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Defined Benefit Pension Coverage and Funding in Ontario: Local Experiences in a Global Context

Gordon L. Clark, Ashby H. B. Monk & Courtney S. Monk Oxford University Centre for the Environment South Parks Rd. Oxford OX1 3QY United Kingdom

Clark, Monk and Monk, 2007

Table of Contents Executive Summary 1) Introduction: A) Ontario Expert Commission on Pensions: Mandate B) Methodologies and Limitations C) Summary Findings D) Plan for Paper 2) Defined Benefit Pension Funding in Ontario A) Baseline: Ontario’s DB pension funding B) DB Funding in a Global Context C) Local Trends: Global factors’ relevance in case of Ontario 3) Defined Benefit Pension Coverage in Ontario A) Baseline: Ontario’s DB pension coverage B) DB Coverage in a Global Context C) Local Trends: Global factors’ relevance in the case of Ontario D) DB Coverage in Canada: Findings from an Expert Survey 4) Conclusions A) Summary of findings B) Areas worthy of further investigation 5) References 6) Appendices

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EXECUTIVE SUMMARY: The funding and coverage of defined benefit (DB) pension plans is an issue of vital concern in Ontario as in the rest of the world. This paper, which is part of the Ontario Expert Commission on Pensions’ (OECP) consultation on the occupational pension system in Ontario, seeks to describe and analyse the various factors influencing funding and coverage of DB plans in Ontario and compare these factors with those in other jurisdictions. We are tasked with making qualitative judgments based on our collective expertise and knowledge of pension systems around the world. We refer to publicly available reports and academic research. In addition, we use public and private data, such as Statistics Canada’s CANSIM database. In short, this paper is an interrogation of existing literatures and data rather than new scholarly material. We find that DB pension underfunding is a recent and ongoing phenomenon in Ontario. However, Canada’s DB pension underfunding today is based more on problems with the liability then on problems with the assets. Indeed, after 2002, equity values appear to have increased considerably. Nevertheless, contribution levels (one of our proxies for funding) have also increased considerably, suggesting that rising assets have not been enough to fill the funding gap. Indeed, low discount rates appear to be the root cause of underfunding, compounded by increasing longevity, actuarial practice and regulation. We also find that DB pension coverage in Ontario shows only a gradual decline over the last 15 years. Nevertheless, we find a much faster decline in the private sector than the public sector. Indeed, private sector coverage has dropped by roughly one third over the period under consideration (1992 to 2005). We conclude that competitive pressures, government regulation and declining unionizing rates have been important factors in driving this decline in DB coverage in the private sector. We conclude that Ontario’s DB pension system is experiencing declining coverage and plan underfunding. However, Ontario exhibits distinct differences from the global experience. Indeed, DB coverage, though on the decline, appears more resilient than in the U.S. and the U.K. Also, underfunding does not appear to be associated with the asset side of the equation (relative to the US and UK) but with the liability side (due to interest rates, increasing longevity, etc.). Future research would benefit from better statistics, as consistent Ontario DB pension funding and coverage data over time was not available. As part of this project’s mandate, the OECP engaged to provide by the mid-summer 2007 detailed statistics and regressions analysis underscoring the factors that drive funding and coverage. Unfortunately, we never received these data, which has limited our ability to make firm conclusions in the Ontario case. As a result, this discussion can only be viewed as tentative conclusions based on a series of necessary assumptions, some of which may certainly be challenged, and indeed should be.

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1) INTRODUCTION A) Project Context: In the aftermath of the stock market bubble and crash in the late 1990s, concerns grew over the viability of existing retirement schemes and institutions (Mitchell and Smetters, 2002). Specifically, defined benefit (DB) pensions have been the subject of widespread interest and concern due to declining funding and coverage rates in countries such as the United States and the United Kingdom (Broadbent et al., 2006; Clark, et al., 2006; Ambachtsheer, 2007; and Clark and Monk, 2007a,b). There are different ways to interpret the implications of this trend. One view, which sympathizes with firms, is that DB pensions are inherited burdens that can, in severe cases, jeopardize the very solvency of their sponsors (Monk, 2007). Indeed, many experts now believe that the DB pension model is at risk in the global economy (Munnell, 2006). A different though not mutually exclusive interpretation focuses more on workers and sees DB pensions as a crucial element of employee compensation (depending on the age of the worker). Employer-sponsored pension benefits have been important in many Anglo-American countries for supplementing modest state social-security (compared to Europe; see De Deken et al., 2006). In fact, one of the success stories of the second half of the 20th century was the diffusion of such benefits to many working men and women in unionised industrial and public sectors (Sass, 2006). The first view is somewhat fatalistic in its approach to evaluating DB pension policy, since it implies that policy interventions designed to save them are both fruitless and harmful, at least for firms. However, the second view offers policy makers a reason to examine the current trends in DB pension funding and coverage, in the hopes of maintaining the DB pension’s place in the labour market. In this paper, we seek to describe and analyse the DB pension experience with respect to funding and coverage in Ontario, Canada. This information will help policy makers to assess with more certainty the potential impacts of possible pension reforms. B) Project Background: This paper is part of the Ontario Expert Commission on Pensions’ (OECP) consultation on the occupational pension system in Ontario. The OECP’s primary focus is on “defined benefit pension plans provided to employees at their workplaces” (OECP, 2007). As suggested above, it seeks to describe and analyse the “various factors influencing the decline in defined benefit pension plans in Ontario and compare these factors with those in other jurisdictions.”1 We have also been asked to examine factors that affect the funding of these plans.2 Specifically, the OECP has requested an outline of a “series of factors influencing coverage and funding of pension plans, with a focus on DB plans” in Ontario.3 1 See OECP’s Research Program Summary for Project #3: http://www.pensionreview.on.ca/english/docs/research.html. 2 Communications with Isla Carmichael and Simon Archer. 3 Communication with Simon Archer.

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This project serves to complement OECP Project #1, which is a quantitative analysis focusing on coverage and funding of occupational pension plans. It is not within the mandate of this paper to undertake detailed quantitative analysis. Instead, we use our “collective experience to outline a thorough list [of factors affecting funding and coverage].” 4 Indeed, this paper uses empirical observations to interpret and make arguments about funding and coverage trends. C) Methodologies and Limitations: We are tasked with making qualitative judgments on the current state of DB funding and coverage in Ontario, based on our collective expertise and knowledge of pension systems around the world. To do so, we refer to publicly available reports and academic research. In addition, we use public and private data, such as Statistics Canada’s CANSIM database. In short, this paper is an interrogation of existing literatures and data rather than new scholarly material. In terms of limitations, the lack of data on DB funding and coverage in Ontario has proven to be a problem. As part of this project’s mandate, the OECP engaged to provide by the mid-summer 2007 detailed statistics and regressions analysis underscoring the factors that drive funding. Unfortunately, we still have not received this data, which has limited our ability to make firm conclusions about funding in the Ontario case. Nevertheless, we try to overcome this by using Canada-wide ‘snapshot’ data available in existing literature and proxies. In addition, consistent longitudinal data on coverage in Ontario only go back to 1992. Clearly, given this relative dearth of data, we have been limited in our capacity to discuss correlations between the different factors and pension funding and coverage. As a result, the discussion below can only be viewed as tentative conclusions based on a series of necessary assumptions, some of which may certainly be challenged, and indeed should be. In particular, we are distinctly aware of our reliance on nationallevel data when Ontario-level data would be much preferred and more informative. As a result, we engage in discussions about correlations, drivers and restrainers acknowledging full well that these conclusions are based on very limited empirical evidence. The persuasiveness of these findings is left to the reader to determine. D) Summary of Findings: The summary findings for this paper are as follows: Funding: Based on existing reports and funding proxies, this paper finds that underfunding is an issue for Ontario DB pensions. Moreover, there is a correlation between this underfunding and capital market behaviour, regulatory oversight, and even longevity. However, underfunding, unlike in other jurisdictions, is largely a problem associated with the liability side of the funding equation, as asset values appear to have been robust (except for a short period between 2001 and 2002).

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Communication with Simon Archer.

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Coverage: This paper shows that DB coverage has been roughly constant in the public sector and declining in the private sector. As such, much of the discussion focuses on the private sector experience (due to its more significant decline). We contend that declining coverage stems from the changing corporate environment, decreasing levels of unionization, and regulatory changes. Nevertheless, these summary findings should not be accepted or referenced without the numerous caveats discussed below. E) Plan for Paper: In line with the OECP mandate for project 3, this paper seeks to: assess and evaluate the status of DB pension funding and coverage in Ontario over the past 20 years; situate the specific case of Ontario in a global context, drawing inferences where possible and underscoring idiosyncrasies when necessary; outline certain drivers and restrainers of global DB pension funding and coverage; and evaluate the relevance of these factors for Ontario specifically. In order to achieve the above goals, the paper will consist of two main sections, one on funding and one on coverage, followed by a conclusion: Section 2 - Funding: • • • •

With reference to a historical baseline of existing reports and data, we determine the current state of plan funding. We then outline the factors, in a general sense, that typically have an impact on plan funding at a global level. We then attempt to determine how these factors have interacted with pension plans in the specific case of Ontario. Finally, where possible, we try to draw links between certain factors and the funding of Ontario’s DB pension plans.

Section 3 - Coverage: • • • •

With reference to historical baseline data, we determine the current state of DB plan coverage in Ontario. We then outline typical factors that influence DB plan coverage at a global level. We then examine if the global factors are relevant in the specific case of Ontario. Finally, where possible, we draw correlations between certain drivers and restrainers and the funding of Ontario’s DB pension plans.

Conclusion: • •

We review the paper’s findings. We end by suggesting further areas of investigation.

