potential Surplus Issues – Depending on the future economic environment, large solvency contributions now could result in plan surpluses in future – a result that plan sponsors wish to avoid.
Two Main Approaches to Solvency Funding Reform
Ontario is considering two broad approaches to reforming the SEPP funding rules:
- first, modify the solvency funding rules; or
- second, eliminate the solvency funding requirements and strengthen going concern funding.
Under each of these approaches, a number of different options are available.
Approach A – Modified Solvency Funding Rules
Under this approach, the Consultation Paper discusses the following options:
- Option 1: Average Solvency Ratios – Plans would be required to fund a deficiency derived from an average solvency ratio calculated over three years. One fifth of this deficiency would be required to be funded each year. Alternatively, pension plans could be funded according to the lower of the average solvency ratio and the actual solvency ratio on the valuation date. Either of these approaches would result in less volatile contribution requirements.
- Option 2: Lengthening the Amortization Period – Solvency deficiencies would be amortized over a period longer than five years (e.g., 10 years). This option would reduce the size of solvency funding payments.
- Option 3: Consolidation of Solvency Deficiencies – When there is a solvency deficiency at a valuation date, rather than establishing a new solvency payment schedule, solvency deficiencies could be consolidated and re-amortized at each valuation date. In most cases, this would result in a reduction in the size of solvency funding payments.
- Option 4: Funding a Percentage of the Solvency Liability – Rather than full funding on a solvency basis, a plan could instead be funded based on a percentage of the solvency liability. This would result in reduced solvency payments. Because this option involves a lower benefit security for plan beneficiaries, it could be coupled with an increase in the $1,000 monthly PBGF guarantee.
- Option 5: Solvency Funding for Certain Benefits Only – Under this option, normal retirement benefits would be funded on a going concern basis only, coupled with an increase in the $1,000 monthly PBGF guarantee for normal retirement benefits. Plans offering additional benefits like subsidized early retirement benefits could fund those benefits on a going concern and solvency basis. Alternatively, normal retirement benefits could be funded on both a going concern and solvency basis while any additional benefits would be funded on a going concern basis only. Any increase in the PBGF guarantee would be in respect of the additional benefits only. These approaches would result in lower contribution volatility while addressing benefit security issues.
- Option 6: Use of Solvency Reserve Accounts – Contributions made in respect of a solvency deficiency could be held in a solvency reserve account (SRA) which is a separate account maintained within a pension plan. When a plan's solvency position is at a certain level above 100%, some of that surplus could be withdrawn. This approach would minimize plan sponsor concerns over high solvency contributions resulting in large surpluses (which in turn could cause sponsors to refrain from making more than the minimum required contributions). Sponsors’ concerns about having large surpluses would be alleviated while benefit security through solvency funding would be maintained. SRAs are currently available under Alberta and British Columbia pension legislation.
- Option 7: Use of Letters of Credit – Letters of credit could be used to cover solvency special payments for more than 15% of a plan's solvency liabilities. This approach would result in reduced solvency payments while continuing to provide benefit security. Letters of credit are currently permitted in a number of jurisdictions and their use is subject to certain prescribed conditions.
Approach B – Eliminate Current Solvency Funding Requirements and Strengthen Going Concern Funding
Under this approach (which is the approach that has been taken in the Province of Quebec since January 1, 2016), the following options are available:
- Option 1: Provision for Adverse Deviation – Funding under a plan would include a Provision for Adverse Deviation (PfAD) prior to any changes being made that could weaken the plan’s funded status, e.g., benefit improvements. By increasing a pension plan’s assets, a PfAD provides some benefit security otherwise provided through solvency funding. The PfAD would be higher for plans with a greater degree of asset/liability mismatch.
- Option 2: Shortening the Amortization Period - Going concern special payments could be amortized over less than the current 15-year period. This would result in increased contribution requirements which, in turn, would improve benefit security.
- Option 3: Restrictions on Plan Assumptions – Plans could require more conservative assumptions for a going concern valuation, e.g., interest rate assumptions. In so doing, benefit security would be enhanced because plan sponsors would be prevented from significantly relying on investment returns to fund accrued benefits.
- Option 4: Solvency Trigger for Enhanced Funding – Despite solvency funding no longer being required, if a plan were to fall below a certain solvency threshold, then additional funding like a lump sum contribution could be required or a plan could be prohibited from taking any action that would weaken its funded position.
- Option 5: PBGF Enhancement – Enhancements could be made to the PBGF, including an increase to the PBGF level of protection - which would result in an increased level of benefit security.
Any option involving an increased level of benefit protection from the PBGF would also require increased PBGF assessments on the part of DB plan sponsors with Ontario members.
Additional Reform Measures
Ontario is also seeking input on certain additional possible reform measures, including:
- Requirement for Annual Valuation Reports: Valuation reports could be required to be filed annually on consistent dates regardless of the funded position of a plan. The report could be required to include the plan’s going concern and solvency financial positions despite the elimination of solvency funding. Annual valuations would increase transparency and disclosure to plan beneficiaries.
- Mandatory Governance and Funding Policies: Plan administrators could be required to establish and file written governance and funding policies, which would increase transparency for plan beneficiaries.
- Modification of Commuted Values: Commuted value payout rules could be modified to reflect the underlying pension plan risks, e.g., by increasing the interest rate used to calculate commuted values. This could reduce a plan sponsor’s costs by reducing the commuted value payout amounts to terminating members.
- Further Restrictions on Contribution Holidays and Benefit Improvements: Additional restrictions could be imposed on contribution holidays. For example, contribution holidays could be permitted only if a Provision for Adverse Deviation (PfAD) is fully funded. Further funding restrictions could also be imposed on plan benefit improvements. If a plan’s going concern funded ratio is less than a certain threshold percentage, then the portion of the benefit improvement below the threshold could be immediately funded and the remaining portion of the benefit improvement funded over an amortization period shorter than that for other funding deficiencies.
- Administrator Discharge on Annuity Buyouts: Plan administrators who purchase buyout annuities for certain plan beneficiaries retain the related pension obligations (unless members transfer their commuted values out of the plan or if annuities are purchased during a wind up). Instead, plan administrators could be fully discharged provided certain conditions are met. If an insurer becomes insolvent, Assuris provides annuity insurance which provides greater coverage than the PBGF. If plan administrators are permitted a discharge on an annuity buyout, then more plan administrators may consider buyout annuities.
- Increasing PBGF Coverage: The level of benefit guaranteed by the PBGF could be increased, together with a corresponding adjustment to the PBGF assessment formula.
What this Means for DB Plan Sponsors
Sponsors of single-employer DB plans in Ontario will be impacted by changes to the funding rules. Plan sponsors may wish to consider providing their input on the options outlined in the Consultation Paper. The Ontario government is keen to hear from as many stakeholders as possible as it strives to improve the solvency funding requirements in a way that balances the interests of plan members and plan sponsors alike.