By Chun-Ming (George) Ma, FCIA
Many Canadian jurisdictions have implemented reforms to their pension legislation, adopting a new funding regime known as “going-concern plus” for defined benefit (DB) pension plans. The objective of this reform is to lower and stabilize the required contributions to DB plans, primarily by reducing solvency funding requirements and by strengthening the going-concern funding requirements. As part of the new regime, pension plans are required to hold a reserve, called a provision for adverse deviations (PfAD), to buffer against unexpected deviations in actual experience from the assumptions used in actuarial valuations.
I have conducted a stochastic analysis to evaluate the impact of the funding-related policies on the risks and costs of a DB plan under the new funding regime. The study considers the amortization period, target asset mix, limits on surplus use and the PfAD as key policy decisions for the plan. The findings of my analysis are published in the CIA paper A Stochastic Analysis of Policies Related to Funding of Defined Benefit Pension Plans.
Policy Insights
The new funding regime aims to determine if a DB plan has enough assets and expected contributions to meet its promised benefits, given its continued existence. It permits plans to use a discount rate based on the expected long-term return on plan assets to calculate funding requirements.
My research aims to assess the potential long-term impact of the new funding regime on DB plans and to inform the appropriate values of its parameters.
In my analysis, I have used three risk measures based on the projected funded ratio of a DB plan over a 20-year period. The three measures are:
- The range within which 90% of the potential funded ratios fall – the wider the range, the more uncertain the future funding level of the plan will be.
- Underfunding risk – the probability that the projected funded ratio will fall below the lower bound of a risk tolerance band.
- Overfunding risk – the probability that the projected funded ratio will exceed the upper bound of a risk tolerance band.
The risk tolerance band is a range of funded ratios with a lower bound below 1.0 and an upper bound above 1.0, representing the accepted level of funding risk by plan stakeholders (such as shareholders, taxpayers and/or employees).
The key policy insights from my research are summarized below.
Amortization Policy
Under the new funding regime, going-concern deficits must be amortized over 10 years, with a fresh start, as opposed to the previous 15-year closed amortization. This 10-year open amortization strikes a balance between stable annual funding requirements and adequate provision for plan liabilities. A longer amortization period would stabilize funding requirements more, but it increases the risk of both significant underfunding and overfunding.
Investment Policy
The funding requirements of DB plans under the new regime are primarily driven by going-concern valuations, which are based on a discount rate determined as the expected long-term rate of return on plan assets. The investment mix has a significant impact on the plan’s costs and risks. A higher allocation of the pension fund to return-seeking investments (e.g., equities) could potentially lower funding costs but also increases the volatility in the funded ratio, the risk of underfunding and the uncertainty in funding requirements.
“In making investment decisions, plan sponsors/trustees should weigh the cost of funding against the risk of the future funded ratio.”
The employer’s financial capacity to meet unexpected increases in funding requirements should also be taken into account. For example, a low-risk investment strategy may be more appropriate if the potential deficit amortization payments are sizable relative to the employer’s cash flow and operating budgets.
Surplus Policy
My modelling results show that unrestricted use of surplus could increase a plan’s exposure to underfunding risk over time. Thus, there should be limits on the use of surplus to control this risk. Canadian jurisdictions adopting the new funding regime require pension plans to maintain a funding threshold above 100% (on a going-concern or solvency basis) before any use of surplus is permitted. Typically, a plan is not allowed to use any amount of surplus that will result in it having a solvency shortfall. However, this solvency-based requirement may be too restrictive, as it could prevent a plan from taking a contribution holiday even if there is a considerable amount of surplus on the going-concern basis. It could also result in significant overfunding and undermine intergenerational equity.
Funding Reserve Policy
Incorporating a PfAD in the funding process can greatly enhance the future funding level of a pension plan and minimize the risk of underfunding over the long term. The larger the PfAD, the more significant the improvement in funding and the lower the risk of underfunding.
However, it is important to note that a higher PfAD also increases the potential for overfunding.
To achieve a plan’s long-term funding goal, a risk-based PfAD can be established. This PfAD should aim to achieve full funding at the end of a specified time horizon (e.g., 20 years) with a desired level of confidence (e.g., 75%). The PfAD reflects the investment risk that the plan is taking on. Plans with a higher proportion of their pension fund invested in return-seeking assets are likely to require a higher PfAD compared to plans with a more conservative investment strategy, all other factors being equal.
Under the new funding regime, plans that adopt a higher-risk investment policy, with a higher expected return, will have lower funding requirements compared to plans that opt for a more conservative investment policy. However, the discount rate alone should not incentivize plan sponsors or trustees to increase investment risk and benefit from lower required contributions. The risk-based PfAD helps to mitigate this potential issue by considering the degree of investment risk associated with the plan.
I have found that the membership profile of a plan (i.e., stationary vs. non-stationary) is not a significant factor in determining a risk-based PfAD. This result calls into question the regulation that mandates a closed plan to fund for a higher PfAD compared to an open plan.
“In conclusion, I believe that policymakers should adopt a dynamic PfAD policy that aligns with the funding ratio risk inherent in a pension plan. The PfAD should vary based on the evolving funding position and investment risk associated with the plan.”
For a given investment policy, the PfAD should be adjusted upwards or downwards in response to significant changes in the plan’s funding level.
Developing a Long-Term Funding Strategy
For DB plans that are expected to continue operation in the foreseeable future, it is possible to develop a long-term funding strategy that meets their funding objectives. A combination of the following policies can be used to control the risk of future funding levels, either upside or downside: (1) the level of PfAD included in the plan’s funding requirement, and (2) the limit on the amount of surplus available for use as a contribution holiday or for other purposes. Where an investment policy and deficit amortization rule have already been established for a plan, setting appropriate values for these parameters can help ensure the plan’s long-term sustainability.
Conclusion
Each DB pension plan has unique funding objectives based on its structure, membership characteristics and stakeholders’ risk preferences. It is challenging to predict the long-term funding level of a plan due to the uncertainty of economic and demographic factors. However, the insights gained from this research can assist plan sponsors or trustees in developing a sustainable long-term funding strategy that meets the plan’s funding objectives.
Chun-Ming (George) Ma is a retired actuary with more than 30 years of experience in retirement consulting and prudential pension regulation in Canada. He served as the Chief Actuary of the former Financial Services Commission of Ontario (now the Financial Services Regulatory Authority of Ontario) until his retirement in 2014. During his tenure, he provided expert advice to government policy makers, pension industry professionals and the general public on regulatory and actuarial issues related to registered pension plans in Ontario.
Dr. Ma is a Fellow of the Society of Actuaries and the Canadian Institute of Actuaries, and he holds a PhD in mathematics. From 2012 to 2022, he served as an Adjunct Professor at the University of Hong Kong, where he taught pension topics. Dr. Ma has been passionate about finding innovative solutions to address the demographic and financial challenges faced by public and private pension systems. He has written and spoken on topics related to the financial management of retirement plans.