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2) DEFINED BENEFIT PENSION FUNDING IN ONTARIO This section starts out by setting a baseline from which we can evaluate DB pension funding in Ontario. This is done using existing literature and reports, as well as national data on DB pension assets, contribution rates, and net income of pension plans. Because direct data on funding levels are not available in Canada, we rely on these three measures to get a better understanding of funding experiences at the national level, which is assumed to mirror Ontario’s experience. Subsequently, we discuss what kind of things affect pension plan funding on a global level, and then address whether these factors are important in the case of Ontario. Finally, we offer tentative conclusions based on the findings. A) Baseline: Ontario’s DB pension funding: Before examining the factors affecting DB pension funding in Ontario, we must first establish a baseline funding level. However, DB pension funding data in Ontario is extremely hard to come by, requiring the use of some creative indicators that act as proxies of funding levels. a) Funding Snapshots: Several studies have provided some insights into the funding status of Ontario and Canadian DB plans: A survey of the funding position at December 31, 2004 by the Certified General Accountants Association of Canada showed a 25% funding deficit with indexation of benefits and 11.5% without indexation.5 The Financial Services Commission of Ontario produced a report covering the period from 2002-2006 that showed the majority of plans were less than fully funded. 6 On a solvency basis, the median ratio funded status for DB pension plans in Ontario in 2002 was 0.80. In 2003 this ratio improved to 0.82. In 2004 this ratio improved again to 0.83. In 2005 the ratio decreased to 0.81, but the FSCO report argues that this decline was partly due to the introduction of the new rules adopted by the Canadian Institute of Actuaries. According to a recent survey of plan sponsors by Greenwich Associates (2007), the most pressing challenges for Canadian plan sponsors in 2006 was underfunding (40%). Nevertheless, this same report showed dramatic improvements for most plans’ funding levels. As of May 31, 2006, 78% of DB pension plans in Canada were in deficit and only 22% were in surplus. This represents a relative deterioration from December 31, 2003 when only 71% of plans were in deficit (Armstrong, 2006). According to calculations done by Keith Ambachtsheer (2004), Canadian DB pension plans lost roughly C$180 billion over the period from 2000 to 2002. 5

`The State of Defined Benefit Pensions in Canada: an Update’ (2005) Certified General Accountants of Canada, available at CGA website. The survey used 784 plans covering 1,787,000 members representing roughly 30% of the defined benefit pension market across Canada. 6 (2007) “Funding Defined Benefit Pension Plans: Risk-Based Supervision in Ontario” Financial Services Commission of Ontario. Available on FSCO website.

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According to Greenwich Associates (2007), strong investment returns over the past few years have helped return Canadian plan sponsors to good financial health: “While these results suggest that Canadian pensions are in better financial health than those in other developed countries, it is important to bear in mind that the overall average encompasses pension plans with considerable variation in funding level – including several large public and corporate pension funds that are significantly under funded.” These reports seem to be somewhat contradictory, but the general consensus implied by these studies is one of recent difficulties with pension underfunding. Specifically, the Ontario data we do have (from the FSCO) gives evidence of widespread underfunding (on a solvency basis). b) National Proxies: In order to supplement the above piecemeal information, we can look to other economic indicators to provide proxies for funding levels. Each of these proxies is collected at the national level. While national-level data do not perfectly reflect the case of Ontario, it is reasonable to assume that financial measures (interest rates, asset prices, etc.) faced by pension plans are similar across Canada. Therefore, we believe that the three financial indicators discussed below are more similar than not for Ontario and Canada more generally. First, the growth of pension assets to GDP in Canada, the U.S. and the U.K. (see Figure 1) provides some relevant information. Indeed, pension plan funding is a function of assets and liabilities, so this chart at least shows us part of the story. Pension Assets % GDP 100 90 80 70 60

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Figure 1: Pension Assets as % of GDP (Source: OECD)

We note in this chart that whereas the United Kingdom and the United States experienced significant declines in pension assets as a percentage of GDP after the turn of the century, Canada’s asset levels increased steadily. While this chart says little about the funding levels without the corresponding pension liabilities data, it does suggest that Canada did not experience similar levels of asset volatility as other countries. This is an important differentiation to make. In addition to the asset growth, another useful proxy for pension plan funding is pension contributions. Ostensibly, pension plan contributions must go up when plan

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funding is low, as stipulated by funding rules; contributions and funding levels are thus negatively related. Figure 2 gives us an indirect indication of pension plan funding levels for Canada over time. This chart suggests that funding deteriorated in the 1970s and 1980s and then stabilized through the 1990s. However, a significant deterioration occurred again in 2002. Public and Private DB Plans in Canada 35000000 30000000 25000000 20000000

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Figure 2: Public and Private DB Plan Contributions in Canada, Total Employee and Employer (Source: Statistics Canada CANSIM 280-0026)

The third useful proxy is the net income of public and private pension funds in Canada. Net income consists of 1) revenues, which are made up of contributions and investment returns; and 2) expenditures, which refer to all the money paid out of the pension plan, both in paid benefits and administrative costs. If net income is high, we can easily assume full funding. If it is low or negative, we can also assume underfunding. The data go back to 1992 (the extent of the CANSIM data set). In Figure 3, we see that in the 1990s, net income was high and allowed for steady and declining contribution rates. This suggests that DB pension plans were fully funded in the 1990s. Between 1998 and 1999, we see an initial increase in pension expenditures followed by a drop in investment income. Significantly, we see a related increase in contributions roughly three quarters later, suggesting that plan funding had been affected by this increase in expenses and decrease in investment returns. In 2001 there is a dramatic decrease in net income, which sets off a gradual increase in contributions. Indeed, these higher level contributions suggest a problem with funding. While we cannot be sure of the significance of this funding gap from these data, we can infer that it was a real problem.

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Pension Plan Net Income for Public and Private Pension Plans in Canada (Quarterly x 1,000,000) 35000 30000 25000 20000 Contributions 15000

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Figure 3: Net Income for Public and Private Pension Plans in Canada (Source: Statistics Canada CANSIM 280-0026)

In sum, based on the above methods used to infer plan funding throughout Canada, we can tentatively conclude that DB pension underfunding has been a problem in Canada and also within Ontario during this period. B) DB Funding in a Global Context: Managing the intersection of pension assets and liabilities has become one of the most pressing issues facing public and private plan sponsors today. In particular, DB pension funding has been a problem throughout the world, especially in the U.K. and the U.S. (see Clark and Monk, 2007a,b). In this section, we examine the global pension environment to highlight five main causes of underfunding. In the next section, we will determine which of these factors are relevant for Ontario. a) Asset Returns and Interest Rates: Pension plan funding is highly dependent on the investment returns of invested assets and interest rates (Munnell and Soto, 2004; Clark and Monk, 2007a). Investment returns dictate asset values, while interest rates are a crucial determinant of the magnitude of liabilities. Pension funds accumulate assets as plan sponsors make contributions to cover future pension liabilities. These assets are then invested in government bonds, corporate securities, and other (alternative) assets. As a result, the funding level of the pension plan depends strongly on the returns generated in the financial markets. DB pension plans are thus highly dependent on sophisticated and effective investment procedures and governance. However, it is significant to note that poor investment decisionmaking and governance have been characteristic of DB pensions in most countries (Ambachtsheer, 2007; Clark and Urwin, 2007). The other key variable for funding levels is obviously the liability. One of the most important issues for the liability side is interest rates, which are typically used by actuaries to determine the size of the pension liability (i.e. the discount rate). If interest rates drop, the pension liability rises. As such, any drop in interest rates has an

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immediate and distinct impact on pension underfunding, independent of the performance of the assets. These two factors recently came together in 2000 to 2002 to send DB pensions around the world into severe underfunding. Outside of Canada, this has frequently been referred to as a “perfect storm.” Few people had expected the confluence of low asset returns and low interest rates, which simultaneously increased the value of expected pension liabilities and decreased the pension assets intended to cover these liabilities. This perfect storm took Fortune 1000 plan sponsors from an average funding level of 122% in 1999 to 76% in 2002 (Coronado and Hewitt, 2005). Although funding levels have recovered somewhat in the five years since 2002, underfunding remains a significant problem. b) Longevity Risks: Population ageing has been tied to significant problems for DB pensions (see Alho et al., 2005; and Fehr and Habermann, 2006). Specifically, mortality risk, or the risk that pension beneficiaries will live longer than expected, is a significant issue for pension plan funding (see Blake and Burrows, 2001; Cardinale et al., 2005; and Dushi et al., 2006). Indeed, as Munnell and Soto (2004) claim, “the aging of the workforce would require plan sponsors to put considerably more into their plans than they contributed in the 1980s and 1990s.” According to Broadbent et al. (2006), “As the workforce has aged, the costs of funding a DB plan have risen because the level of accrued benefits is higher and the post-retirement period has lengthened due to early retirement and increased longevity.” Moreover, for mature DB plans, which are those with a high percentage of retirees and a low percentage of active workers contributing, the costs created by increasing longevity are significant (see Clark and Monk, 2007a for a discussion). As a result, we anticipate two main impacts from unanticipated longevity risks: 1) Plan sponsors will pay for pensions longer than anticipated, increasing the financial burden for the sponsoring firm. Indeed, academic research has shown that increasing longevity has raised DB costs by 1% per year since the early 1980s (Muir and Turner, 2003).7 2) Current pension plan contributions may not fully reflect the increased life expectancy of current and future beneficiaries. In an academic study on aggregate mortality risk of DB pensions, Dushi, Freidberg and Webb (2006) find that many plan providers underestimate the longevity of their employees by using mortality forecasts that are biased upwards. Comparing the assumptions made using these mortality forecasts with the more reliable Lee-Carter model (1992), the authors conclude that the incorrect mortality forecasts understate the future pension obligation by 15.2%. Moreover, despite considerable research and promising developments in insurance products and financial markets, the tools available for DB pensions plans interested in managing idiosyncratic or aggregate mortality risks are still limited (Lin and Cox 2005; MacMinn et al., 2006). 7

This assumes “an average retirement age of 62 in both 1982 and 2002, an interest rate of 4%, and no inflation indexing of benefits”.

