Government Operations Committee on Oct. 31st, 2016

[Lynn Hemmings, Senior Chief, Payments and Pensions, Financial Sector Policy Branch, Department of Finance]

Thank you very much, Mr. Chair.

Good afternoon. My name is Lynn Hemmings. I'm the senior chief of the pensions team in the financial sector policy branch at the Department of Finance.

I'm here today to answer your questions about the Canada Post pension plan, but let me first provide you with a bit of context on the funding requirements under federal pension legislation, the Pension Benefits Standards Act, or PBSA.

Under the PBSA, the federal government regulates the plans of crown corporations and private sector plans covering areas of employment under federal jurisdiction, such as telecommunications, banking, and interprovincial transportation. At this time, there are over 1,200 federally regulated pension plans, and over 300 of those are defined benefit plans. Canada Post's is the largest defined benefit plan under federal jurisdiction, with almost $22 billion in plan assets as of December 31, 2015.

Under the PBSA, defined benefit pension plans are required to be funded on both a going concern and a solvency basis. “Going concern” assumes the plan operates indefinitely, whereas solvency assumes the plan is terminated and all the promised pension benefits must be paid immediately.

The intent of the solvency funding requirement is to protect the pension benefits of plan members and retirees by ensuring that plan assets are sufficient to meet the plan's full obligation. In cases where a plan does not have a solvency funding deficit, the PBSA provides the flexibility to fund that deficit over a period of five years.

Today, some plan sponsors continue to face funding challenges for their defined benefit plans as a result of a combination of factors, including the ongoing low interest rate environment, volatile market returns, and increasing life expectancy of retirees. Over the last 10 years, the government has implemented a number of reforms to provide funding relief to plans to address these challenges.

In 2006, a sharp decline in long-term interest rates combined with poor investment returns and increasing life expectancies resulted in solvency deficits in many plans. To help alleviate these pressures, the government passed temporary solvency funding relief measures that allowed solvency deficits to be paid over a longer period. Following the implementation of these measures, funding levels in plans began to improve.

In 2009, following the financial crisis, plan funding levels began deteriorating again as a result of the significant decline in global markets and even further reductions in interest rates. To help plans address these challenges, the government once again passed temporary funding relief measures. As it became apparent that low interest rates and uncertain market returns were becoming the new normal, the government moved to put in place permanent relief measures. These measures included allowing the use of letters of credit to cover solvency special payments up to a limit of 15% of the market value of plan assets and moving to a three-year average for the calculation of solvency ratios in order to reduce the volatility of a plan's deficit.

For pension plans facing unique financial challenges, the Minister of Finance has the authority to grant funding relief through the use of special regulations. In the case of Air Canada, for example, in order to provide the company with the time needed to restructure its operations, its pension plan was exempted from solvency funding requirements from 2014 to 2020 in exchange for making payments of at least $150 million per year into the plan. As a result of improving its business operations, changes in plan design, and new investment strategy, Air Canada has been able to eliminate its solvency deficit and announced in May 2015 that it was opting out of the special regulations, with the pension plan now in surplus.

The Minister of Finance has also exempted Canada Post from solvency funding requirements from 2014 to 2018. This funding relief was provided within the context of a continued decline in mail volume and little to no net income generated by the corporation. As with Air Canada, the purpose of the relief was to provide Canada Post with the time to make itself financially sustainable. As this funding relief is set to expire at the end of 2017, we are continuing to monitor the developments in Canada Post's pension plan.

We look forward to hearing the recommendations of this committee on the business operations of Canada Post, which will help to inform our advice to the Minister of Finance on the pension plan going forward.

Thank you.

[The Chair, Conservative, Tom Lukiwski]

Thank you very much.

Now we have Mr. Skinner, for 10 minutes.

Go ahead, please.

[Cory Skinner, Actuary, Mercer (Canada) Limited]

Thank you for inviting us to speak with the committee today regarding the Canada Post pension plan.

I would like to make a few observations about the plan, during which I will make reference to the supplementary document that has been circulated, and then we look forward to taking your questions.

