Help clients address an underfunded pension

In a previous column, we learned that the pension rules in the Income Tax Act have not been updated since they were introduced in 1991, leading to artificial caps on contributions and the potential for significant underfunding of designated defined-benefit pension plans.

In this article, we’ll use case studies to illustrate how the required maximum funding value (MFV) methodology leads to underfunding, and explain what you can do about it.

Impact of the rules on Jonathan

We met Jonathan, a 50-year-old CFO of a privately owned manufacturer, in our last article. He has 20 years of service and wishes to retire at 60. He’s a member of a designated plan along with his fellow executives, who all earn about $250,000 per year.

Actuaries must use the MFV method to value and fund Jonathan’s designated plan, but the MFV method artificially caps contributions, which can lead to underfunding of the plan. There are other valuation methods such as the going concern method and the solvency/windup method, but they can’t be used when valuing the plan to determine tax-deductible contributions for funding.

The graph below shows that at time of set up, using the going concern valuation puts the plan assets (including any RRSP transfer) at approximately $1.8 million, assuming that Jonathan is now the last member remaining in the plan. However, the MFV method limits the plan assets (including any RRSP transfer) to approximately $1.0 million. Thus, there is a shortfall of $0.8 million from the outset. The difference is primarily due to the different long-term interest rates that must be used as well as the inflation and retirement assumptions.

On an ongoing basis, annual tax-deductible contributions can be expected to be higher under the going concern method, as we can see via the green line.

Once Jonathan starts to draw his pension at age 60, the MFV method would result in the plan’s assets being depleted when Jonathan is 81. The going concern method allows the required funds to be contributed to the plan, with Jonathan able to draw a pension for a decade longer.

So what can be done for Jonathan?

Relief from the MFV requirement

Fortunately, the MFV method no longer needs to be applied once all the plan members have retired. Since Jonathan is the last member in the plan, this situation benefits him. The plan also needs to ask the CRA to waive designated plan status. Once both have occurred, the plan sponsor can make a significant contribution, known as “terminal funding.”

Deduction room for this contribution becomes available the year after the pension starts to be drawn. In essence, Jonathan’s plan could be topped up to approximately the going-concern level so it can have the required funds to pay the promised pensions for its members’ lifetimes. In other words, Jonathan’s employer could make a tax-deductible top-up contribution of $1 million after Jonathan starts drawing his pension. This would help ensure that the plan could meet its obligation to Jonathan.

If Jonathan’s employer foregoes making the terminal funding contribution when Jonathan retires and starts drawing his pension from the plan, the employer must top up the plan in the future to remedy the underfunding. The magnitude of the underfunding will be outlined in triennial valuations as “experience deficiencies.” While the employer may be willing to wait for these future valuations, Jonathan would prefer that the employer terminally fund the plan, since his pension stream would be less exposed to the risk of his employer going bankrupt or being otherwise unable to fund the “experience deficiencies.” Unfortunately, Jonathan can’t compel his employer to terminally fund the plan.

Employers may decide to terminally fund a plan if they can use the contribution to offset income that would otherwise be taxable.

For planning purposes, a company implementing a plan for an older member would want to know the size of any terminal funding deduction so it may be anticipated.

If the company chooses not to make a terminal funding contribution, the plan member and their advisor need to account for the risk of the pension not providing lifetime income due to the aforementioned economic and bankruptcy risks. The plan member could suggest that the company amending the plan eliminate cost-of-living adjustments, which would extend the period of the payout. And in parallel, the advisor and client should ensure the client develops alternate sources of retirement income.

Employment termination and designated plans

Many plans contain provisions allowing plan members to commute their pensions when they terminate their employment.

But a designated one could be underfunded, leading to unexpected outcomes. Consider Carol, who is a high earner and a member of a designated plan. Her employer is eliminating her position and she must decide what to do with her pension. She is allowed to commute her pension.

Carol’s commuted value (CV) will be calculated using the solvency/windup method discussed in the last article, which will result in a much larger amount than under the MFV method.

Whether or not she will be able to receive her CV as a lump sum as calculated under the solvency/wind-up method at the time of termination depends on the plan’s funding status. Most jurisdictions will look at the plan’s ratio of assets to solvency liabilities, known as the transfer ratio (TR). If the TR is below a threshold amount, which is usually 90%, Carol’s immediate transfer may be limited to this percentage, with the balance being paid to Carol over a period of usually five years.

Carol’s CV is calculated at $1.6 million, but the plan has a TR of only 75%. This means that if she chooses to commute the pension, she would only receive 75% of her CV, or $1.2 million, immediately.

As she is employed in Ontario, the plan has until the last day of the fifth year following the termination to pay her the balance. While interest would be added to this amount, Carol could have to wait another five years to receive the remaining $400,000 (plus interest).

Carol should seek expert advice at the time of termination and should not sign any releases before doing so. Specific steps could be built into her termination agreement that would allow her immediate access to the full $1.6 million. This is especially important if the employer is less than stable.

Pensions are key to clients’ retirement. It is important for plan members and their advisors to monitor the funding status of the plans they participate in. No member wants to be surprised when they retire.