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c) Accounting: In the U.S., nontransparent financial reporting has been flagged as an important component of pension plan underfunding (see Zion and Carcache, 2005). While this is in the process of changing, it has been a problem in the past because this ‘nontransparency’ allowed firms to smooth the volatility in the asset-to-liability ratio of the pension plan over select periods of time. It also permitted firms to use assumed investment returns on the pension portfolio instead of actual investment returns. (As we will see later in Section 3, accounting may also be having an impact on DB pension coverage). d) Actuarial Calculations: According to Munnell and Soto (2004), there are “factual and judgmental” factors that are used by actuaries when calculating the projected benefit obligation: “The factual elements are the benefit provisions of the plan and the characteristics of current workers and retirees, such as age, sex, length of service, and current salary. The judgmental factors include the likelihood that the person will live to receive benefits, the duration of the benefit payment, the rate at which salaries will increase over the employees’ work lives, the rate of employee turnover, and the interest rate used to discount future liabilities back to the present.” All of these characteristics will have an impact on the reported funding of the pension plan. In particular, there has been considerable debate about the “judgemental factors” and their role in the current levels of underfunding globally. In addition to difficulties in anticipating the impact of increasing longevity on plan sponsors discussed above, actuaries often incorporated expected returns of pension assets to fund obligations more fully. In practice, this meant that a riskier investment with a higher expected return could in fact improve the funding level of the pension plan and reduce mandated contributions. Indeed, Cowling, Gordon and Speed (2005), in a paper to the U.K. Institute of Actuaries, expressed unease over “an element of self delusion within the actuarial profession; regardless of the reference to expected returns, using a higher discount rate is simply a way of reducing the pace of funding, i.e. advising lower contributions now (at the expense of potentially higher contributions later and lower member security).” This practice is the opposite of what would occur in the insurance industry, where riskier investments require more assets in order to secure the liability (Cowling, Gordon and Speed, 2005). The underlying problem is the oftentimes tenuous actuarial connection between assets and liabilities. What a fund does with its assets affects future funding levels, but this must remain separate from the current funding targets (Exley, Mehta and Smith, 1997). e) Regulation: According to Munnell and Soto (2004), in the U.S. context, changes in regulation—such as reductions in the full funding limit, the cap in employee compensation that can be considered when contributing to tax qualified plans, and the introduction of a ‘reversion tax’ on surpluses—have greatly altered DB pension plan funding. This view of the regulatory impact on funding has been confirmed by others. For instance, Ippolito (2001) shows that if firms are limited by regulation in their ability to access excess pension assets then they are less likely to keep the plan fully funded, or may terminate the plan all together. Moreover, in the post-bubble economic environment, “firms have now entered a period where their pension contributions will have to increase substantially to maintain compliance with ERISA’s funding requirements” (Munnell and Soto, 2004). In essence, higher contributions can

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actually put more pressure on plan sponsors to keep their pension plans fully funded, which also has implications for coverage levels (discussed below). In addition, the role of governmental guarantee agencies has been linked to pension plan underfunding. For example, Coronado and Liang (2005) argue that the U.S. Pension Benefit Guaranty Corporation creates moral hazard that results in a degradation of pension plan finances, particularly for those firms under threat of bankruptcy. Also, in the U.K. context, McCarthy and Neuberger (2005a,b) demonstrate that firms that sponsor DB pensions can increase the value of the ‘put’ option on the government by underfunding their pension plans. C) Local Experiences: Global factors’ relevance in case of Ontario: In part A of this section, we tentatively concluded through reference to snapshot data and proxies that pension plans in Canada, and Ontario, are underfunded. In this section, we seek to take the factors highlighted above in the global context and situate them in Canada and for Ontario specifically. However, we must also acknowledge certain limitations in this regard, as very little Canadian academic research has focused on this issue. a) Asset Returns and Interest Rates: Capital market indicators have played a large role in the funding status of DB pensions in Canada, specifically stemming from a mismatch in asset-liability management strategies (Ambachtsheer, 2004). Armstrong (2006) summarizes nicely this situation: “Weak equity markets from 2000 through late 2002 initially raised concerns about the deteriorating funding condition of corporate defined benefit pension plans. This is because the typical Canadian corporate pension fund had 50 to 60% of its assets invested in equities. An even more important adverse factor for pension plan funding has been the decline in long-term interest rates, which has increased actuarial estimates of pension plan liabilities.” According to this description, it appears that the Canadian DB plans, like their global cousins, also experienced underfunding during this specific time period as a result of asset decreases and liability increases. This point is worthy of further investigation. We look to several of the capital market indicators and evaluate how they interact with our funding proxies in Canada highlighted above. First, we examine the relationship between our three proxies for funding levels (pension fund assets, net income, and contributions) and asset returns. Then we turn to bond yields, as a measure of interest rates, to investigate how they correlate with the three proxies. This is all done using Canadian data, and we attempt where possible to make inferences about Ontario throughout this discussion. In Figure 4 below, we show the relationship between stock returns and pension plan net income. Clearly, in the time period 2000-2002, the funding status of pension plans suffered as a result of low asset returns. Since that time however, asset returns have increased dramatically, bringing pension plan net income along with them.

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Public and Private sector Pension Plans in Canada 80000

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Figure 4: TSX compared to pension plan net income (funding proxy) (Source: Statistics Canada and Datastream)

Another funding proxy is pension plan assets. Figure 5 shows how pension plan assets interact with stock returns. Clearly, (and understandably) there is a significant correlation between the two categories, as DB pension funds allocate relatively large percentages of assets to investments in stock markets. (For further details about asset and pension performance before 1993, see Galarneau, 1990; and Weitz, 1992). Pension Plan Assets in Canada (Quarterly x1,000,000) 1000000

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Figure 5: TSX compared to pension plan assets (funding proxy) (Source: Statistics Canada and Datastream)

Finally, we chart the relationship between stock returns and pension plan contributions (Figure 6). 8 This is an important correlation to establish, because if stock prices fall, we would anticipate contributions to go up to fill the funding gap. Indeed, that is what we see below. Between 1993 and 2000 (1993 is the oldest yearly data available), as stock returns went up, contributions remained low or even stagnant. However, in 2001, when stocks fell dramatically, it sparked off a trend in increasing contributions. Moreover, we note that despite a robust equity market since 2002, contribution levels continue to rise. This counter-intuitive finding for the most recent years suggests that other factors are working against pension plan funding as well. In

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In this section, we aggregate employer / employee and public / private contributions, since we are trying to make a broader point about DB pension funding. However, we acknowledge that there are differences that apply. We take this issue up below in Figure 26.

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particular, it is very probable that the liability is increasing more quickly than the assets, which is driving contributions higher. Public and Private Sector Pension Plans in Canada (Quarterly x1,000,000) 12000

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Figure 6: TSX compared to pension contributions (funding proxy) (Source: Statistics Canada and Datastream)

In Figure 7, we include a longer time period for this same analysis. However, these data are less consistent in the 1970s and 1980s. This chart suggests that contributions have been going up over time despite rising stock prices. Before the 1990s, this could be due to the fact that pensions were largely invested in bonds (see Weitz, 1992). Alternatively, this also suggests that liability growth is a crucial part of the underfunding story. Pension Plans in Canada 35000000

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Figure 7: TSX compared to pension contributions for a longer time period (funding proxy) (Source: Statistics Canada and Datastream)

Tuer and Woodman (2005) of the Bank of Canada clarify the above situation, arguing that “a severe downturn in global equity markets from 2000 to 2002 reduced the value of pension assets substantially because many pension funds had large allocations to equities. At the same time, a decline in long-term interest rates increased the present

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value of accrued pension liabilities…In 2003 and 2004, pension assets grew, mainly as a result of a recovery in global equity markets and an increase in plan contributions. But liability growth kept pace, owing in part to a continued decline in long-term interest rates.” Recall that pension liability valuations are sensitive to interest rate fluctuations through the discount rate, which is based on prevailing interest rates. A 25 basis point change in the discount rate will, according to DBRS’ (2007) internal calculations, result in a 200 to 700 basis point change in the pension obligation, depending on the age of the employees covered under the plan. Significantly for funding levels in Ontario and Canada, the Bank of Canada Target Rate and interest rates more generally have been decreasing over time. According to Bank of Canada research, “The persistence of funding deficits in recent years is largely attributable to the interest rate sensitivity of pension liabilities.” 9 This is a crucial statement of the impact that interest rates have had in Canada. Below are several charts that link the funding proxies to the BOC Target Rate (1993 is the extent of the Statistics Canada data). Also, further below are the Canadian Bond Yields compared to the funding proxies (1997 is the extent of the data). There appears to be a clear correlation in these charts: Public and Private Sector Pension Plans in Canada 9

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Figure 8: Bank of Canada Target Rate compared to Net Income (funding proxy) (Source: Statistics Canada)

Net income (Figure 8 above) clearly drops off when the BOC rate came down in 2000. However, it is very difficult to pinpoint any correlation between the BOC rate and pension plan assets (see Figure 9).

9

See Bank of Canada Review Summer 2005: Recent Trends in Canadian Defined-Benefit Pension Sector Investment and Risk Management.

15


Pension Plan Assets in Canada (Quarterly x1,000,000) 1000000

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900000

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19 98

19 97

19 96

0 19 95

1

0 19 94

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100000

19 93

200000

BOC Target Rate

Figure 9: Bank of Canada Target Rate compared to pension plan assets (funding proxy) (Source: Statistics Canada)

The BOC target rate is also demonstrated in Figure 10 in the context of contributions. Clearly, when the BOC rate started to come down in 2000, contributions shot up. Indeed, one can make a tentative conclusion that contributions and the BOC rate have an inverse relationship, which would also suggest that the BOC rate and funding are causally related (i.e. BOC comes down, funding goes down). Public and Private Pension Plans in Canada (Quarterly x1,000,000) 12000

9 8

10000 7 8000

6 5

6000 4 4000

3 2

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Contributions

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20 04

20 05

20 03

20 02

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19 99

19 98

19 97

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19 95

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0 19 93

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BOC Target Rate

Figure 10: Bank of Canada Target Rate compared to pension plan contributions (funding proxy) (Source: Statistics Canada)

Also, longer bi-annual data in Figure 11 show that contributions and the BOC target rate appear to be inversely correlated over time. This is an important finding, as it gives further credence to the importance of pension liabilities for DB plan underfunding.

16


Pension Plans in Canada 35000000

25

30000000

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25000000 20000000

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10000000 5

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0 Dec-1976 Dec-1977 Dec-1978 Dec-1979 Dec-1980 Dec-1981 Dec-1982 Dec-1983 Dec-1984 Dec-1985 Dec-1986 Dec-1987 Dec-1988 Dec-1989 Dec-1990 Dec-1991 Dec-1992 Dec-1993 Dec-1994 Dec-1995 Dec-1996 Dec-1997 Dec-1998 Dec-1999 Dec-2000 Dec-2001 Dec-2002 Dec-2003 Dec-2004 Dec-2005 Dec-2006

0


BOC Target Rate

Figure 11: Bank of Canada Target Rate compared to pension plan contributions (funding proxy) (Source: Statistics Canada)

In terms of bond yields, we do see a link between dropping yields and pension plan contributions (Figure 12). Clearly, in 2002-2003, yields began a steady downward trend which appears to be correlated with volatile increases in contributions. Public and Private Pension Plans in Canada (Quarterly x1,000,000) 12000

4 3.5

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3 8000

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0.5

Contributions

20 06

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19 97

19 96

19 95

0 19 94

19 93

0

Gov. of Canada Real Return Benchmark Bond Yield, Long Term

Figure 12: Bond Yields compared to pension plan contributions (funding proxy) (Source: Statistics Canada)

In terms of net income’s relationship with bond yields, it is not as easy as the above to find a clear story (Figure 13). Since 2004, bond yields have been very low, but net income has increased substantially (buoyed by the asset markets). Nevertheless, the above contributions data suggests that the increases in net income were not enough to bring the DB pensions back to full funding.