I'm an actuary with Mercer, which has been the plan's actuarial firm since its inception in 2000. In my role as an actuary, I work on the annual valuations of the plan prepared for funding and accounting purposes. Our valuations are performed according to the applicable legislation and regulatory guidance under the federal jurisdiction, and according to the professional standards of the Canadian Institute of Actuaries. The results of the valuation are presented each year to Canada Post's management, the pension committee of the board, and the pension advisory council, which includes representatives from management and the various unions.

Joining me is my colleague Michel St-Germain. Michel brings a broader perspective on trends in the pension landscape across the country and over time. Michel plays or has played various roles within the Canadian Institute of Actuaries and the Association of Canadian Pension Management.

I have a few comments on plan size. The Canada Post pension plan has been growing steadily since plan inception. As shown in figure 1 of the supplementary document, the plan's assets have almost tripled in size between 2001 and 2015. Over that same period, the solvency liability more than quadrupled.

The solvency deficit at the end of 2015 was about $6 billion, which has grown to about $8 billion so far in 2016. The biggest driver of the increased solvency liabilities and deficits has been the decline in interest rates in recent years. Figure 2 shows that the interest rate net of inflation used to value the solvency liability had fallen to 1.2% at the end of 2015 versus 2.25% 10 years earlier. By June 30, 2016, that rate had declined to 0.08%.

As it has grown, the plan has become very large compared to the size of Canada Post itself. We've illustrated this in two ways in figures 3 and 4. Figure 3 shows the size of the pension obligation on a corporate accounting basis as a percentage of corporate revenue. This excludes, by the way, the obligation for other non-pension employee benefits which are worth about another $4 billion. This ratio has grown almost every year in the last 10 from 226% to 390% of revenue. To put these numbers in context, the graph also shows the distribution of the same sort of results for organizations in the TSX Composite with DB, defined benefit, pension plans.

Clearly, the growth of Canada Post's pension plan has far outstripped that of its revenue, which has been consistently around $6 billion per year excluding the subsidiaries over the period shown.

Besides the fairly flat revenue, another reason for these large ratios is the relative generosity of the Canada Post plan benefits, for example, full guaranteed indexation. Given the current size of the active membership, and given that many of Canada Post's new hires continue to join the DB component, the plan is expected to continue to grow for many years to come.

Another way to look at relative size is given in figure 4, which shows the employer pension contributions over time also as a percentage of corporate revenue. Canada Post's contribution requirements in the absence of the CPC special relief measures, which Ms. Hemmings described, varied widely between 1% and over 15% during this period.

In figure 5 we show the historical contributions to the Canada Post plan. The solid blue and red bars show how the employee and employer current service contributions have changed over time to reflect a more balanced sharing of these costs. In addition to current service contributions, Canada Post is responsible for funding any deficits. Going concern deficits must be paid off over 15 years. Solvency payment requirements are more complicated since we are required under federal funding rules to determine the special payments based on a three-year average solvency ratio. There are details on these calculations in figure 8 of my supplementary document, but we won't go through those in detail unless they come up in questions.

The striped red bars show Canada Post's deficit contributions, which are over $1.6 billion in total, mostly for solvency deficits. There are two items worth pointing out on this graph. Since 2011, agent crown corporations like Canada Post have been permitted to reduce their solvency special payments up to a cumulative total reduction of 15% of plan assets. Canada Post used this to reduce its special payment requirements from 2011 through 2013 with a cumulative special payment reduction of $2.4 billion. That cumulative reduction limit of 15% of assets would have been reached in 2014 with the chance that the remaining required payments could exceed Canada Post's ability to pay.

In response to this issue, special regulations were enacted in early 2014—that's the CPC special relief—exempting Canada Post from special payment requirements for 2014 through to the end of 2017. The yellow bars in figure 5 show the special payments that would have been made to the plan if the CPC special relief had not happened.

In figure 6, we show the expected range of projected future employer contributions over the next five years, based on market conditions and valuation results as at year-end 2015. As shown by the small blue squares, the median projected contribution over this period ranges from about $260 million to $540 million. However, the graph shows that there's at least a 25% probability of required contributions exceeding $1 billion in 2019 and 2020, as shown by the top of the light green bar. Since year-end, market interest rates have declined significantly, so our current estimates of future contributions would tend to be higher than the ones shown on this graph.

