Even though some experts say concerns may be overstated, the vast majority of Canadians are worried about a pension underfunding crisis in this country.

According to a survey conducted by the Conference Board of Canada in September 2005, four out of five Canadians are concerned that there is a pension underfunding crisis in Canada. Of the 2,000 people surveyed across the country, 34% said they were very concerned about pension-plan underfunding , while another 29% were somewhat concerned and 17% were mildly concerned.

Women were more likely than men to say they were very concerned, and people in their 30s and 40s were more likely than other age groups to say they were very concerned about pension underfunding.

The results are similar to a January 2005 survey of chief financial officers — conducted jointly by the Conference Board and pension consultants Watson Wyatt Worldwide — that showed an increasing number of CFOs are worried about the funding situation faced by pension-plan sponsors.

“Actuaries and financial managers aren’t the only people concerned about the state of pensions in Canada,” says Edward Reed, senior research associate with the Ottawa-based Conference Board. “The general public is also worried about having enough for retirement.”

Underfunded pension plans have an impact on employees, retirees and their sponsor companies, says the Conference Board. For employees and retirees, an underfunded pension plan means uncertainty about future benefits. And for companies? “It means they may have to inject significant sums of money into the plans — money that might otherwise have ended up on the bottom line or invested in new plants and equipment,” says the Conference Board.

Reed notes that a 2004 survey of CFOs found 20% of respondents thought the underfunding problem was severe but, by early 2005, that had jumped to 43%. The 2004 survey also found that only 5% of CFOs with large pension plans felt there was a widespread problem that was likely to remain beyond the next few years. But by 2005, 47% of CFOs felt that way. The survey noted heavy cash flows are being diverted from other business activities into pension funds and that the management of pension risk remains at or near the top of the agenda for many CFOs.

Adding to the bad news was an announcement by the Office of the Superintendent of Financial Institutions in late November that said 72% of federally regulated defined-benefit plans were less than fully funded as of June 2005, compared with 53% in December 2004. But, says Julie Dickson, assistant superintendent in OSFI’s regulation sector: “It is important not to overreact.” Although the number of underfunded plans is high, on average the shortfall is less than 10%. “The situation can be described as ‘stable but fragile’,” she says.

Dickson points out that pension regulations do not require defined-benefit pension plans to be fully funded at all times. But in a situation in which the ratio of assets to liabilities on a solvency — or liquidation — basis is less than one, the plan must fund the deficiency over no more than five years.

And most underfunded plans should be able to meet those requirements, says Karen Badgerow-Croteau, managing director of OSFI’s private pension plan group in Ottawa.

OSFI regulates and supervises about 10% of all pension plans in Canada, representing about 20% of total pension assets; the rest fall under provincial jurisdiction. The federal agency tests the solvency of pension plans on a regular basis to detect problems and challenges early on, so it can take steps to safeguard members’ benefits. The pension plans that give rise to serious concerns are placed on a watch list and are actively monitored. There are currently 83 pension plans on the watch list — 50 of which are defined-benefit plans.

In the spring of 2005, a common sentiment in pension circles and among economic forecasters was that long-term interest rates would be higher in 2005, with positive implications for plan solvency, says Dickson. But instead of rising, long-term rates have remained at historical lows and even declined further, she adds.

OSFI’s latest test shows the average estimated solvency ratio (ESR) fell from 1.00 in December 2004, to 0.91 in June 2005, with three main factors contributing to the 9% drop, Dickson says. Although the strong performance in equity markets improved the average ESR by 3%, that was offset by lower long-term bond rates, which were responsible for a 5% drop, and changes in actuarial methods, which resulted in a further 7% drop.

@page_break@Those new actuarial standards “will have a very real impact on individual plans’ solvency ratios going forward,” says Dickson.

Two of the changes that created these standards, which were recently introduced by the Canadian Institute of Actuaries, will affect the way pension fund liabilities are calculated, says actuary Tony Williams, retirement practice leader for Western Canada in Watson Wyatt’s Calgary office.

First, mortality rate assumptions have been changed to reflect the fact that people are now living longer. And, second, assumptions about the rate of return on pension fund investments have been changed to bring them more in line with current bond market yields. These two changes together could increase solvency liabilities by as much as 10%, Williams says. The January 2006 valuation of pension plans will be the first to reflect the new standards. “The timing was not particularly good,” he admits.

Although 2005 was a really good year for pension fund returns, “it won’t be enough because liabilities are growing faster than assets,” Williams says. But, he adds, he wouldn’t call the current pension funding situation a “crisis,” noting that some plans are in good shape and some still have significant surpluses. Funding is much more of an issue for certain industries and particular companies, he notes, pointing to Air Canada and General Motors Corp. in the U.S. as examples.

It’s also important for individuals to look at the health of their own particular pension plans, says Williams. Advisors need to remind clients to review the annual statements they receive from their pension-plan sponsors with care. The statement will indicate if there is a solvency deficiency in the client’s pension plan. Williams recommends looking for the actuary’s opinion statement. If the “transfer ratio” is less than 1.0, it means the solvency assets are less than solvency liabilities.

But, even then, if the company sponsoring the plan is sound, there may be no need to worry because the plan sponsor may be able to make up the shortfall over the requisite five-year period, says Williams, who notes that Air Canada was given a special dispensation to make up its pension funding shortfall over 10 years. “It isn’t every plan that’s in trouble,” he says. “It’s just some plans.”

Given that changes in financial and economic variables have triggered the “expected deterioration” in the financial position of many pension plans, Dickson emphasizes that “heightened vigilance” will be needed. OSFI offers six key points for stakeholders to consider:

> Pension plans need to focus on the impact of low interest rates and the new actuarial standards.

> Funding requirements are very sensitive to changes in economic conditions. An increase in long-term interest rates or a very strong equity market could go a long way toward alleviating the situation. “But don’t bet on such favourable outcomes,” says Dickson.

> Disclosure to plan members — and member awareness regarding the health of the plan — is key in this environment.

> OSFI does not necessarily consider a plan facing a significant increase in funding to be a high-risk plan. Rather, it depends on the health of the sponsor and the number of active members paying into the plan.

> OSFI will continue to exercise its authority to ensure compliance with pension legislation and regulations. It will also continue to identify underfunded plans in which plan sponsors are taking contribution holidays and it will take action — ranging from strongly encouraging plan sponsors to cease contribution holidays to requiring enhanced notification to members and/or requesting early valuation reports.

> The agency is also prepared to continue working with plan sponsors and members “to find reasonable solutions,” Dickson says. “This could involve plan restructuring to make them more affordable and approving benefit reductions, which is better for plan members than the alternative of plan termination.”

The Conference Board and Watson Wyatt will hold a pension summit in Toronto in early May, when the results of a new survey of CFOs and senior human resources people will be available.

Regarding a move away from defined-benefit plans (which guarantee pensions related to earnings and years of service) toward defined-contribution plans (in which no particular pension is guaranteed), Reed suggests the pendulum is slowly swinging the other way. He says employers will see defined-benefit plans as a way to hold on to older workers and to attract younger workers who are becoming concerned about their financial security over the longer term. IE