17


Public and Private Pension Plans in Canada (Quarterly x1,000,000) 25000

4

20000

3.5 3

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2.5 10000 2 5000 1.5 0

20 06

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-5000 -10000

0.5 0

Net Income


Figure 13: Bond Yields compared to pension plan net income (funding proxy) (Source: Statistics Canada)

Finally, we look at how yields have interacted with pension plan asset values over time (Figure 14). Here, we see that dropping interest rates are linked with rising pension plan asset values. Pension Plan Assets in Canada (Quarterly x1,000,000) 1000000

4

900000

3.5

800000

3

700000 600000

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500000

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20 06

20 04 20 05

20 02 20 03

20 01

19 99 20 00

19 97 19 98

19 95 19 96

0 19 94

19 93

0


Figure 14: Bond Yields compared to pension plan assets (funding proxy) (Source: Statistics Canada)

All this seems to imply that pension plan underfunding (which we assume exists due to the high contribution rates) is being driven through interest rates on the liability side of the equation and not the asset side. This is highly suggestive that the perfect storm, as defined above, did not have the same effect on plan funding in Canada as it did in the U.S. Rather, interest rates, and not asset values, seem to have been the main source of underfunding of Canadian pension plans. Indeed, in an econometric analysis of private pensions in Canada, Nielson and Chan (2007) find that increases in interest rates do produce increases in DB underfunding due to liability calculations. It is unlikely that interest rates will return to the lofty rates seen in the 1980s if inflation continues to be well controlled by the central bank. Therefore, pension obligations will remain relatively more expensive compared to previous decades. These declining bond yields are due primarily to better monetary management, inflation control, and increased global liquidity. To be sure, inflation has been an issue of enormous concern over the past 30 years in Canada (see Figure 15 below).

18


Annual Inflation Rate (% ) in Canada 14 12.47

12 10 8

CPI - Annual Inflation Rate 6

5.89

5.64

4 2.77 2

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

0

Figure 15: Canadian Inflation (Source: Datastream and Statistics Canada)

However, while taming inflation has improved macroeconomic stability, it has also had a tangible impact on pension liabilities (Figure 16). Pension Plans in Canada 14

30000000

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0 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

35000000


CPI - Annual Inflation Rate

Figure 16: Canadian Inflation compared to long-term contributions (Source: Datastream and Statistics Canada)

This graph attempts to show how inflation may have interacted with pension plan funding during the 1970s and 80s. Clearly, high inflation is linked with lower contributions and low inflation is linked with higher contributions, ceteris paribus. To further make this case, we include two more charts, though for much more recent time periods, comparing inflation and the proxies (this is the extent of the data for these two proxies). We acknowledge that general trends are hard to discern in these short time periods, but we nonetheless include these charts for historical context.

19


Public and Private Sector Pension Plans in Canada 80000

3

70000 2.5 60000 50000

2

40000 1.5 30000 20000

Net Income (Annual) CPI - Annual Inflation Rate

1

10000 0.5

19 9 19 3 94 19 9 19 5 9 19 6 97 19 98 19 99 20 0 20 0 0 20 1 0 20 2 03 20 04 20 05 20 06

0 -10000

0

Figure 17: Canadian Inflation and Net Income (funding proxy) (Source: Datastream and Statistics Canada) Public and Private Sector Pension Plans in Canada (Quarterly x1,000,000) 12000

5

10000

4.5 4 3.5

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3 2.5 2

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-0.5

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0

CN CPI - ANNUAL INFLATION RATE

Figure 18: Canadian Inflation and Contributions (funding proxy) (Source: Datastream and Statistics Canada)

It is worth returning briefly to the ‘perfect storm’ in Ontario. Did DB pensions in Ontario experience what analysts in other countries called a ‘perfect storm’? In the case of Ontario, it is difficult to make firm conclusions. However, we do see a sell-off in the S&P/TSX composite index in 2001 that corresponded with a sudden drop in interest rates (see Figure 19). Some might argue that this Canadian experience matched the ‘perfect storm’ faced by sponsors in other countries. It may be, as we suggest above, that the perfect storm occurred in Canada, but for some reason had a different impact on Canadian pension plans than it did elsewhere. Perhaps the storm’s degree of magnitude was lower in Canada than in the U.S. Due to the controversial nature of this issue and term in Canada, we leave the final judgement of this point to the reader.

20


Canadian capital market trends over 30 years 14000

25

12000

20

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15

6000

10

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0

Oc t- 1 97 Oc t- 1 6 97 Oc t- 1 7 9 Oc t- 1 78 97 Oc t- 1 9 980 Oc t198 Oc t- 1 1 98 Oc t- 1 2 98 Oc t- 1 3 984 Oc t- 1 98 Oc t- 1 5 98 Oc t- 1 6 98 Oc t- 1 7 98 Oc t- 1 8 98 Oc t- 1 9 99 Oc t- 1 0 991 Oc t1992 Oc t- 1 99 Oc t- 1 3 99 Oc t- 1 4 99 Oc t- 1 5 99 Oc t- 1 6 99 Oc t- 1 7 998 Oc t1999 Oc t- 2 00 Oc t- 2 0 00 Oc t- 2 1 002 Oc t- 2 00 Oc t- 2 3 00 Oc t- 2 4 00 De c-2 5 006

0


BOC Target Rate

Figure 19: Canadian capital markets (Source: Datastream and the Bank of Canada)

b) Longevity Risk: We demonstrated in the global context that unanticipated increases in longevity can have negative consequences for pension plan funding. Tuer and Woodman (2005) argue (for Canada as whole) that pension liabilities have unmistakably increased “as the workforce has aged, sometimes equalling or exceeding the market capitalization of the firm.” Here, we narrow the focus to Ontario’s experience with ‘population ageing’. Moreover, we make some general inferences based on the above for DB pensions in Ontario. Ontario, like Canada as whole, is definitely experiencing population ageing (Strauss, 2007, confirmed in Figure 20 below). Life Expectancy at 65 in Ontario 1979-2004

22 21 20 19 Both Sexes Females Males

18 17 16 15 14

19 99 20 01 20 03

19 95 19 97

19 91 19 93

19 87 19 89

19 83 19 85

19 79 19 81

13

Figure 20: Life expectancy at 65 in Ontario 1979-2004 (Source: Statistics Canada)

As Figure 20 demonstrates, the aggregate life expectancy for Ontarians has improved for both men and women in the last two decades. In 1979 the average life expectancy at 65 was 14.4 years for men and 18.9 for women. By 2004 the average was 17.9 years for men and 19.6 years for women. The question remains, however, whether this increase has had any effect on DB funding in Ontario? A simple example illustrates why, theoretically, such population ageing should lead directly to a change in benefit outlays. If a plan sponsor promised a male employee a pension in 1979, that sponsor would today be required to pay for at least five more years of retirement than anticipated. So, the years of extra funding brought about by

21


population ageing should be large enough to have a measurable impact on DB pension funding in Ontario. Let’s investigate this point further. Looking at Figure 21, we see that as life expectancy has gone up over the period 1993-2004, pension plan expenses, comprised mostly of payments to retirees, have also risen. Although the direction of causality is debatable, it seems to us more reasonable to deduce that expenditures have risen because benefit streams for individuals are getting longer, rather than the opposite— retirees could be living longer (i.e. are healthier) because their benefits are higher, but this is unlikely given that there has been a steady supply of good healthcare for the elderly in Canada over the period. Therefore, we tentatively conclude that increasing longevity in Ontario has contributed to DB pension plan underfunding. Pension Plans in Canada - Life Expectancy in Ontario at 65 60000

20

50000

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0

17 1993

1994 1995

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1998 1999

Expenditures

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2002 2003

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Both Sexes

Figure 21: Pension Plan Expenditures and Life Expectancy (Source: )

c) Accounting: Under current pension accounting rules (following Employee Future Benefits, Section 3461 of the CICA handbook), the amount reported on the balance sheet does not represent a fair value of the benefit obligation. In other words, Canadian pension plans, and thus Ontario plans, do not have to abide by a mark-tomarket accounting policy. Indeed, accounting rules in Canada do allow for a certain amount of smoothing: “They allow extensive smoothing of gains and losses, typically over 10 to 15 years” (Wiedman and Weir, 2005). This is not necessarily bad, as some argue that volatility created by mark-to-market pension accounting will drive DB pension plan sponsors to close their plans in other jurisdictions (Fore, 2004). However, some do fear that such accounting rules allow DB pensions to hide underfunding. Indeed, Wiedman and Wier (2005) find in the case of Canada that “47% of the companies in our sample reported net pension assets on their balance sheets when their pensions were in fact underfunded.” Again, this is an issue of considerable controversy, as it is not the smoothing itself that causes problems, but the abuse of the smoothing rules that leads to hidden/extra underfunding. As a result, accounting for pension obligations is an area of increasing interest in Canadian provinces. According to Tuer and Woodman (2005), “The growing focus on corporate governance by shareholders, ratings agencies, and regulators has renewed a long-standing push for greater transparency in pension accounting and comparable global standards.” However, while a change in accounting rules may make pension funding more transparent, it can also discourage DB pension provision (see section 3). 22


d) Actuarial Calculations: There are two actuarial problems in Canada and, by extension, Ontario, that have contributed to today’s level of plan underfunding. The first is incorrect actuarial estimates of risk, an issue that is not unique to Canada. The second is a Canadian-specific actuarial practice that, in our opinion, has exacerbated underfunding. In Canada, “liabilities are estimated using several assumptions, including projected retirement age, expected longevity upon retirement, and wage and salary increases prior to retirement” (Tuer and Woodman, 2005). These estimations are done by actuaries. Mistakes in the estimations can lead to large differences between expected liabilities and actual liabilities for plan sponsors. Ambachtsheer (2004) claims that Canadian actuaries are partially responsible for the DB pension underfunding: “Rather than identifying the embedded risks in DB plans, quantifying them, and explicitly allocating the risks among the various stakeholders, pension actuaries have often focused on controlling DB plan liabilities through their generally accepted actuarial methods.” Accordingly, he argues that “the more risk you take on the asset side of the pension balance sheet, the lower the balance sheet reserve required to hedge that risk needs to be” (Ambachtsheer, 2004). As such, this creates an environment in which DB plans are encouraged to invest in riskier assets to lower the discounted value of the pension liability. However, these risky assets do not match the liabilities as well as less risky assets, such as government bonds. Canadian DB pensions are mandated to provide an actuarial valuation every three years, both as a going concern and in a wind-up scenario (i.e. solvency valuation).10 The solvency valuations were put into effect in 2005 by the Canadian Institute of Actuaries11 and were transposed into the Ontario PBA by Regulation 386/04. Under these rules: “The actuary should select economic assumptions that depend on the reported rates for the applicable CANSIM series for the second calendar month preceding the month in which the valuation date falls.” These “reported rates” are the 7-year Government of Canada benchmark bond yield, the long-term Government of Canada benchmark bond yield, and the long-term real return Government of Canada bond yield (see Figure 22). However, the specific rates adopted by this rule have been declining over the past 10 years. Thus by construction, actuarial calculations have resulted in increasing pension liabilities and thus plan underfunding.

