Bank of Canada warns on pension deficits

(June 14, 2004) The Bank of Canada is warning that most of Canada’s corporate defined benefit (DB) pension plans are still facing a deficit, despite the positive returns made on the stock market in 2003.

In its Financial System Review released late last week, the central bank says the majority of DB pensions were in a slight deficit position, with solvency ratios between 90% and 99%. But about 10% of pensions have fall below 80% solvency, placing their sponsors in a difficult position with catch-up payments threatening to account for between 19% and 25% of their payroll.

“It is possible to conclude that only a handful of plans are so severely underfunded that the requirement to make pension contributions may well call the viability of the sponsoring firms into question,” the report reads. “A large number of firms will, however, need to make substantial contributions in order to close funding gaps, even in a generally benign financial market environment.”

Part of the pension problem can be blamed on the government, as Section 147.2 of the Income Tax Act limits the level of overfunding for a plan sponsor. During the runaway bull market of the late 1990s, many pension sponsors were forced to take a contribution holiday, because their plans had reached the overfunding limit.

When the stock market crashed, the losses wiped out the overfunding issue, replacing it with a deficit.

Even though the markets bounced back in 2003, DB plans are still underfunded because their liabilities have grown. While assets grew by 14.5%, liabilities grew 12.5%, leaving only a 2% boost in funding ratios. The liability growth included not only 7.1% in “normal growth” but an additional 5.4%, based on the 36 basis point decline in the discount rate.

As the discount rate declines, plan sponsors must pay a higher proportion of the beneficiary’s pension income.

“While difficulties in funding pensions may not pose meaningful risks for the stability of the financial system, they may represent a prolonged drain on corporate earnings and cash flow,” the report warned. “This, in turn, could leave firms vulnerable to other shocks, such as an economic slowdown that significantly reduces cash flow.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com