The decline of defined-benefit (DB) pension plans in Canada is being exacerbated by federal laws and regulations that foster employer underfunding, says a study released today by the C.D. Howe Institute.

An example is the prohibition by the federal Income Tax Act (ITA) of sponsor contributions to single-employer, DB plans when their assets exceed recorded liabilities by 10%, says the e-brief, “Lifting the Lid on Pension Funding: Why Income-Tax-Act Limits on Contributions Should Rise.”

Recent volatility in asset prices and interest rates, and resulting volatility in DB plan balance sheets, highlights the desirability of raising — or even removing — this restriction, say authors Robin Banerjee and William Robson. Limiting employer contributions stops plan sponsors saving in fat years to cushion lean ones, they note. It either forces sponsors to inflate the size of reported liabilities so the cap does not constrain funding, or stops companies from pursuing consistent contribution strategies as interest rates and asset markets fluctuate.

Using a model of a DB plan invested 40% in bonds that match its liabilities and 60% in equities that do not, the authors show the effect of lifting the limit to 25% and removing it entirely on the frequency of annual deficits and surpluses under plausible assumptions about market volatility. At a 25% limit, deficits are as infrequent and as small as when there is no limit at all.

The ITA limit on contributions is not the only problem afflicting DB plans, but raising it to 25% or removing it entirely would be a useful step toward more healthy DB pension plans in Canada, the C.D. Howe Institute says.