10

The going concern valuation assesses the long run values for plan assets and liabilities. In short, this assumes the DB pension is going to continue to exist. If a deficit exists, it must be funded by the employer sponsor over a maximum of 15 years. Assumptions are typically left up to the discretion of the Actuary, who is guided by the standards of practice issued by the Canadian Institute of Actuaries. A solvency assessment is made on the expectation that the DB plan is wound up on the day of the valuation. Any deficits on this basis must be made up over five years. Assumptions under this valuation are dictated by legislation. In Ontario, this valuation can use averaged interest rates over a period of five years in order to reduce volatility of the funding level (CGAAC, 2005). 11 See, “Standards of Practice- Practice-Specific Standards for Pension Plans” Revised May 1, 2006. Available at: Canadian Institute of Actuaries website.

23


Government of Canada Bond Yields 8 7 6 5

7 Year

4

Long-Term Long-term Real Return

3 2 1

Jan-07

Jan-06

Jan-05

Jan-04

Jan-03

Jan-02

Jan-01

Jan-00

Jan-99

Jan-98

Jan-97

0

Figure 22: Government Bond Yields (Source: Statistics Canada)

e) Regulation: Canadian DB pension plans are regulated at either the federal or provincial level, depending on whether the workers are employed in a business that falls under federal or provincial jurisdiction (Armstrong, 2006). In Ontario, the Pension Benefits Act is the principal statute governing DB pensions, and DB plans fall under the regulatory purview of the Financial Services Commission of Ontario. The Canada Revenue Agency also has oversight responsibilities via the Income Tax Act. In Ontario, three judicial and legislative issues have potentially affected DB pension funding: i) Surplus: For Canadian DB plan sponsors, “the most contentious issue in the regulation of DB pension plans pertains to surplus ownership and risk sharing” (Tuer and Woodman, 2005). Indeed, the most infamous Canadian case associated with the ownership of pension plan surplus occurred when Conrad Black withdrew over $56 million from Dominion Food Store’s DB plan, which was in surplus at the time, without consulting plan members. The Supreme Court of Ontario eventually ruled against Black on this case, eventually leading to the current surplus rules in effect today. Bank of Canada representatives interpret the current law in the following way: “Surpluses beyond statutory requirements are shared with plan members while deficits are seen as the sponsor’s responsibility. This asymmetry of risk creates a disincentive for plan sponsors to build a surplus cushion as protection against a period of adverse market conditions and ultimately makes it more challenging for plan sponsors to offer DB plans” (Tuer and Woodman, 2005). This point was recently raised during the Monsanto v. Ontario12 case. The Supreme Court of Canada upheld an original ruling of the Superintendent of Financial Services, which stated that “a surplus is, in effect, a windfall because it was not within the expectations of either the employer or the employees when the regime was implemented.” The Monsanto decision pertains exclusively to section 70(6) of the Pension Benefits Act and particularly to partial wind-ups. Plan sponsors affected by 12

Monsanto Canada Inc. v. Ontario (Superintendent of Financial Services), 2004 SCC 54, [2004] 3 S.C.R. 152

24


this ruling will have less incentive to create a surplus cushion in the future (Tuer and Woodman, 2005). Indeed, in Canada, “sponsors hesitate to accumulate surpluses to which they may lose title, and since normal course of events will see well-funded plans swing between surpluses and deficits, this hesitation also tends, on average, to produce underfunded plans” (Laidler and Robson, 2007). i) Income Tax Act: Another possible reason for pension underfunding in Ontario stems from some provisions of the Income Tax Act. According to the Act, sponsors may face a tax penalty if they do not cease making contributions to their pension plans once the assets exceed a certain level vis-à-vis the liabilities. 13 As such, in periods of actuarial surplus, plan sponsors are likely to take contribution holidays. Indeed, a report by Gil Yaron of the Shareholder Association for Research and Education found that out of 110 federally registered pension plans in Canada that were underfunded as of December 30, 2003, 56% took at least one contribution holiday between 1994 and 2003.14 The study argues that underfunding would be less significant had contribution holidays not been taken. As such, this Act and its relationship with contributions holidays have a clear relevance to pension underfunding. Indeed, in Canada, “many plans took contribution holidays in the 1990s when plans were in surplus, either voluntarily or because of the limits imposed by Income Tax Act regulations” (Armstrong, 2006). According to Tuer and Woodman (2005), “During the 1990s, this situation occurred often, and surpluses that could have provided a buffer in later years were distributed to current employees and pensioners.” iii) PBGF: The final key factor raised here for DB pension underfunding in Ontario is the Pension Benefits Guarantee Fund, established in 1980. According to Nielson and Chan (2007), “Ontario became the only Canadian province to provide a system of governmental protection for the pension promises of private employers.” The authors indicate that “The PBGF guarantees specified benefits, up to C$1,000 per month per member, in respect of service in Ontario.” The PBGF does not guarantee benefits under a plan which has been operating for less than three years. This same principle goes for promised benefits that were made within three years of a bankruptcy as well. The PBGF is financed through employer contributions: every Ontario employer with a DB plan must contribute $1 to the PBGF per plan member, and a sliding scale determines contributions for underfunded plans. Nielson and Chan (2007) claim that in Ontario, as in the global context cited above, the PBGF does in fact affect the funding of DB pension plans: “…the results given here show conclusively that the one Canadian province that offers a governmental guarantee (Ontario) exhibits a market for private pensions that behaves significantly different from the rest of Canada. Furthermore, the existence of the government guarantee is related to the lower funding of DB pensions to the amount of approximately $4,500 per participant.” However, although this study finds a clear correlation between government guarantees in Ontario and pension underfunding, it

13 Section 147.2 of the Income Tax Act stipulates that registered pension plans must stop contributing to their plan when a 10% surplus is achieved vis-a-vis the liabilities. 14 Yaron, Gil, “Taking a Holiday: The impact of employer contribution holidays on the funding of defined benefit pension plans” Shareholder Association for Research and Education. June 2005.

25


concludes that interest rates and general economic health are ultimately more important to pension funding (and coverage).

26


3) DEFINED BENEFIT PENSION COVERAGE IN ONTARIO This section begins by setting a baseline from which we can evaluate DB pension coverage in Ontario. Subsequently, we examine the factors affecting pension plan coverage on a global level. Next, we narrow our focus to Ontario. Finally, we discuss tentative conclusions based on the findings. A) Baseline DB Coverage: This section begins with a simple analysis outlining Ontario’s trends in DB pension coverage. We rely on the initial findings from Richard Shillington’s OECP project (# 1), which provides considerable insight into DB pension coverage in Ontario for the period 1992 to 2005. However, Shillington’s charts only represent his initial studies, and they will need to be extended back further in time once his final report becomes available. Nevertheless, even at this early stage, the below data advance considerably our understanding of Ontario’s DB pension coverage trends. The data are broken down into three main categories: general employer pension coverage, public employer pension coverage and private employer pension coverage. a) General DB Coverage: Within Ontario, public and private DB pension plan coverage as a percentage of the paid labour force has been trending downward, from just under 40% to just above 30% over the period under consideration. However, while this percentage declined, there has been an increase in the number of paid workers in Ontario covered by registered pension plans (see Straus, 2007), implying that DB pensions are offered to new workers at a slower rate than these workers enter the labour force. Ontario-Employer Pension Coverage as a Percentage of the Paid Labour Force, by Type of Coverage, 1992-2005 100% DC and Mixed

90%

DB

80% 70% 60% 50% 40% 30% 20% 10% 0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: Calculations by Informetrica Limited based on Pension Plans in Canada, Statistics Canada

Figure 23: DB pension funding coverage: paid labour force

b) Public Sector: DB pension coverage in the public sector has been resilient to downward trends since 1992. Indeed, during this short time period (13 years), DB

27


coverage even marked a slight increase in coverage, though most recent years showed a very small decline. Ontario - Public Sector Employer Pension Coverage as a Percentage of the Paid Labour Force, by Type of Coverage, 1992-2005 100% 90% 80% 70% 60% 50% 40%

DC and Mixed DB

30% 20% 10% 0%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: Calculations by Informetrica Limited based on Pension Plans in Canada, Statistics Canada

Figure 24: DB pension funding coverage: public sector paid labour force

Private sector: Relative to Ontario’s public sector, DB pension coverage in the private sector is low: In 2005, the below chart shows a coverage ratio of roughly 20% (compared with nearly 80% in the public sector). In addition, private sector coverage is down from 1992. While the overall drop in coverage percentage has not been dramatic, the rate of DB coverage has dropped by roughly one third. We tentatively conclude that DB pension coverage in the private sector is slowly falling and is being replaced, at a rate of less than one for one, by DC and mixed plans. Ontario-Private Sector Employer Pension Coverage as a Percentage of the Paid Labour Force, by Type of Coverage, 1992-2005 DC and Mixed

20 05

20 04

20 03

20 02

20 01

20 00

19 99

19 98

19 97

19 96

19 95

19 94

DB

19 93

19 92

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Source: Calculations by Informetrica Limited based on Pension Plans in Canada, Statistics Canada

