Provision for adverse deviations: In search of a balanced approach
By Jeff Bradley
Insights – November 2020
All views expressed are the authors’ own and do not necessarily reflect the official position of any agency, organization, plan sponsor or company.
Conservatism in a pension plan is a lever to provide secure benefits and is an important tool that guards against future negative events. However, the higher the level of conservatism, the lower the level of benefits that can be provided. In addition, higher levels of conservatism can shift plan assets from the current generation of members to future members. Trustees must be able to balance the level of conservatism with the desired level of benefits, with an appropriate level of benefit security, while maintaining equity among different generations of members.
New pension plan funding rules that are being implemented across Canada for target benefit plans (TBPs) will shift how conservatism is viewed and the role it will play in a plan’s funding approach. When funding rules impose an excessive level of conservatism, trustees will be compelled to remove the conservatism currently built into other areas of their funding approach and may be forced to reduce benefits. Minimum funding rules should balance benefit security with benefit level and allow trustees to retain some measure of influence over the prudent level of funding.
Over the last five years, significant pension funding reform for TBPs has been introduced across Canada, resulting in the permanent removal of solvency funding requirements and the introduction of more rigorous going concern funding rules. Removing solvency funding is a necessary change since it is simply an inappropriate minimum funding requirement for these plans. The enhanced going concern funding rules contain new requirements, including:
- Mandating plans hold a large contingency reserve, or buffer, known as a provision for adverse deviations (PfAD); and
- Restricting benefit improvements until the plan’s assets exceed a certain threshold, such as the
going concern liabilities plus the PfAD.
The purpose of a PfAD is to build a new reserve in the funded status of the plan and enhance benefit security. How the PfAD is calculated and applied varies by jurisdiction. In some jurisdictions, the PfAD can exceed 30%, which means one-third of the members’ contributions are allocated to building a reserve fund instead of earning a pension. While not all jurisdictions have PfADs at such an excessively high level, even a 15% PfAD will have a considerable impact on the amount of benefits earned by members.
To make matters worse, the PfAD in most jurisdictions is based on current interest rates. With PfAD levels tied to volatile interest rates, the recent decline in interest rates has resulted in massive increases in PfADs that change substantially year after year. This is one of the significant problems with solvency funding – very high, volatile, minimum funding requirements. The recent increases in PfADs come at a time when many plans are facing challenges due to the current economic environment and are in desperate need of relief.
What should trustees do?
With the implementation of new funding rules, trustees should undertake a close review of all actuarial assumptions with particular attention to where conservatism is built into their funding approach. Given that the new rules in several jurisdictions already force excessive conservatism, trustees may want to avoid “doubling up” if there is conservatism currently built into other areas of their funding approach. Too much conservatism can lead to members paying too much for too little pension when contributions go toward building a buffer to guard against unexpected future events rather than earning benefits. Conversely, if the contributions are not enough to support the level of pension earned, this can result in benefit reductions or future members picking up the slack by contributing more and earning less pension.
What should the government do?
Pension funding rules should impose minimum funding requirements with trustees implementing a prudent level of conservatism given their specific situation. A few changes to the existing and proposed funding rules for TBPs will help balance benefit security with benefit level and allow trustees more discretion over where buffers are built into the plan, and to what extent. Minimum TBP funding requirements should:
- Impose a modest level of any mandatory PfAD (minimum PfAD greater than 10% is excessive);
- Eliminate the volatility of PfAD levels;
- Allow benefit improvements if contributions can support the improved benefits, regardless of the funding level of any PfAD on the balance sheet; and
- Allow the PfAD to be reflected in actuarial assumptions.
Without these changes, it will be difficult for TBPs to provide reasonable benefits and trustees will be restricted in the management of pension plans.
This issue of Insights has been prepared for general information purposes only and does not constitute professional advice. Should you require professional advice based on the contents of this notice, please contact an Eckler consultant.