The task force has proposed some options to modify or eliminate solvency funding requirements for Canada Post. The elimination of mandatory solvency funding would relieve much of the short-term funding pressure the plan places on Canada Post; however, significant risks would still remain in the longer term. Even in the absence of solvency special payments, the size of the plan relative to that of Canada Post would remain at least as large. For instance, the relative size of the accounting obligation in figure 3 is not affected at all by contribution requirements.

Currently, the going concern basis is much less expensive than the solvency basis; however, this is largely due to an assumption that the plan's asset mix—specifically, its allocation to riskier asset classes such as public equities—will yield higher returns than the conservative asset mix required for solvency purposes. While we expect that to be the case on average over the long term, it's not guaranteed to occur over any particular period. It's also worth noting that if members live longer than we have assumed, plan costs could increase.

Canada Post can reduce the risk of volatility in the net position of the plan by decreasing its allocations to risky assets; however, this will decrease the expected return and increase the cost. It's not hard to imagine the current going concern surplus turning into a deficit due to a bad experience. One year of asset returns like we saw in the market crisis of 2008 could result in as much as $2 billion of special payments being made to the plan over a 10-year period, even in the absence of solvency funding requirements. In addition, assumptions may change over time as the asset mix or the actuary's outlook for the future changes.

These types of risks are expected with traditional DB plans. It is the size of this plan relative to the size of Canada Post that makes this of special concern.

It's interesting to note that two of the most well-regarded public sector pension plans, Ontario Teachers' and the Healthcare of Ontario pension plan—HOOPP—are exempt from solvency funding, yet these plans have both taken steps to modify their benefits, particularly the level of guaranteed indexation, to control costs and volatility.

If Canada Post were to become exempt from having to fund on a solvency basis, we would also encourage consideration of additional changes to address the remaining risks.

On changes to investment policy, Canada Post plans to gradually reduce their allocation to riskier assets as the plan's position improves over time. This will make the plan less sensitive to changes in market interest rates, although it does not address the current deficit.

On defined contribution, a defined contribution, or DC, plan like the one offered by Canada Post represents the lowest cost volatility possible for the portion of the plan covered by it. DC designs are increasingly common, particularly in the private sector. Recently, Unifor agreed to a DC plan for new hires at General Motors when it became clear that GM would not be able to afford the DB plan. While extending DC to more members would slow the growth of the DB component of the plan, the problem of funding the existing DB component would remain.

On risk-shared plans, there are some middle-ground options, which aim to retain much of the predictable benefit stream of a traditional DB plan while significantly lowering cost volatility. Such plans share risks between the employer and members or across the members as a group, which is preferable to individual risk-bearing. One such planned design would reduce or eliminate guaranteed pension indexation, indexing pensions only when the plan's financial position permits, according to rules laid out in advance. Canada Post has been looking into designs like this.

Another option is a target benefit plan, or TBP. In a TBP, employer contributions would be predictable and clear rules would be set out in advance regarding the handling of surpluses and deficits, with some benefits at risk of reduction in bad times. The federal government tabled a bill earlier this month to permit the establishment of TBPs in the federal jurisdiction. We have discussed the TBP concept with Canada Post.

While risk-shared plans can work well for the future, benefits already accrued remain in the traditional DB plan, unless members or their unions consent to a conversion to the new plan.

One final option for consideration is joint governance. Some of the most successful large Canadian pension plans are governed on a joint basis with representatives from employers and members making decisions together. Ontario Teachers' and HOOPP are examples of such plans. Under the right conditions, this can work very well, but we believe that joint governance is best accomplished in conjunction with shared responsibility for the funding of any past service benefits.

This concludes our prepared remarks. We thank you and look forward to your questions.

[The Chair, Conservative, Tom Lukiwski]

Thank you very much.

Ms. Cover, you have 10 minutes.