Figure 25: DB pension funding coverage: private sector paid labour force

28


Given that the public sector has shown much more resilience in terms of coverage than the private sector, the below will focus on the private sector experience. B) DB Coverage in a Global Context: DB coverage is clearly on the decline in certain countries. For example, in the United Kingdom, DB coverage dropped by roughly 15% during the 17 years preceding 2000 (Strauss, 2007). Below is a list of four factors that have frequently been associated with declining DB pension plan coverage in the private sector around the globe.15 It is clear that there is a strong link between the above section on funding and this section on coverage. If a pension becomes increasingly costly for the sponsor due to a perceived threat of underfunding, then the sponsor will be encouraged to close or freeze its plan. As such, some of the explanations for underfunding cited above are equally relevant here. a) Competitive Pressures: Increasing globalization has exposed firms with DB pensions to competition from other firms, both local and global, that do not offer such benefits. Pension plan coverage in the U.S. may be on the decline because private sector sponsors are keen to cut costs in the face of competitors with different benefit structures (Munnell et al., 2006). This is an important point, as in the private sector, DB pensions are offered voluntarily as part of employee compensation packages. As such, to understand declining coverage is also to understand the competitive pressures placed on the plan sponsor. Indeed, as Munnell and Soto (2007) illustrate: “The changing nature of work and the labor force that diminished the desirability of longterm employment relationships, the rising costs of providing lifetime benefits, the financial hit from the ‘perfect storm,’ and legislative and accounting developments all conspired to make defined benefit plans look particularly unappealing to employers at the beginning of the 21st century.” Referring specifically to private pensions, Clark and Wrigley (1995) argue, “Large sunk costs [such as DB pensions], in the end, threaten the very future of the corporation.” Indeed, DB pensions can reduce corporate competitiveness (Monk, 2007; Clark and Monk, 2007c). One way to evaluate this competitiveness claim—ie that pension obligations can have negative financial consequences on firms—is to investigate the effect of unfunded liabilities on a firm’s credit rating. Various studies have shown empirically that unfunded pension obligations do indeed impact the credit rating of the sponsoring firm (Carroll and Niehaus, 1998; Dhaliwal, 1986; Maher, 1987). In fact, according to Tuer and Woodman (2005) of the Bank of Canada, Standard & Poor’s downgraded General Motors Corporation and Ford Motor Credit Company because of pension deficits. Lower credit ratings will have tangible consequences for the sponsoring firm because capital, though still accessible, becomes more expensive. Further evidence shows that unfunded pension obligations are reflected in share prices (Feldstein and Seligman, 1981; and Franzoni and Marín, 2006), which is a standard barometer for the financial health of the firm.

15

We are focusing on the private sector because public sector coverage in Ontario is not an issue of concern.

29


Another way to look at the effect of DB pensions on competitiveness is to examine whether cash flow is constrained for the purpose of covering increased contributions. An econometric study by Rauh (2006) did just this by comparing a sample of firms’ capital expenditures with the funding status of their pension plans. Rauh shows that capital expenditure is reduced on the order of $0.60-$0.70 for every dollar of mandatory contribution. Constraining capital expenditure may have significant consequences for a firm. If the firm is forced to siphon off cash from investment in needed upgrades or research and development and put it toward pension contributions, this can reduce profitability in the long run and thus place downward pressure on the share price and decrease capacity to service debt.16 Take the example of General Motors’ experience with its DB pension. In 2003, GM contributed US$18.5 billion to its U.S. pension plans. According to CEO Rick Wagoner, DB pensions “put U.S. manufacturers at a severe disadvantage to overseas competition…the cumulative effect of many well-intentioned policies that now harm American manufacturing and our nation’s ability to compete effectively in the global market place.”17 While blaming pension costs for the entirety of GM’s problems may be overly simplistic due to the complex dynamic nature of competitiveness, additional pension costs will certainly compound other problems by tying up much needed capital that could otherwise be reinvested in the business. According to John Engler, CEO of the National Association of Manufacturers, “these external costs reduce profitability and tie up dollars that would otherwise be spent on investment, research and development, and new product lines.”18 As Monk (2007) argues, by diverting this capital, “a downward cycle takes hold that can affect all facets of the organization and threaten the very future of the firm.” In sum, as Exley, Mehta, and Smith (1997) argue, underfunding can, and does, result in the diversion of valuable capital to fill a gap in the sponsors’ pension funds. Clearly, increasing contributions in the current highly competitive environment is contributing to declining coverage, at least in the case of the United Kingdom and the United States. b) Government Regulation: Munnell et al. (2006) point out that “sponsors of [DB] plans face the risk that the rules governing these plans could change in a way that makes them more expensive.” Since DB pension provision by private sector firms is voluntary, any cost increases caused by changes in government regulation will lead some firms to close or freeze their plans (see Broadbent et al., 2004). In the U.S. context, regulation of DB pensions has over time been correlated with decreasing levels of coverage (Monk, 2007). First, regulatory rules in the form of benefit insurance (PBGC), bankruptcy (Chapter 11) and funding (ERISA, Pension Protection Act) have had long-term market-distorting effects, which stymie the private sector intra-firm process of pension restructuring by making public institutions 16 A DB pension can also potentially constrain the firm’s capacity to undertake expensive changes in its organizational structure or to exit poor performing investments by closing factories and laying-off employees. Altogether these effects may make the firm an easier acquisition target by other firms or private equity groups. 17 Remarks by Rick Wagoner to the Economic Club of Chicago. February 10, 2005. 18 Remarks of John Engler at the Economic Club of Pittsburgh (see: http://www.nam.org/s_nam/doc1.asp?CID=69&DID=236677)

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the first-order choice for restructuring. In addition, the reversion tax implemented in 1986 provided perverse incentives for plan sponsors to avoid overfunding (see Ippolito, 2001, 2003). Furthermore, stricter funding rules and a solidification of the pension promise has arguably contributed to the decline in coverage in the U.S. and the U.K. (Munnell and Soto, 2004; Monk 2007; Clark and Monk, 2007c). c) Accounting Changes: In general, global accounting standards are moving towards a mark-to-market form of pension accounting. Two important examples of this trend are: United States: In September 2006 the FASB introduced SFAS No. 158 amending the Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. This change has significantly altered the methods of pension accounting for sponsoring firms using U.S. GAAP in two ways. First, previous standards failed to recognize the true funded status of the pension plan in its statement of financial position. Under the new change sponsors of single-employer DB plans must recognize the fair market value of the difference between plan assets and the benefit obligation, and recognize the gains or losses during the period as a component of other comprehensive income. Secondly, the new rules now require the financial status of the DB pension plan to be reported directly on the balance sheet of the firm. Previous statements permitted the reporting of post-retirement benefit obligations in the footnotes of financial statements. International: Pension accounting under international standards follows IAS 19 Employee Benefits. Currently the IASB is undergoing a project to improve post-employment benefit accounting by 2010. So far the project has made important decisions, such as strengthening the mark-to-market form of pension accounting. For financial markets, mark-to-market is an improvement because it provides more transparent and timely information to capital market participants. However, it is widely accepted that this accounting change will contribute to the decline in the provision of DB pensions in the private sector (Fore, 2004; Broadbent et al., 2006; Klumpes et al., 2007). For firms with DB pension plans, mark-to-market can inject significant volatility into their balance sheets, thereby constraining the financial manoeuvrability of the firm in the short-run. This alone may give ample reason to firms to discontinue sponsoring a defined benefit plan or conversely refrain from opening a new plan. As Munnell et al. (2006) poignantly says with respect to these new accounting rules: “An attempt by the FASB to provide a more realistic assessment of pension plan finances is likely to introduce substantially more volatility in the reported financial results of the sponsoring companies, discouraging sponsorship of defined benefit pensions [emphasis added].” d) Unionization and Labour: Unionization is very strongly linked with DB pension provision (see Monk, 2007). Through their collective bargaining power, unions have been successful in negotiating for and protecting DB pension provision for their

31


members. For example, in the United States in 2003, 72% of unionized employees participated in a DB pension, as compared with only 15% of non-unionized workers. However, union membership, and thus union influence in the labour market, is on the decline in many countries. In the U.S., 20% of employed workers were in a union in 1983, but in 2006 only 12% claimed union status.19 Membership rates do vary by geography and industry, but most unionized employees are today concentrated in the public sector in the U.S. Canada has also faced a decline in union membership, although it has not been as severe as in the U.S., falling from 38% to 31% from 1981 to 2004. 20 We will discuss this in more detail in the next section. Given the link between DB pensions and unions, we can conclude that in regions where unionization is on the decline, DB pension provision will also decline. C) Local Trends: Global factors’ relevance in the case of Ontario: In part A of this section, we tentatively concluded from Shillington’s (2007) data that DB pension plan coverage in the Ontario private sector is on a downward trend (public sector coverage was resilient if slightly down). In this section, we seek to evaluate the factors that could be affecting this private sector coverage (since public sector coverage is high and stagnant, we refer less frequently to these funds and factors). This is done by linking the global factors cited above to the specific case of Ontario. Before starting this section it is worth acknowledging that the specific case of Canada is different from the global context. According to Broadbent et al (2006), “The shift from DB to DC pension plans is considerably less evolved [in Canada] than it is in the U.S., despite the close integration of the U.S. and Canadian economies and the many similarities of their pension systems.” Nevertheless, according to Luchak et al (2004), Canada, like the U.S., has witnessed a decline in private sector DB pension coverage in recent years. However, according to these authors, there is very little academic research discussing this trend in the Canadian context (one exception being Swidinsky and Kupferschmidt, 1991), suggesting that our task below will be difficult. a) Competitive pressures: Competitive pressures on plan sponsors have been linked above with a movement away from DB pension provision. Indeed, as plan sponsors face increased competition, they are looking to limit costly benefits. This begs the question: Are these same pressures relevant for DB plan sponsors in Canada and Ontario? First, we referred earlier in the paper to the increasing contribution rates over the recent past in order to try to illustrate changing levels of DB pension underfunding. In terms of competitiveness, it is important to evaluate who is in fact making these contributions. If employees are making the contributions in periods of underfunding, then the impact on the competitiveness of the firm will be negligible. However, if it is the employer making these contributions, then our argument about the impact on competitiveness in Ontario can proceed. Figure 26 shows a breakdown of public / private and employee / employer contributions to DB pension plans in Canada. We 19 20

US Bureau of Labor Statistics, http://www.bls.gov/news.release/union2.nr0.htm. Statistics Canada, http://www.statcan.ca/english/freepub/75-001-XIE/10405/art-1.htm.

