The Bank of Canada's cut in its overnight lending rate is yet another blow to Canadian corporate pension plans already struggling with mark-to-market accounting rules and investments hurt by the country's sagging economy.
The impact of the change Jan. 21 in the overnight rate, to 0.75% from 1%, won't immediately lead to declines in the 30-year Canadian government bond rate used to measure plan liabilities, but industry experts said it will hurt DB plan funding — even if most Canadian corporate plans already have taken on some kind of derisking strategy or changed their plan design.
The overnight rate cut “will obviously have an impact on Canadian corporate plan sponsors,” but not immediately, said Benoit Labrosse, Montreal-based partner in consultant Morneau Shepell Ltd.'s pension investment unit. “But because Canadian plans' fiscal years usually end on Dec. 31, that impact won't be fully recognized now, but instead at the end of 2015. But if I'm a plan sponsor and suddenly rates go down when I've been expecting them to go up, then I know the cost of accruing benefits is going to be more than expected and the deficit will increase.”
What makes it difficult for Canadian corporate plans is that under various provincial regulations governing pension accounting, plans must base their contributions on a mark-to-market solvency rate, which measures liabilities based on if the plan had to terminate immediately and without smoothing, as is allowed in the U.S.
In the U.S., a cut in the overnight rate “wouldn't change discount rates very significantly,” said Mathieu Tessier, senior consulting actuary with Towers Watson & Co. in Montreal. “In Canada, it can. Will this rate hike affect funding? That's the question. In the last 14 months, rates on long bonds are down 120 basis points, to about 2% for a 30-year Canadian government bond.”
But the decline in the long-bond rate has been affected more by the decline in the Canadian economy than by the Bank of Canada's recent actions, Mr. Tessier said. On Dec. 31, that rate was 2.33%; on Jan. 15, before the bank of Canada's action, it was 2.1%. From the Jan. 21 rate cut announcement through Jan. 22, the rate slipped just three basis points, to 2.07%.
The news of the rate cut has corporate pension fund executives even more concerned about the mark-to-market rules and put many in a position to choose among adopting liability-driven investing strategies, changing plan design or shutting down the pension plan and potentially forcing the sponsoring company into bankruptcy since it would still be responsible to fund the plan under solvency rules, said Jana Steele and Douglas Rienzo, partners, pensions and benefits group, at the law firm of Osler, Hoskin and Harcourt LLP, Toronto.
One Canadian corporate plan that adopted LDI is the C$13.6 billion (US$10.9 billion) Air Canada Pension Plan, Montreal. The shift helped it turn a C$3.7 billion deficit at the start of 2013 into a “small surplus,” the company reported in an investment update in January 2014. Isabelle Arthur, Air Canada spokeswoman, said the company wouldn't comment on its pension investment strategy.
Pension fund executives are “really looking at changes in plan design, potentially freezing their plans, opening target benefit plans, defined contribution plans, buy-ins and buyouts,” Ms. Steele said. Pension buy-ins and buyouts have been of particular interest to clients since the overnight rate was cut, she added. “A lot of our clients see changes in plan design as a big way to mitigate risk.”
Changing plan design “is one way to attack” funding shortfalls, said Mr. Rienzo. “There are other things they are looking at, like increasing corporate contributions to get more money into the plan. But there are those looking more at increasing employee contributions as well. I definitely think that (DB plan executives) are taking action. The rate announcement was a surprise, but most people look at it and see that it's just more of the same. No one expects to see rates of 5%, 6%, 7% anytime soon. This is the new normal. Plans have a lot of tools in the tool box to derisk, and they're looking more at those tools.”
However, Manuel Monteiro, partner, retirement business, at Mercer (Canada) Ltd., Toronto, doesn't expect “a rush to derisk” after the rate cut. In fact, corporate funded status since the Jan. 21 announcement has been “a little counterintuitive,” Mr. Monteiro said, as funding positions actually improved. According to the Mercer Pension Health index, which gauges the median funding ratio of Canadian corporate pension funds, funding was a median 95% as of Jan. 1, fell to an estimated 92.5% on Jan. 20, the day before the rate cut announcement; and rebounded to 94% as of Jan. 27.
Still, changing plan design, while helpful, doesn't solve the issue of valuing liabilities through a solvency calculation, said Leo LeBlanc, vice president, human resources and corporate affairs, at the C$155 million Co-op Atlantic pension plan, Moncton, New Brunswick.
The DB solvency rate is an “artificial calculation,” said Mr. LeBlanc. “Because of it, the government with their rules has stripped away billions of dollars in pension assets across the landscape. Imagine if rates go down to 0%, you'll need to come up with some new funding calculation or you are going to squander a lot of wealth that has been built over time by employees in their pension plan. Otherwise, all sorts of pension plans and companies will go out of business — especially with the decreasing interest rates we have been experiencing.”
What has benefited Co-op Atlantic, Mr. LeBlanc said, was a New Brunswick law that allowed DB plans in the province to impose a shared-risk design on a traditional DB plan. Under the shared-risk plan, a stable accrual rate of 4.5% is set and deficit catch-up payments are spread over 15 years, as opposed to five years under solvency rules for traditional DB plans. The company pays the present deficit, but future contributions are shared by the employer and employees. Under this formula, Co-op Atlantic's plan is 85% funded; under the solvency rules, it's 75% funded.
Mr. LeBlanc said the Co-op Atlantic plan would have shut down and the company might have gone bankrupt without the shared-risk option. Still, he said, “we're always facing the solvency question — which is fine for transparency. But with our SRP rules, we took a deficit of C$64 million at Dec. 31, 2012, and cut it in half” by Dec. 31, 2014. “Now another cut in rates forces us into a difficult situation again. We're still worried about solvency even with the changes we've made.”
Mr. LeBlanc suggested that provincial and federal governments set the actuarial rate minimum threshold for calculating solvency “possibly around 4% to 4.5%. Keep in mind that the long-term market returns are probably around 7%. So when the interest rates drop to record lows, plans would be protected. Instead of using Canada Saving Bonds as the benchmark, you would use a combination of stable investments as a base and minimize the risk. Then when buying annuities, insurance companies could use a wider range of investment vehicles. … The rate to determine accruals should include combined rates from mortgages, corporate bonds, provincial bonds and infrastructure. That would provide for the long term, a better forecast of where your funding levels really are.”