MEMORANDUM

October 19, 1999

To: Pension Industry

From: Ronald J.M. Bergeron
Senior Director
Supervision

Subject: Negotiated Contribution Defined Benefit Plans

This document outlines some of the problems OSFI has encountered in its supervision of federally regulated negotiated contribution defined benefit plans.

Pension plans are typically defined contribution (provide a benefit at retirement or termination whose amount depends on the value of contributions made during the members' working lives) or defined benefit (benefit is fixed; contributions vary). Negotiated contribution defined benefit (NCDB) plans combine aspects of those two categories. This makes them a challenge to administer, fund and regulate. While they may be sponsored by only one employer, these plans usually involve the participation of several, and it is in this latter case that difficulties tend to be more common. Employee unions are often involved in, or solely responsible for, the plan's management.

While the Pension Benefits Standards Act, 1985 (PBSA) recognises that a board of trustees, rather than the employer, administers these plans, they are treated like any other defined benefit plan. In particular, NCDB plans are subject to the same funding regulations as other plans. Many other Canadian jurisdictions treat NCDB plans in the same manner. Ontario, however, excludes these plans from participation in its guarantee fund, and exempts them from restrictions on an administrator's ability to reduce benefits.

The purpose of this memorandum is to share issues and concerns related to NCDB plans with a view to alerting interested parties to the special challenges they pose. While many of these plans are well run, the paper centres on the difficulties we have faced as a regulator. The following comments are made public to help NCDB plans avoid known pitfalls and continue providing retirement benefits to their members. In keeping with the best practice guidelines recently issued by OSFI on various pension topics, this memorandum will hopefully promote prudence in the administration of these plans.

Funded Status and Supervisory Challenges
As of March 31, 1999, OSFI supervised twenty-eight plans of this type. This amounts to 2.4 per cent of all plans regulated by OSFI, or 6.2 per cent when only defined benefit plans are considered.

Our experience shows that these plans have a greater tendency than other defined benefit plans to experience solvency problems: as of March 31, 1999, eight of the twenty-eight NCDB plans we supervise reported a solvency ratio less than 1.00. This compares to 9.6 per cent for all defined benefit plans.

Supervision of NCDB plans tends to take more time than other defined benefit plans. The extra time involved depends on the plan. For example, if a plan becomes insolvent and no new collective bargaining is planned in the near future, the situation must be rectified as soon as possible, even though additional contributions cannot be anticipated. We estimate that approximately 50 per cent of time attributed to off-site plan supervision is spent on NCDB plans. Most of the plans rated at stages 1 and above, according to the Private Pension Plans Division's risk-based rating system, are plans of this type. Not surprisingly, these plans require more than their share of examinations.

Nature of NCDB Plans
For the vast majority of plans we supervise, one of the following two characteristics - required contributions or promised benefits - is fixed; the other is variable.

(i) In defined contribution plans, benefits result from accumulated contributions. These plans are rarely worrisome. The main consideration is ensuring that contributions are made in accordance with the terms of the plan.

(ii) In defined benefit plans, the amount of contributions required varies and these must cover the cost of accruing benefits and deficit amortization, if any. Required contributions are detailed in an actuarial report, which must be filed with OSFI at least every three years. Here, the sponsor's financial stability is key to its delivering the pension promised at retirement.

The nature of NCDB plans increases the risk of failure in delivering this promise, as the rate of contributions to be made to a plan is fixed - usually for the duration of a negotiated collective agreement between a union and participating employers who negotiate their contributions rather than contribute an amount recommended by the plan actuary. The rate of contribution is determined independently of the granting of benefits.

The distinctiveness of these plans does not warrant more lenient funding requirements, in our opinion. Members of NCDB plans should be given the same level of protection as that requested from sponsors of other defined benefit plans. In particular, declining memberships and the need to maintain intergenerational equity argues in favour of solvency standards for these plans.

1. Problems Related to Governance

(i) Because employers have no commitment to contribute other than what is set out in the collective agreement, trustees of NCDB plans have the responsibility to set benefits at a level the plan can presently afford - a responsibility that may be overlooked. In some cases, trustees anticipate contributions from future collective agreements, possibly at increasing rates of contribution.

(ii) Trustees sometimes have difficulty balancing their loyalties and ties to the employer and the union with their fiduciary responsibility to ensure that the plan can afford the benefits it is promising to pay.

(iii) Because several employers or union locals may be involved with possibly different negotiated contribution rates, monitoring contributions can be difficult. In addition, trustees don't always have an effective process in place to ensure timely remittance of required contributions.

(iv) Administrative costs and professional fees pose a special challenge: as neither employers nor unions pay for these, they must be drawn from the pension fund. This, in turn, reduces the security of benefits and the feasibility of improving them.

