Is your pension plan underfunded?
By Jim Middlemiss • Bankrate.com

Debt rating agency Moody's Investors Service has sounded the alarm about the underfunding of defined-benefit pension plans, noting that it is "quite material to some companies" and raises a "red flag as to their future funding requirements and their impact on cash flow."

In a November report, Waylon Iserhoff, vice-president and senior accounting analyst at the agency, cites the 10 most underfunded company pension plans. Alcan tops the list with a current $3.1-billion shortfall. Nortel, BCE Inc. and Bombardier all have deficiencies in the $2-billion-plus range. Pulp company Abitibi Consolidated and Canadian Pacific Railway have deficiencies in the $800-million range, while Quebecor World ($518 million), Petro-Canada ($378 million), Thomson Corporation ($343 million) and Domtar ($282 million) round out the list. Moody's based its list on 2005 financial results.

However, underfunding is not confined to those companies' plans. Dozens of defined-benefit plans are running in the red at the moment. In May, a joint survey by the Conference Board of Canada and pension consulting firm Watson Wyatt found that 61 per cent of Canada's top chief financial officers believe the pension crisis is "widespread and likely to persist beyond the next few years."

Few plans go flat-out broke
So, what does that mean for employees? Will their pensions be there at the end of the day? Pension experts say you can relax -- despite the funding deficiencies, most employees don't have to worry. "Most of the underfunding is expected to go away over time," says David Burke, retirement practice director at Watson Wyatt, in Montreal.

Michel St-Germain, an actuary at Mercer Human Resources Consulting, in Montreal, adds "you don't have to worry if your employer is very solvent." It's in the cyclical industries and heavy manufacturing where an employer might go bankrupt that causes concern.

Even then, however, it wouldn't be a total catastrophe. Most plans are funded to the tune of 75 per cent or more, so there's money to cover pension obligations in those situations, just not the full amounts.

Besides, those situations are relatively rare and usually get worked out in restructuring, as was the case recently with Air Canada. Moreover, at least one province, Ontario, has put in place an insurance fund to protect pensioners in the event of a default.

Nonetheless, employees need to pay attention to what is happening with their defined-benefit plans and how they work.

Defined benefits and defined contributions
For employees, a defined-benefit plan is considered more attractive than a defined-contribution plan, because it determines exactly how much you will get in retirement. So, you might be entitled to 50 per cent of your salary. With a defined-contribution plan, however, an employer simply agrees to make a contribution. The amount you end up with in retirement depends on the performance of your investments -- you may do better; you may do worse.

It's that obligation to meet a percentage of your earnings in a defined-benefit plan, however, that gets employers in trouble and can lead to deficiencies. That's because employers must set aside enough money to cover the obligations, which fluctuate as people earn more over their careers and live longer.

There are a range of rules in place to govern those commitments, and plans are either overseen at the federal level, if you work for a federally regulate industry such as banking or telecommunications, or they are governed provincially.

Pension laws require that underfunded plans be paid up over time, between five and 15 years depending on the type of deficit the plan is running. The fact that many plans are in deficit is a relatively recent phenomenon; in the 1990s, most plans were in surplus positions.

Plan funds are subject to stock market movement
Plans fluctuate in and out of surplus for a number of reasons. Part of the problem is that companies must make a number of assumptions that have an impact on the payout. Actuaries must determine the rate of return on investments in a plan and how long the plan members will live.

Randy Bauslaugh, a pension lawyer at Blake Cassels & Graydon LLP, in Toronto, says under pension law there is a disincentive for employers to run surpluses because court cases have ruled that pension surpluses go to employees, so employers are also reluctant to put in more than required.

Most importantly, though, is the return on investment. Most plans invest between 50 per cent to 60 per cent of their money into equities and the balance into fixed income, so plans are subjected to the vagaries of stock markets and bond yields. Rising markets and bond yields are good, declining ones are bad.

When the global stock markets declined in the late 1990s and the dot-com bubble burst in 2000, it knocked the wind out of pension plans' equity sails. Since then, the markets have rebounded. However, interest rates have declined noticeably since the mid-1990s and that also hurts pension plans, since they rely on income from bonds to pay for their obligations.

Pension plans to reach surplus by 2010
St-Germain says if rates were to rise 200 basis points, or two per cent, the whole pension underfunding problem would evaporate. In fact, it is easing now. The Bank of Canada recently issued its review of Canada's financial system, which included a look at pension underfunding and studies from Mercer.

Based on various economic scenarios, the report notes that the overall system should be in a surplus position once again by 2010, with only a handful of pension assets in deficit. To get there, the interest rates will have to remain stable or rise, markets will need to continue to perform well and plans that are in the red will have to continue providing top-up payments.

Nonetheless, there will be pain. Companies will have to divert cash to pensions, which will have an impact on operations, though St-Germain says the stock markets have factored pension problems into stock prices of companies with pension issues.

He adds that a "significant number of corporations are doing something to try to reduce risk and reduce their pension costs." That means possibly re-jigging their plans so new employees aren't entitled to the same benefits or eliminating early retirement incentives. It could also mean employers will require employees to contribute more to their own plans.

"Is it all doom and gloom? Definitely not." However, Burke says setting the pension ship right and sailing it forward "is going to take some time."

Jim Middlemiss is editor of Canadian Lawyer magazine and co-author of "Your Guide to Canadian Law." He's a frequent contributor to the National Post and Investment Executive.