On May 3, 2010, the federal government released draft regulations, which propose changes to the defined benefit plan funding provisions and the federal investment rules. The proposed changes will directly affect pension plans that are registered under the Pension Benefits Standards Act, 1985 (PBSA) with the Office of the Superintendent of Financial Institutions (OSFI). But don’t stop reading if your plan is not registered with OSFI - the proposed changes to the investment rules will likely impact most pension plans in Canada.

The draft regulations implement a portion of the changes announced by the federal government on October 27, 2009. Other changes to the PBSA announced in the fall were made in Bill C-9, the Budget Bill, which was introduced by the federal government on March 29, 2010. Among other things, Bill C-9 amends the PBSA to require employers to fully fund pension benefits on plan termination, a change which brings the federal pension statute in line with most pension standards legislation in Canada. More amendments will be required to implement the package of proposals announced in 2009.

The draft regulations propose three key changes.

New Solvency Funding Rules

The proposed regulations introduce a new standard for establishing minimum funding requirements on a solvency basis that will use average – rather than current – solvency ratios. Under the proposal, the average solvency position of the plan for funding purposes would be defined as the average of the solvency ratios over three years (i.e., the current and previous two years). The three solvency ratios used in the determination of the average would be based on the market value of plan assets. Past deficiencies would be consolidated annually for the purpose of establishing solvency special payments. To put this funding model into effect, annual filing of valuation reports would be required.

The new standard is intended to mitigate the effects of short-term fluctuations in the value of plan assets and liabilities on solvency funding requirements due to, among other things, volatility in the equity market and changes in interest rate levels, by allowing sponsors to better manage their funding obligations. It is seen by the federal government as a better alternative to extending the amortization period for solvency deficiencies.

The current amortization period for funding solvency deficiencies would thus remain at 5 years (and the going-concern 15 year-period would similarly remain unchanged). The current solvency ratio would also continue to be the relevant measure for all other purposes under the PBSA and the regulations (e.g., for information statements sent to beneficiaries).

These changes would apply to the first actuarial report required to be filed after the proposed regulations come into effect. (However, for the first valuation report filed after the new rules come into force, the solvency ratio on the valuation date may still be used instead of the new averaging method. In that case, solvency assets may be smoothed for a period of up to 5 years.)

In terms of timing, the Regulatory Impact Statement indicates that the new rules will apply to valuations with an effective date of December 31, 2009.

New Restriction on Taking Contribution Holidays

Under the proposed regulations, plan sponsors would only be permitted to take contribution holidays when there is a solvency margin (in excess of full funding) of 5% of the plan’s solvency liabilities. The introduction of this restriction on contribution holidays is intended to create a funding cushion in order to protect plan benefits.

The solvency margin would not be required to be funded. Solvency funding requirements would continue to be based on an objective of bringing the solvency ratio of the pension plan to 1.0. The difference is that where the current solvency ratio exceeds 1.0, but is less than 1.05, the employer would have to continue making its normal cost contributions.

Elimination of the Quantitative Restrictions on Investments in Real Property and Canadian Resource Property

The current regime for pension fund investing combines the “prudent person” approach with a set of quantitative limits. The proposed regulation would eliminate certain of these limits. Specifically, the 5%, 15% and 25% quantitative investment limits in respect of resource and real property investments will be eliminated. These restrictions are viewed by the federal government as “cumbersome and no longer required” in a prudent person environment.

The regulatory impact statement indicates that the government intends to propose further modifications to the investment rules in respect of the 10% concentration limit and the general prohibition on pension fund investment in the shares of its sponsoring employer. However, the statement goes on to say that the 30% rule, “remains appropriate at this time for prudential reasons.”

Because most Canadian jurisdictions have adopted the federal investment rules for purpose of harmonization, this proposed change would have an impact on most pension plans in Canada. However, not all jurisdictions have adopted the federal investment rules in a way which would make the changes apply automatically. Ontario, for example, adopted the investment rules as they read on December 31, 1999 so any changes to the rules made by the federal government would have to be specifically adopted by the Ontario government.

Proposed Regulations out for Comment

Comments on the regulations may be submitted until May 29, 2010. Once finalized, the regulations will come into force on registration.

I expect these regulations will be of interest as much for the issues they address as for those that they do not (such as the 30% rule).