Pension plans treading water

Canada's pension plans are "running in place" and struggling to return to financial strength despite two years of strong market returns that have bolstered the value of their holdings.

The culprit is falling interest rates, which are offsetting - even outpacing - the improvement in investment returns on pension plans' assets.

The result, pension experts say, is that many major plans are still grappling with significant financing deficiencies at the end of 2010, and companies are still facing new obligations to put more cash into their plans, more than two years after stock markets fell sharply in 2008.

"Pension plans are running in place," said Paul Forestell, senior partner at pension consulting firm Mercer. "As interest rates go down at the same time assets go up, the funded position doesn't move."

Federal and provincial finance ministers wrestled with similar issues affecting government pension plans in a meeting in Kananaskis, Alta., and have agreed on a framework for a pooled private-sector pension plan for small firms and the self-employed.

Many of Canada's biggest companies are coping by plowing cash into their pension funds to make up shortfalls. Some payments are being made ahead of the required schedule for eliminating shortfalls because companies have available cash.

BCE Inc., for example, announced this month that it will make a voluntary $750-million payment to its employee pension plan, on top of a regular required payment this year of $500-million. The company, parent of Bell Canada, said its estimated pension solvency deficit of $2.4-billion at the end of 2010 will be reduced to $1.6-billion as a result of the special payment.

BCE's chief financial officer Siim Vanaselja told analysts that the company decided it makes sense to speed up funding of the pension plan, given the sustained low interest-rate environment in Canada.

"We believe it's prudent to address permanently our pension deficit," he said. "By making what should be a final special contribution, we've set a clear path to eliminating altogether any deficit funding obligations for Bell by the end of 2014."

Canadian National Railway Co. has similarly said it will put $430-million into its pension plans this year - including a $300-million additional voluntary contribution above required levels. The company said it wanted to strengthen the financial condition of its primary employee plan.

The ongoing funding problems are linked directly to falling bond yields.

Pension plans have two sides to their funding equation. One is the value of the plan's assets, which are investments made to finance pensions for retirees. On that front, plans have posted strong returns for the past two years. In 2009, for example, a typical plan earned returns of 16 per cent. In the first 11 months of 2010, plans earned about 7 per cent on average.

The problem lies on the other side of the equation with the pension liability, or the estimated cost of financing the plan's future benefits. Those liabilities are calculated using bond yields, and are highly sensitive to even small changes in interest rates. As rates fall, more money needs to be in the pension plan to cover future costs, because it is assumed long-term returns will be lower.

Pension specialist Ian Markham at consulting firm Towers Watson says a one-percentage-point drop in interest rates typically causes a plan's liabilities to rise by about 15 per cent - creating a huge hole in a plan's funded status.

He estimates that a typical plan earned a return on its investment portfolio of about 7 per cent in the first 11 months of 2010, while plan liabilities have climbed about 15 per cent on an accounting basis for financial statement reporting.

That means many companies are going to be reporting a bigger pension deficit at the end of 2010, and will face increased funding costs from a financial statement perspective.

Companies also measure pension liabilities on a so-called solvency basis, which measures how much money is needed to be in the pension plan under the assumption that the company would go out of business immediately and freeze pension contributions.

On a solvency basis, Mr. Markham said liabilities have climbed about 7 per cent so far this year, which means the funded ratio of a typical plan is not worse, but has also not improved in 2010, despite better market returns.

Either way, the decline in interest rates is whipsawing companies who are trying to budget for future pension-plan costs.

"These are very dramatic changes that are taking place," Mr. Markham said. "Unfortunately, the trend has been toward lower and lower long-bond yields, as the markets believe that inflation is going to remain relatively low."

While statistics for 2010 are not available yet, numbers for 2009 compiled by Mercer show that the 111 companies with defined-benefit plans in the benchmark S&P/TSX composite index contributed a total of $8.5-billion to their pension funds last year. They still had pension shortfalls totalling $13.6-billion at year's end.

Mr. Forestell said that while companies are looking at longer-term solutions such as changing their investment strategies or closing their plans to new members, in the short term, most must put even more cash into their plans to address immediate funding problems.

"The only thing that will fix the problem quickly is an increase in interest rates," Mr. Forestell said. "But I always tell my clients that will fix your pension problems - but what does it do to the rest of your business?"