[Mary Cover, Director, Pension Strategy & Enterprise Risk, Ontario Teachers' Pension Plan Board]

Thank you.

I'm also an actuary by profession, and I've been asked to speak to some of the key features of the Ontario Teachers' pension plan that contribute to the sustainability of the arrangement.

The Ontario Teachers' Pension Plan, or OTTP, Board was established as an independent, arm's-length organization in 1990. We are a jointly sponsored pension plan, or JSPP, designed and governed to ensure a balance of stakeholder interest. We have a robust governance structure with clearly articulated roles and responsibilities consisting of an independent, professional, 11-member board. The plan sponsors are the Province of Ontario, more specifically the Minister of Education, and the Ontario Teachers' Federation, which represents the plan members.

The board's responsibilities include managing the investments of the pension fund, setting key accrual assumptions, including the valuation discount rate, and administering the pension benefits for our 385,000 active and former teachers. Plan sponsor responsibilities include determining benefit and contribution levels by determining how deficits are funded and how surpluses are utilized. The JSPP structure ensures that both plan members, through OTF representation and the province have a voice at the table in these critical decisions and are aware of the associated risks. We are a contributory defined benefit pension plan with full inflation protection provided on benefits earned prior to 2010 and with conditional inflation protection for benefits earned after 2009. I'll speak more to how CIP works in a moment.

Our teachers currently contribute 12% of their pay, on average, which is matched by the Province of Ontario. Our strategic destination is to have a fully funded plan with the contribution rate of 11% of pay, on average, which is matched by the province, and 100% inflation protection on all benefits. As of the end of 2015, our market value of assets was $171 billion. We recently filed the January 1, 2016, valuation report disclosing a surplus on a going concern basis of $4.5 billion. Note that our valuations must be balanced, as we cannot file an evaluation with a deficit.

Going back historically to the early 2000s, the plan's funding position and demographic realities have a direct impact on how our assets are managed. We set an asset mix policy by taking into account what the plan needs to deliver its pension obligations. Sustaining benefit levels for future teachers without contribution increases requires consistently meeting our return targets. Today, for a new entrant to the plan, providing a pension fully indexed at an average contribution rate of 11% matched by the province would require a real return of 4% per annum. The plan's demographic circumstances moderate our ability to take risks. The return target and the plan's ability to take risk by managing the impact from potential losses must remain aligned to meet our sustainability objective.

An important factor over the long term that impacts our return target is the expected lifespans of our members. This ultimately led to the adoption, in 2008, of a custom OTPP mortality table and mortality improvement scales. These tables were most recently updated in 2014, including the adoption of a two-dimensional mortality improvement scale.

In 2001, discussions began between OTPP and the plan sponsors related to reserving some gains in the fund to create a cushion to protect against the loss in difficult times and to keep contribution rates stable.

Back in 2003, the sponsors adopted a funding management policy, or FMP, with the objective to provide a guidance framework for decision-making when there is a funding surplus or shortfall. A key component of the creation of the FMP was the concept of funding zones, each defined by a range. The funding zones provide a point of reference for whether action is required by the sponsors, and if so, guidance is provided on how to use any surplus funds or resolve any shortfall, specifically answering the question of when it is prudent to increase or decrease benefits, raise or lower contribution rates, or simply conserve assets for an uncertain time.

While the FMP outlines preferred mechanisms associated with its various funding zones, it is ultimately the sponsors' responsibility to decide what actions to take.

In March 2015, a zone for temporary plan improvements was added to the FMP to allow for temporary contribution decreases, surplus distribution, or benefit improvements, so long as they do not increase the long-term costs of the plan.

Uses of surplus in this zone are paced, and a provision is included such that temporary improvements cease if a significant market event occurs.

Commencing roughly a decade ago, we began experiencing recurring deficits in preliminary funding valuations resulting from a combination of low returns, a low interest rate environment and increasing longevity. It is necessary to take on risk from an investment perspective to achieve the returns necessary to ensure the sustainability of the plan, particularly in a low interest rate environment.

Knowing that we will have losses from time to time, we needed to introduce a mechanism for addressing downturns, which would share losses with our plan members, including retirees.

