Canada's Pension Plan Straitjacket?

Michel Kelly-Gagnon, president of the Montreal Economic Institute, wrote an op-ed for the Toronto Sun on Canada's pension plan straitjacket:

Defined-benefit private pension plans are those in which an employer promises a predetermined monthly benefit based on the employee's earnings history, tenure of service and age, rather than depending on investment returns.

In Canada, these plans are under a lot of stress. About 90% of them have a so-called "solvency" deficit, meaning they would come up short if the companies sponsoring them were suddenly to go bankrupt or otherwise cease their operations. When a company goes bankrupt, employees' benefits have to be paid out at once, and retirees' pensions have to be purchased from an insurance company.

The main cause of these solvency deficits is that long-term interest rates are exceptionally low. For example, since 2000, rates have decreased from 6% to 2.5% on long-term federal government bonds and from 4% to 0.3% on real return bonds used in indexed pension plans. This reduces investment returns, but the benefits are not accordingly adjusted.

As I wrote in a column in June, this is another unfortunate consequence of our current monetary policy. It creates a major problem for many Canadian companies that have those types of pension plans. Air Canada, Resolute Forest Products, Canadian Pacific, Bell Canada, Canada Post, Canadian National, are but a few of the companies impacted.

Several of Canada's competitors, including the U.S, have taken concrete steps to help companies cope with the problem, while Canada has not.

For example, American companies that sponsor a defined-benefit pension plan are now allowed to use a discount rate to fund their plans based on the average of corporate bond rates over 25 years. Currently, this produces a discount rate of about 6.5%. Conversely, Canadian pension regulators require a discount rate based on federal government bonds; this rate is currently around 3%.

The discount rate is an assumption made of the rate of return that the plan's assets will earn in the future. The higher the returns, the lower the capital needed now in order to be able to pay the pensions when employees retire.

This means that if Canadian companies that have defined-benefit pension plans were allowed to use the same rules as their American competitors, their liabilities would be reduced by about 50%. Actually, most of them wouldn't even be considered as having a deficit.

The U.K., Sweden and Denmark have also indicated they would follow the U.S. move.

The practical consequence of all of this is that Canadian companies suffer a substantial drain on their cash flows since they have to make important "deficit payments" that sometimes represent up to 30% of their total payroll. This is money that is not available to make investments, give pay raises or hire new employees.

Let's take for example the case of Resolute Forest Products (the former AbitibiBowater). Their Canadian pension plans have performed well, in relative terms, generating a 5.4% investment return in 2011. However, the company's solvency deficit has steadily increased to $1.9 billion simply as a result of the precipitous decline in the yield on government bonds in Canada. Its retirees could lose 30% of their revenues if the company were to cease its operations. Air Canada is another example, with a $4.4-billion pension solvency deficit.

When faced with this issue, Canadian authorities say that they apply those rules in order to protect retirees. This is indeed a laudable goal. However, putting important Canadian companies at a major competitive disadvantage with their American counterparts, harming their cash flow and, in some case, pushing them closer to bankruptcy, won't protect anyone in the end.

I've already discussed how pensions can potentially deliver a crushing blow to Canadian corporations. This isn't an easy issue to solve and the drop in long-term rates is only part of the problem.

The reality is that for years, many corporate defined-benefit plans were completely mismanaged. Contribution holidays, poor investment decisions and outright theft on pensions all contributed to the dismal state of corporate pension plans.

How bad is it? Janet McFarland of the Globe and Mail reports, Study warns of funding shortfalls for pensions:

North America’s major pension plans have seen their cumulative funding shortfall balloon to more than $389-billion (U.S.), leaving many plans facing critical funding shortfalls, a new study shows.

A pension study by debt rating agency DBRS Ltd. shows the majority of 451 major Canadian and U.S. pension plans that were examined are entering the “danger zone” where their funding shortfall is so large it is not easily reversed. The shortfalls are the result of weak markets harming the investment portfolios of pension plans, as well as declining interest rates hurting returns and boosting the funding obligations for future retirees.

DBRS said 53.4 per cent of the pension plans it studied had assets below 80 per cent of their funding obligations at the end of 2011, which means their funding shortfall had passed the 20 per cent level. That compares to 45.7 per cent of pension plans with funding falling below 80 per cent in 2010.

While there is no official measure of adequate funding for a pension plan, DBRS said it considers 80 per cent to be a reasonable level of shortfall that companies can recover from fairly easily. Below that level, the gap is so large that it becomes more difficult to fund.

The growing shortfall is putting stress on employers, who are obligated to make contributions to their pension plans to return them to fully funded status, typically within five years.

DBRS said the 451 pension plans studied – including 65 Canadian plans – had a combined financing deficit of $389-billion at the end of 2011, up 32 per cent from $294-billion at the end of 2010.

“For companies to address this funding gap, employers will have to maintain high levels of contributions, as many plans have now entered the danger zone of funded status,” said DBRS senior vice-president James Jung.

A DBRS report last year presented a possible scenario where pension plans could return to fully funded status by 2012 if investment returns improved and interest rates climbed. The firm said the actual results in 2011 “differed materially” due to low interest rates, and DBRS does not expect full funding to be achievable before 2014 at best.

Fully funded status in 2014 is a pipe dream for most pension plans, even if stocks and bond yields skyrocket from these levels. After the tech crash in 2001, it took at least three years for most plans to get in better funding shape. This time around, it will take much longer.

Having said this, we shouldn't blow the funding crisis way out of proportion either. Michel Kelly-Gagnon is right to say that if Canadian companies that have defined-benefit pension plans were allowed to use the same rules as their American competitors, most of them wouldn't even be considered as having a deficit.

The same can be said of Canadian public pension plans. If US public plans had to use the same discount rate as Ontario Teachers' or other large Canadian public plans, most of them would be insolvent!

So, is the simple solution to follow the United States and raise the discount rate? Not that simple. What if we enter a protracted Japanese-style deflationary era or worse, an outright debt-deflation spiral? Not saying we will but if this is the case, bond yields will remain low for decades and so will return on all assets.

In such a scenario, it would be foolish to raise the discount rate as it would only buy companies a little more time to deal with their pension deficits but the discount rate wouldn't reflect true economic conditions.

Moreover, the pension law President Obama signed last month is a dead giveaway to US corporations, allowing companies to contribute billions of dollars less to their workers' pension funds, raising concerns about weakening the plans that millions of Americans count on for retirement.

Ottawa is taking a much more measured approach and with good reason, there is no simple solution to the retirement crisis. Tinkering with the discount rate only buys companies time, it doesn't address the fundamental structural problems of our pension system. If we truly want to improve retirement security for all Canadians, we need to bolster DB plans in the public and private sector.

The situation is even more pressing in the United States where seventy-five percent of Americans nearing retirement age in 2010 had less than $30,000 in their retirement accounts.Their ridiculous approach to retirement really needs a major rethink on pensions or else America's 401(k) nightmare will only get worse, leaving millions in pension poverty.

Below, Daily Ticker's Henry Blodget interviews economist Teresa Ghilarducci on why America's retirement system has failed.