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see clearly that in the private sector the costs of filling funding gaps are largely borne by the employers. Indeed, private sector employees have seen only a very gradual increase in their share of the cost over time. In the public sector, however, this is a very different story, as both employees and employers are sharing this cost. This perhaps helps to explain why coverage rates are so much higher than in the private sector. In any case, we can now make our argument about competitiveness, having demonstrated the burdensome impact on the plan sponsors. Pension Plan Contributions: Public / Private & Employee / Employer 16000000 14000000 12000000 10000000

Public: Employee Public: Employer

8000000

Private: Employee

6000000

Private: Employer

4000000 2000000

03

01

99

97

95

93

90

86

82

78

05 20

20

20

19

19

19

19

19

19

19

19

19

74

0

Figure 26: Pension plan contributions breakdown (Source: Statistics Canada and Datastream)

Since the introductions of the Canada-U.S. Free Trade Agreement (FTA) in 1989 and the North American Free Trade Agreement (NAFTA) in 1994, the structure of the Canadian economy has transformed from an east-west trading axis to a north-south trading axis. This has led some to view Canadian provinces as ‘North American economic region states’ (Courchene, 2003). Indeed, “the introduction of new technologies, new patterns of global competition, new strategies of production and distribution and new corporate structures has reconfigured Ontario’s economy” (OECP, 2007). Consequently, competition is clearly an issue for Canadian firms. Also, the dynamics of unexpected cash contributions have repercussions for Canadian firms’ competitiveness (for the reasons described above). Tuer and Woodman (2005) state that “the deterioration in the financial health of DB pension plans has underlined various long-term structural issues that could make it increasingly difficult for plan sponsors to manage the financial risks of DB plans…As we have seen in recent years, swings in pension fund performance can cause increasingly large unexpected cash contributions and adjustments to the financial results of plan sponsors.” Indeed, with respect to Canada, Armstrong (2006) argues, “Unfunded pension obligations can affect the financial position of the sponsoring corporation or government entity, representing a potential drain on cash flow through the need to make special contributions.” Nevertheless, according to the Dominion Bond Rating Service (DBRS, 2006), DB pension plans are only of concern for Canadian firms in manufacturing industries with an aging population and high levels of unionization. Moreover, we contend that firms who do not index DB pension benefits to inflation face lower costs and may view their pensions as more sustainable. Significantly, Ontario’s DB pension system does

33


not require benefit indexation (still, roughly 17% of DB pensioners do receive full indexation while 35% more receive partial indexation (OECP, 2007)). In contrast, in the U.K. inflation indexing has been a significant problem for plan sponsors (Clark and Monk, 2007a). (Also, see Appendix 1 for a series of charts that attempt to show how capital market indicators interact with DB pension plan coverage in Ontario over the long term. We decided not to include these charts in the actual text due to our concerns about the data used.) b) Government Regulation: Certain regulations can contribute to diminishing coverage. On the other hand, tax incentives can be a key driver of increasing coverage (Sass, 2006). In the Canadian context, we find evidence in the literature that government regulation has been both a positive and negative force for DB pension plan coverage. In short, Luchak et al. (2004) suggest that government policies in Canada have successfully increased coverage among DB pension plans. Specifically, they find that the tax treatment of pension plans is important, and that lower eligibility requirements in terms of income levels also increase coverage. Some also see negative impacts from government regulation on DB coverage in Canada. Pension legislation, regulation and case law, in particular in the area of surplus ownership, have created incentives in Canada for firms to stop providing DB pension plans according to Armstrong and Selody (2005) and Broadbent et al. (2006). In addition, since pension underfunding has a role in DB pension plan sponsors’ desire to close or freeze plans, the regulations cited in section 2 also have relevance here. c) Accounting Changes: In other jurisdictions, a shift to mark-to-market pension accounting has had a clear impact on DB pension coverage. However, to date, Canadian accounting has not adopted a mark-to-market approach. As such, it is unlikely that accounting has had impacts on DB pension plan coverage in Ontario (accept for those Canadian firms subject to U.S. or international accounting standards). Nevertheless, while mark-to-market has not yet arrived in Canada, it appears to be on the way. In October 2006, the Canadian AcSB issued a proposal to harmonize Canadian GAAP with U.S. GAAP as pertained to post-retirement benefit obligations.21 Also, in January 2006 the Canadian AcSB ratified a strategic plan to converge Canadian accounting standards with IFRS in the coming years. While the AcSB decided not to proceed with the proposal to harmonize with U.S. GAAP after receiving comments from stakeholders in July 2007,22 the convergence to IFRS is anticipated by 2011. Once IFRS is fully adopted, Canadian GAAP will cease to exist

21

See AcSB exposure draft ‘Employee Future Benefits (Amendments to Section 3461) Background and Basis for Conclusions’ May 2007. 22 See AcSB website.

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as a separate reporting standard,23 and accounting standards for pension obligations will move towards mark-to-market accounting. So, in the future, accounting may have a much bigger role to play in Canadian pension fund coverage. d) Unionization and Labour: Organized labour has a historic role in driving increased occupational pension coverage in Canada (Carmichael, 2005). Unionization is clearly linked with DB pension plan coverage at the global level. This trend appears to hold true in Canada and Ontario as well (see Figure 27). In Ontario, “defined benefit plans are often (but not always) associated with unionized workplaces” (OECP, 2007). Indeed, Canadian unionization levels have consequences for DB pension coverage (Luchak et al., 2004). Also, Canada’s higher DB pension coverage rate is the direct result of higher levels of unionization in Canada relative to the United States (Brown and Liu, 2001). Percentage of Paid Employees Reporting Pension Coverage by Firm Size and Unionization Ontario - 1999-2005

90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

1000 and over 500 to 999 100 to 499 Firm Size 20 to 99

M em be r

N ot

U ni

on

M em be r

Less than 20

Unionization

Less than 20 20 to 99 100 to 499 500 to 999 1000 and over

Source: Calculations by Informetrica Limited based on SLID, Statistics Canada

Figure 27: Pension Coverage. Firm Size and Unions

Nevertheless, “since the early 1980s, the proportion of Canadian workers belonging to labour unions has declined considerably.”24 According to data from Statistics Canada, unionization in Ontario decreased by 6.4 percentage points between 1981 and 2004 (from 33.7% to 27.3%). Moreover, when looking only at the Ontario commercial sector, union membership over the same time period fell by 9.9 percentage points (from 27.9% to 18%). Statistics Canada also claims that “these trends have important implications for earnings and pension coverage…Between 1986 and 1997, pension coverage among men aged 25 to 34 declined by 8 percentage points, with almost 60%

23

For more information see AcSB’s ‘Accounting Standards in Canada: Implementation Plan for Incorporating IFRS into Canadian GAAP’, available at the AcSB’s website. 24 See: http://www.statcan.ca/english/freepub/75-001-XIE/10405/art-1.htm.

35


attributable to declining unionization.”25 Clearly, one cannot overstate the importance of unionization for DB pension coverage, whatever the jurisdiction (see Mainville and Olineck (1999) for a more detailed discussion about unionization rates in Canada). D) DB Coverage in Canada: Findings from an Expert Survey: Gordon Clark and Ashby Monk (2007c) recently conducted a survey of ‘pension experts’ in order to understand the reasons for the decline in DB pension provision. While this survey was global in nature, it did produce roughly 120 pension ‘expert’ responses from Canada. A large majority of the experts had over 10 years experience working on issues directly pertaining to pensions. This type of expert perceptual data is frequently used in social sciences. See Appendix 2 for a discussion of the academic merits of expert opinion surveys. Also, see Appendix 3 for details of the survey setup and design. In short, the findings from these individuals provide additional insights into the factors impacting DB pension coverage in Canada and Ontario. These insights are shared below. The first finding of relevance has to do with how the Canadian experts perceived the future of DB pension plans in the private sector. The experts were presented with the following statement: “In 20 years, there will still be private sector defined benefit pension schemes open to new members.” The results are shown graphically below in Figure 28. Clearly, the Canadian expert respondents hold an optimistic view of DB pension coverage going forward.

strongly agree

9.1

agree

49.6

neither

10.7

disagree

24.8

strongly disagree

5.8

0

10

20

percent

30

40

50

Figure 28: DB pensions’ future

Next we evaluated to what extent competitive forces were behind declining coverage rates among private sponsors. As such, the experts responded to the following: “Increased market competition stemming from deregulation and globalization has weakened the competitive position of private DB plan sponsors with large pension liabilities.” On this issue, as demonstrated in Figure 29, the experts overwhelmingly agreed that global economic forces are weakening the competitive position of Canadian DB plan sponsors. This could help to explain the declining coverage rates in the private sector.

25

See: http://www.statcan.ca/english/freepub/75-001-XIE/10405/art-1.htm.

36


strongly agree

14.3

agree

51.3

neither

9.2

disagree

19.3

strongly disagree

5.9

0

10

20

30 percent

40

50

Figure 29: DB pensions and competitiveness

In order to see which types of employees were driving the persistence in DB, the experts assessed the following: “The most forceful advocates for DB pensions are older workers nearing retirement.” They largely agreed (see Figure 30).

strongly agree

13.2

agree

49.6

neither

12.4

disagree

23.1

strongly disagree

1.7

0

10

20

percent

30

40

50

Figure 30: DB pensions and Older Worker Support

Finally, we tried to determine whether DB pensions were viewed as valuable benefits for young people. As such, we presented the experts with following: “Mobility and pension portability are more important than generous DB plans for young workers.” Most agreed with this statement, suggesting that young people are not interested in maintaining DB pensions, preferring benefit systems with more portability.

strongly agree

22.3

agree

44.6

neither

11.6

disagree

19.0

strongly disagree

2.5

0

10

20

percent

30

40

50

Figure 31: DB pensions and Young Workers

Finally, we explicitly asked the experts why sponsors were closing or freezing DB pension plans in the private sector. The Canadians overwhelmingly put ‘increasing costs’ as the primary reason. This could be interpreted in many ways: higher

37


contributions stemming from underfunding; higher contributions stemming from increasing longevity; higher administrative costs associated with regulation; and many more. 26 In any case, those intent on maintaining DB pension plans in the private sector will need to reconcile coverage with cost.

26

In addition, Canadian experts also mentioned, in order of importance, inflexible regulation, competitive pressures, unquantifiable risks, and finally unreasonable accounting rules.