Our current ratio of active to retired members is 1.4:1, which is expected to continue to decrease and will likely be 1:1 at some point in the future. We have negative net cash outflows of $2.2 billion. We received $3.3 billion in contributions in 2015 and paid $5.5 billion in pensions, which means that strong liquidity management is crucial.

On average, Ontario teachers retire at age 59 after having worked and contributed to the pension plan for 26 years, and they receive benefits for 31 years on average. Additional benefits may be provided to a surviving spouse for a further period of time.

We need to ensure that our asset mix and risk management take the aging of the plan into consideration. As mentioned above, the board has responsibility for managing the pension fund and therefore we are constantly focused on risk management and asset allocation.

It is clear that contribution increases alone will not be sufficient to protect the plan against major investment losses. Along with that is the reality that with an 11% contribution rate, a 4% real return is necessary, a return that is difficult to achieve, particularly in today's environment.

Therefore, in 2008 the concept of conditional inflation protection was introduced. CIP is not only a powerful lever for managing funding volatility, it also promotes intergenerational equity.

Benefits earned after 2009 are conditionally indexed in accordance with the plan's ability to pay. There are three service breaks, with different levels of protection as follows: All benefits earned before 2010 are still fully indexed to inflation. Benefits earned after 2009 but before 2014 are conditionally indexed with a minimum adjustment guarantee of 50% of consumer price index. Benefits earned after 2013 are conditionally indexed with no minimum guarantee.

Consistent with the spirit of a shared risk plan, any inflation payments forgone by plan members are matched by the government via additional contributions to the fund up to the first 50% of inflation protection forgone.

CIP is an extremely powerful funding lever, and the expectation is that by 2025, fully invoked CIP will be powerful enough to absorb an asset loss of $62 billion.

As mentioned by my colleague, OTPP is subject to going concern funding requirements and is exempt from solvency funding on a named plan basis under the regulations of the Pension Benefits Act of Ontario.

In 2010 Bill 120 was passed in response to recommendations by the Arthurs commission to strengthen pension funding rules and to clarify rules for surpluses, contribution holidays, and other funding-related issues. The rationale for the exemption from solvency funding includes that both the province and OTF have a role in selecting the board members that oversee the pension plan, thus promoting good governance.

The JSPP governance model means that both plan sponsors are involved in and responsible for decisions related to benefit design.

Funding on a going concern basis is appropriate for our plan, given the size, maturity, and robust governance structure. Because of this, we can use the aggregate cost method, which allows us to factor in the expected impact of future contributions and benefit accruals, whereas resolution of any solvency deficits could be done only via contribution increases, a mechanism at odds with those proposed by the funding management policy and particularly with the ability to share the risk with retirees through conditional inflation protection.

Solvency-based tests are not a suitable measure for OTPP given our long-term perspective and our joint governance capacity to change future contribution and benefit levels to address funding shortfalls or surpluses.

In the unlikely event of plan windup, given the size of the plan, it would be impossible to settle benefits via annuity purchases given the limited market in Canada. Thus, there would need to be legislative intervention to allow the plan to continue in some capacity.

Finally, we are not subject to, nor a risk to, the pension benefits guarantee fund of Ontario.

In closing, the plan's sustainability is defined as its ability to meet the needs of the present without compromising the ability of future generations to meet their own needs. The strong governance framework of the plan is key to ensuring its long-term sustainability.

[The Chair, Conservative, Tom Lukiwski]

Thank you very much, all of you, for your presentations.

Colleagues, we'll have time for one complete round of questions.

We will start with Monsieur Drouin, for seven minutes.

[Francis Drouin, Liberal, Glengarry—Prescott—Russell, ON]

I want to thank each of the witnesses for being here today. We certainly appreciate your taking the time.

All of you touched a bit on the governance issue. I know that the Ontario expert commission recommended at some point that jointly sponsored plans and joint governance be exempted from solvency payments. The rationale provided at the time was that it's a superior governing structure that allows for better risk management.

I just want to hear from you on that. Do you agree with that? We have one example here, but do you agree with that statement?