2. Problems Related to Trustees' Lack of Authority and Expertise

(i) Trustees have no authority to increase contribution levels from plan members or employers. If no collective bargaining is in the offing, no additional contributions can be expected to cover a shortfall in assets. Even if collective bargaining is anticipated, it is difficult to negotiate increased contributions, especially in declining or competitive industries where jobs are less secure and employers face financial difficulties. Also, younger members may not like having part of their deferred wages support older or retired members' benefits.

(ii) During negotiations, pension contributions may be less important than wage rates or contributions to health/disability plans. Also, where employers operate in declining industries, we have noted that unions may try to sign up new employers to the plan, who sometimes contribute at a lower level.

(iii) Members on occasion make unreasonable benefit demands, for example asking for benefit increases immediately upon a plan paying off its deficit or even where no surplus exists. The focus is obtaining a commitment to benefit increases, with little consideration as to whether this promise of enhanced benefits can be delivered.

3. Problems Related to Valuation and Funding

(i) Contrary to what typically prevails with defined benefit plans, the advice of the plan actuary to fund the plan in accordance with regulatory requirements is, in NCDB plans, only one of several competing factors and may not get the required attention.

(ii) Contributions, typically made on a per hour basis (but can also be on a per mile driven, per container handled, or any other base appropriate to an employer's circumstances), are variable in nature, and may fall short of what was anticipated; e.g., the number of hours worked is fewer than the actuary's projections. This, in turn, means that promised benefits cannot be supported.

(iii) Valuations sometimes fail to project costs of flat benefit or career average earning increases which have been given in the past and which the membership has come to expect. Another problem is not fully valuing unreduced early retirement benefits subject to consent, where consent is routinely granted.

(iv) Because several employers are usually involved, and the often transient nature of the employees' work (and, therefore, plan participation), data errors, where information on members is incomplete or inaccurate, may occur.

(v) In plans where employer contributions are uniform, the "low cost" participating employers (e.g., those with younger employees, for whom the value of accruing benefits payable at retirement is below average) effectively subsidize the "high cost" employers. Low cost employers or employees may be tempted to cease their participation, leading to (or compounding) financial difficulties for the plan.

(vi) A reduction in the number of employers will reduce the ratio of active members to retirees. The resulting drop in contributions places increased reliance on investment income to maintain solvency, particularly in poorly funded plans.

4. Termination
Employers may leave a plan either voluntarily or after bankruptcy. However, cessation of employer participation does not necessarily mean that members have ceased membership, which is usually not linked to the employer's participation but to the industry in which they work.

When employers leave an underfunded plan, a partial plan termination may have to be declared; otherwise, the members who leave may receive full benefits and deplete the plan unduly. The granting of benefit improvements by plans involving employers from a declining industry is particularly worrisome.

If only a few employers terminate, the plan may continue to function, but if terminations become a trend among the plan's employers, the future of the plan and members' benefits may be threatened.

Several problems may occur when a plan is completely terminated, the biggest one coming from data errors. This can be especially severe for multi-employer plans. Problems that must be addressed when insolvent plans are terminated include:

• benefit reductions;
• unremitted contributions;
• legal issues (e.g., interpretation of the plan text);
• liquidity of assets (real estate, private placements, etc.);
• immunization of the portfolio until wind-up (to prevent further deterioration of the plan's solvency);
• improper plan amendments;
• administrative practices that violate the terms of the plan; and
• unclear provisions on division of assets.

While plan insolvency is our primary concern, these difficulties (with the exception of benefit reductions) may also arise if the plan is fully funded and in an on-going plan.

Conclusion
Because they entail the need to match variable costs to a limited flow of contributions, NCDB plans require enhanced monitoring. This is rendered even more necessary by some plan trustees' lack of expertise in pension matters and the fact that they and their professional advisors sometimes do not recognize problems, or are overly optimistic about future contribution levels and membership increases. In addition, plans usually group employers involved in a single industry, so that sector-wide problems can easily spell trouble for the plan as a whole.

Alertness to negotiated contributions becoming insufficient is essential. When this arises, regulators cannot assume the issue is being appropriately dealt with. We have had to intervene, request remedial action from the Board of Trustees and monitor its implementation. The first avenue for the Board is to reopen collective bargaining. If this does not raise the contribution level, reduction of future benefits will be necessary. Finally, if reducing future benefits is an insufficient remedy, the Board has no choice but to consider a reduction of accrued benefits - a difficult decision as this may also entail reduction of benefits in payment.

It is our experience that NCDB plans that do well for their members assess negative future scenarios, plan for contingencies and respect solvency funding standards.