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5) CONCLUSION The funding and coverage of DB pension plans is an issue of vital concern in Ontario as in the rest of the world. In this paper, we have tried to evaluate the current state of pension funding and coverage in Ontario. Despite severe data limitations, we have reached, through reference to available literature and data, the following conclusions. First, DB pension underfunding is a recent and ongoing phenomenon in Ontario. We come to this tentative conclusion by looking at data on funding proxies and by reviewing several funding studies available in the public domain. However, Canada’s DB pension underfunding today is based more on problems with the liability then on problems with the assets. Indeed, after 2002, equity values appear to have increased considerably. Nevertheless, contribution levels (one of our proxies for funding) have also increased considerably, suggesting that rising assets have not been enough to fill the funding gap. Indeed, low discount rates appear to be the root cause of underfunding, compounded by increasing longevity, actuarial practice and regulation. As for coverage, DB pensions in Ontario show only a very gradual decline over the time horizon provided by Shillington. Nevertheless, we find a much faster decline in the private sector than the public sector. Indeed, private sector coverage has dropped by roughly one third over the period under consideration (1992 to 2005). We conclude that competitive pressures, government regulation and declining unionizing rates have been important factors in driving this decline in DB coverage in the private sector. (We did not focus our attention on the public sector due to more resilient coverage levels.) In short, Ontario’s DB pension system is facing similar problems as their global cousins. Declining coverage and plan underfunding are noted. However, Ontario also exhibits distinct differences from the global experience. Indeed, DB coverage, though on the decline, appears more resilient than in the U.S. and the U.K. Also, underfunding does not appear to be associated with the asset side of the equation (relative to the US and UK) but with the liability side (due to interest rates, increasing longevity, etc.). Future research would benefit from actual Ontario DB pension funding data over time, as the specific case of Ontario presents an interesting and unique case study with which to examine the impact of the above factors. In addition, the qualitative judgements made herein should be challenged through quantitative testing. It is our understanding that other OECP mandates will do just that.

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Van Riel, B., J. De Deken, et al. (2006). Social solidarity. The Oxford Handbook of Pensions and Retirement Income. G. L. Clark, A. Munnell and M. Orszag. Oxford, Oxford University Press: 141-60. Waverman, L. (1991). Corporate globalization through mergers and acquisitions. Calgary, University of Calgary Press. Weitz, H. (1992). The Pension Promise: The Past and Future of Canada's Private Pension System. Toronto, Carswell Thomson Professional Publishing. Wiedman, C. and H. Weir (2005). "Pension accounting: The end of smoothing?" Ivey Business Journal(March/April). Yaron, G. (2005), "Taking a Holiday: The impact of employer contribution holidays on the funding of defined benefit pension plans." Shareholder Association for Research and Education. June 2005. Zion, D. and B. Carcache (2005). Let The Games Begin: FASB to Tackle Pensions and OPEB. New York, Credit Suisse.

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7) APPENDICES Appendix 1: Our mandate asks us to provide long-term charts (20 years or more) demonstrating how funding and coverage interact with capital market factors. This has been made extremely difficult due to severe data shortages. In terms of funding, we have attempted to overcome this by using contribution data (one of our proxies for funding) that goes back into the 1970s. In terms of coverage, we are also forced to be resourceful: While Shillington’s work has the coverage data for Ontario, we were never given access to these data in raw form. As such, we attempt below to offer three charts on Ontario’s DB coverage and capital market indicators. These charts come with several important caveats. The DB coverage data was calculated using the amount of DB pension plan members in a given year (Stats Can) and dividing it by the number of employed persons in Ontario for that same year (Stats Can). We believe the simplicity of this calculation makes any flaws in this approach transparent to those who intend to interpret the charts. Indeed, we say this because there are limitations: For example, the employed persons used in this calculation undoubtedly include the self employed, which may artificially lower the DB pension plan coverage in the province. In any case, we leave the interpretations of the below to the reader. DB Coverage in Ontario 45.0%

14

40.0%

12

35.0% 10

30.0% 25.0%

8

20.0%

6

15.0%

4

10.0% 2

5.0%

0

19 19 76 19 77 19 78 19 79 19 80 19 81 19 82 19 83 19 84 19 85 19 86 8 19 7 19 88 19 89 9 19 0 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 20 99 20 00 20 01 20 02 20 03 20 04 20 05 06

0.0%

DB Coverage

CPI - Annual Inflation Rate

Figure 32: DB pension coverage and CPI (Statistics Canada and Datastream) DB Coverage in Ontario 0.45

25

0.4 20

0.35 0.3

15

0.25 0.2

10

0.15 0.1

5

0.05 0

De De c-1 9 De c-1 976 De c-1 977 7 De c-1 9 8 De c-1 979 8 c De -1 9 0 8 De c-1 9 1 De c-1 982 De c-1 983 8 De c-1 9 4 De c-1 985 De c-1 986 De c-1 987 De c-1 988 8 De c-1 9 9 De c-1 990 De c-1 991 9 De c-1 9 2 De c-1 993 De c-1 994 9 De c-1 9 5 De c-1 996 c De 1 997 9 De c-1 9 8 De c-2 099 c De -2 000 De c-2 001 De c-2 002 0 De c-2 0 3 De c-2 004 c-2 05 00 6

0

DB Coverage

BOC Target Rate

44


Figure 33: DB pension coverage and BOC Target Rate (Statistics Canada and Datastream) DB Coverage in Ontario 45.0%

14000

40.0%

12000

35.0% 10000

30.0% 25.0%

8000

20.0%

6000

15.0%

4000

10.0% 2000

5.0%

0

D Dee cDe c-11 97 De c-1 976 De c-1 977 De c-1 978 De c- 989 De c-11 980 De c-1 981 De c-1 982 De c-1 983 De c- 984 De c-11 985 De c-1 986 De c-1 987 De c-1 988 De c- 999 De c-11 990 De c-1 991 De c-1 992 De c- 993 De c-11 994 De c-1 995 De c-1 996 De c-1 997 De c- 998 De c-22 009 De c-2 000 De c-2 001 D c- 002 Dee c-2 003 c-2 004 20 5 06

0.0%

DB Coverage


Figure 34: DB pension coverage and TSX (Statistics Canada and Datastream)

Appendix 2: As Useem (1995) noted, perceptions and opinion are not always accurate reflections of experience and reality. Nevertheless, expert opinion surveys are increasingly important methodological tools within social science research. According to Castles and Mair (1984), in situations where reliable and objective data is missing, ‘expert’ opinion or judgments can act as a reliable substitute. The key to these surveys, however, is the characteristics of the respondents; surveys of highly educated individuals will typically be more reliable than surveys of the mass public for a given domain (Alwin and Krosnick, 1999; and Weber, et al., 2002). This implies that being an expert on a subject makes one’s responses on this subject more reliable (Huber and Inglehart, 1995). So, as Dorn and Huberman (2005) claim, experts’ responses can be proxies for actual evidence when they are surveyed in the specific domains in which they are knowledgeable. As such, the survey explicitly sets out to match domain specific questions with the appropriate group of expert respondents. By virtue of their education, profession, and experience, the Canadian pension ‘experts’ surveyed arguably have special knowledge of this subject beyond that of the average person, sufficient enough that we may rely upon their opinion as a proxy for actual evidence. Appendix 3: With the support of the British Academy, the Lupina Foundation, and colleagues at Harvard University and the University of Toronto, a “DB pension liability summit” was convened in May 2006 at Oxford University to consider the prospects for private DB pensions (for details and a summary of proceedings for this conference, which Clark and Monk organized, see: http://www.ouce.ox.ac.uk/news/phclcs/). To inform the conversation, Clark and Monk (2007) prepared the background paper detailing the prevailing forces at work undercutting the institution as well as the ways DB pension institutions may be reconceived to be relevant to 21st century financial and economic realities. Amongst the 50 or so attendees were plan pension plan sponsors, trustees, labour representatives, actuaries and benefit lawyers, finance professionals, consultants, government regulators and academics. So as to gauge the level of agreement and disagreement on crucial issues, attendees were asked to respond to a 27-statement survey with the results compiled and then distributed after the event. 45


In designing the survey, a number of issues were considered. First, it was crucial that the topics raised be relevant to the history of DB pensions in a variety of settings. At the same time, it was clear that it should not be so general that its reach produced superficial conclusions of little relevance to any particular country. Second, it was important that respondents’ opinions be tested for coherence and consistency; there were thus overlapping and related questions included in the survey. Third, it was important that the survey allow for the assessment of opinions against core academic assumptions such as the “implicit contract” hypothesis. Fourth, we sought opinions on likely behavioural aspects of pension decision-making such that responses could be matched against the behavioural finance literature (especially Kahneman and Tversky 1979 and Tversky and Kahneman 1991). This allowed for the collection of information and the evaluation of respondent responses against recognised benchmarks (e.g. that most people are risk adverse). For all the insights generated from the pilot survey, the sample size was hardly adequate to draw firm conclusions. Even so, the survey results caught the interest of the editors and publishers of Pensions & Investments. After review, revisions, and further trials, a new survey was launched in early January 2007 as an online instrument with the support of the newspaper and academic institutes and experts from around the world. After an “open-window” of about 4 weeks (beginning January 7th 2007), the data were collated into a composite file for analysis. Of the nearly 1600 responses, roughly 120 were from Canada. 8) APPENDIX REFERENCES: Alwin, D. F. and J. A. Krosnick (1991). "The Reliability of Survey Attitude Measurement - the Influence of Question and Respondent Attributes." Sociological Methods & Research 20(1): 139-181. Castles, F. G. and P. Mair (1984). "Left Right Political Scales - Some Expert Judgments." European Journal of Political Research 12(1): 73-88. Clark, G. L. and A. H. B. Monk (2007a). "The 'crisis' in defined benefit corporate pension liabilities Part 1: Scope of the problem." Pensions: An International Journal 12(1): 43-54. Dorn, D. and G. Huberman (2005). "Talk and Action: What Individual Investors Say and What They Do." Review of Finance 9: 437-481. Huber, J. and R. Inglehart (1995). "Expert Interpretations of Party Space and Party Locations in 42 Societies." Party Politics 1(1): 73-111. Kahneman, D. and A. Tversky (1979). "Prospect Theory - Analysis of Decision under Risk." Econometrica 47(2): 263-291. Tversky, A. and D. Kahneman (1991). "Loss Aversion in Riskless Choice - a Reference-Dependent Model." Quarterly Journal of Economics 106(4): 10391061. Useem, M. (1995). Reaching Corporate Executives. Studying Elites Using Qualitative Methods. R. Hertz and J. B. Imber. London and New Delhi, Sage: 18-39. Weber, E. U., A. R. Blais, et al. (2002). "A domain-specific risk-attitude scale: Measuring risk perceptions and risk behaviors." Journal of Behavioral Decision Making 15(4): 263-+.

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