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Pension funding: How solvency and going-concern funding have diverged since 2006

For many years now, Morneau Shepell has been tracking the funded status of pension plans on a month-by-month basis and reporting it in News & Views. At the end of each year, we reset the starting values to 100 in order to track the following year. It is instructive to take a step back periodically in order to see the longer-term evolution of pension funding in Canada. In particular, this enables us to understand more clearly why so many employers in the private sector have been closing their DB pension plans to new hires.

The chart on this page shows how the funding of a typical defined benefit pension plan would have evolved with market conditions over the last decade.

  • The blue line shows how solvency funding has evolved. A DB plan that was fully funded at the end of 2006 on a solvency basis would be only 86 percent funded at the end of 2016. (This assumes no special payments toward liquidating the deficit.)
  • The orange line shows how going-concern funding produced an entirely different story. If the plan had been fully funded ten years ago, then today it would be 155 percent funded!

Funding on a going-concern basis improved so markedly because of excellent investment returns, mainly since the end of 2012, easily undoing the ravages of the 2008-2009 market debacle. The improvement is especially impressive given that the mortality assumption has been strengthened twice in the past ten years and even the going-concern valuation interest rate has been reduced to reflect lower future return expectations.

So when governments require plan sponsors and administrators to consider both bases in making decisions on funding DB promises and in managing the substantial financial risks involved, we can see the daunting challenges that result. Around the mid-1980s, when DB plans flourished, plan sponsors and actuaries had the luxury of focusing only on going-concern funding. Mark-to-market accounting did not exist yet and the regulators did not insist yet on solvency funding. Going-concern deficits were not a major problem then since they could be amortized over 15 years and besides, one could count on the bad years eventually being offset by good ones. Had the investment experience we have enjoyed in the last decade been combined with the funding and accounting rules as they existed in the 1980s, DB plans would now be enjoying a golden age. They would have continued to thrive, with plan stakeholders having plenty of opportunities to consider significant contribution holidays and benefit improvements.

The funding divergence in DB plans since 2006

The funding divergence in DB plans since 2006

Conclusion

The problem with DB plans has not been poor investment performance; it has been the impact of ever-lower interest rates on solvency liabilities (as well as accounting liabilities), combined with burdensome solvency rules aimed at theoretically safeguarding the tragic but rare events of plan wind-ups following the insolvency of the employer. The strict rigidity of DB plan promises, long considered to be a strength of the defined benefit model, has ultimately proven to be its greatest failing. This one chart alone shows that the time has come for substantial changes in pension legislation, such as solvency reform (already implemented in Quebec and discussed in Ontario) as well as new plan designs like shared risk or target benefit plans (already implemented in New Brunswick and proposed for Federal employers and for multi-employer plans in a few provinces).


News & Views - February 2017 (PDF)