[Michel St-Germain, Actuary, Mercer (Canada) Limited]

You're correct on the joint governance. The advantage of joint governance is that you can get a consensus from the various stakeholders on the proper balance between security and affordability. That's the reason for it. You have an example here of a group that was able to attain that consensus.

Having said that, not all joint governance plans are able to achieve this consensus. Reaching a consensus between various stakeholders is a challenge if the number of stakeholders is high, if it includes, for example, non-unionized employees, different unions, and pensioners. But if you can resolve that difficulty of achieving consensus, the plan sponsors or the regulator will get a feel for what is the proper trade-off between affordability and security.

[Francis Drouin, Liberal, Glengarry—Prescott—Russell, ON]

From your experience, if you look at the past 20 or 30 years, is the trend that when there's a low stakeholder environment, joint governance structures tend to work more?

[Michel St-Germain]

No, it works when the stakeholders are content to agree among themselves, either because they have a common interest or because the number of stakeholders is low. It doesn't work when the interests of the various stakeholders are not aligned or when the number of stakeholders is too high.

There are very good examples of joint governance and very bad examples of joint governance.

[Francis Drouin, Liberal, Glengarry—Prescott—Russell, ON]

Do you have an example of a bad joint governance model?

[Michel St-Germain]

I won't....

[Voices]

Oh, oh!

[The Chair, Conservative, Tom Lukiwski]

We are in public.

[Francis Drouin, Liberal, Glengarry—Prescott—Russell, ON]

That's fine.

[Michel St-Germain]

No, they've made the name.... I will mention that amongst multi-employer groups—I'll let you find examples of multi-employer groups. There are horror stories within those groups.

[Francis Drouin, Liberal, Glengarry—Prescott—Russell, ON]

Thank you.

[Michel St-Germain]

Having said that, I do want to make the point that those multi-employer groups are not JSPP.

[Francis Drouin, Liberal, Glengarry—Prescott—Russell, ON]

Okay.

There was another issue that this committee heard from one of the witnesses. One of the recommendations was about ensuring independence from the sponsor. Do you agree with that? I don't believe Canada Post right now has an independent structure. Do you tend to agree that the investment board should be completely separate from the company?

[Cory Skinner]

I would say that's part of the joint governance. That can be one aspect of the joint governance that Michel spoke about. Separating the investment function, let's say, or the benefit policy, etc., from the employer can work. What would the body that oversees it look like instead? It would presumably be some sort of joint body that involves retiree input or member input. That can work, yes.

[Francis Drouin, Liberal, Glengarry—Prescott—Russell, ON]

Okay.

To go back to joint governance, and I don't know if you're willing to answer this, do you see Canada Post being able to operate in that joint governance model?

[Cory Skinner]

I don't see why not. I think there's a distance to go to reconcile the members and the corporation to come together to work on something like that, but if the interests are aligned, then I think something like that could be workable, yes.

[Francis Drouin, Liberal, Glengarry—Prescott—Russell, ON]

You both briefly touched on risk management. In the low interest world we now live in, what types of challenges does that present to funds such as the Canada pension plan? You would know the trends in the market right now.

[Cory Skinner]

On the investment trends, I'd say we see generally more and more plans moving into what we call liability-driven investing where there is a greater portion of the plan fund allocated to fixed income securities, bonds. In the marketplace, they rise and fall more in sync with the liabilities of the plan than would, say, stock investments, equity investments. That's certainly a trend we've seen for the last couple of decades, and accelerating in recent years.

The biggest problem with that sort of approach at the moment, implementing a de-risking approach like that, is that with interest rates as low as they are, there is sometimes a fear from some plan sponsors that moving it all, or a great deal of it, into bonds now, if rates were to rise, the value of those assets is going to fall. To the extent that there is upward pressure on bonds, that's a risk.

We hope interest rates will rise, but we've been hoping that for many years now. We keep thinking that it can't get any lower, and yet it does. It's very difficult to predict, of course.

[Francis Drouin, Liberal, Glengarry—Prescott—Russell, ON]

Ms. Cover, on the Ontario pension plan, when did you move over to a joint governance model?