Wednesday, November 18, 2009

Pension priority in backruptcy

An article in the November 11, 2009 issue of Macleans included the following comment on why bankruptcy protection could not be extended to pension plan members:

"Despite the calls from Nortel employees, Ottawa stopped well short of suggesting legislative changes to protect pensioners in the event of a corporate bankruptcy. While Liberal Leader Michael Ignatieff has said employees deserve to be near the front of the line as an insolvent company’s assets are being carved up, experts argue such a move could displace other creditors and, in turn, make it difficult for frail companies to raise badly needed financing, potentially forcing more bankruptcy proceedings. In short, pensioners may never be guaranteed a soft landing when their employer goes belly up."

Do CEO's and business leaders agree with the Macleans' experts? A recent Compas poll found that its panelists, CEOs and business leaders, are especially supportive of the idea of legal priorizing of pension rights in the event of corporate bankruptcy. In fact, this idea had more support other ideas such as expanding the CPP or giving tax incentives to build pension surplus. So, the question is: is prioritizing pension rights in a corporate bankruptcy really a bad idea?

There are at least a couple of ways of looking at this question. There is no question that pension plan deficits are a real headache for corporations and their CFOs, but let's assume that deficits are given priority in bankruptcy proceedings - what would happen? For a start, CFOs would have a strong incentive to improve plan funding, or at least put in place a letter of credit, to ensure that creditors are not concerned with the pension plan and its new priority status. A plan that is fully funded, or backed by a letter of credit, would not add to the list of unsecured creditors in the event of bankruptcy. There would be more inclination to match asset duration to liability duration, which would mean reduced equity investments. This would reduce the likelihood of surprise deficiencies in the future. Funding flexibility and the opportunity to take contribution holidays may be reduced, but true costs would be better known and pensions would be substantially more secure.

From another perspective, a creditor today must assess the risk of any loan. As the new accounting rules (IFRS) come into play, pension plan deficits will show up on the balance sheet. Even if the pension plan members are not given bankruptcy priority, the creditor and rating agency will know the risks. A big one is that it would only take a change in government to flip the situation. In other words, pragmatically, the creditor should be operating as if the bankruptcy protection was now in place. Not having bankruptcy priority for the pension plan will not do much to improve the chances of getting a business loan.

How should a CFO respond? Clean up the pension plan financing as quickly as possible. A plan deficit is like the proverbial albatross. A corporation's finances will not be helped by ignoring the security needs of pension plan members and retirees. The government could help by adopting the Canadian Institute of Actuaries proposal to allow a Pension Security Trust. This Trust would be attached to the pension plan, but allow for reimbursement to the corporations of funds no longer needed once a suitable solvency margin is reached.

Pensions as financial instruments

Imagine walking into a bank and being told that your $10,000 savings account was only worth $8,800 because they made some bad investments. Or, imagine your heirs being told by your insurance company that it will take 5 years to pay out the proceeds because some of their mortgage investments defaulted. Unthinkable? Then why does it happen in some pension plans?

For many people, a pension plan is their largest financial asset. Employees and retirees view the pension promise as a financial commitment made by the plan sponsor – something they can rely upon. Yet pension legislation doesn’t treat the pension plan as a financial instrument, it treats it as a labor contract. And that’s where the problems start – the contracts are frequently incomplete and depend upon an external value assessment if the plan gets into trouble. Or they are run like a mutual association, where the security of the retiree is often dependent on the desire of active employees to keep the faith.

I think it’s time to start managing and regulating pension plans differently. Pension plans should offer a similar level of security to members as insurance companies and banks offer to their customers. Provincial authorities need to move from rule based regulation to principal based supervision. Supervision would avoid rule of thumb funding and instead focus on the risk characteristics of the plan, member demographics, investment selection and the sponsor’s ability to cover shortfalls.

Plans might have to change to simplify designs, to remove contingent benefits that don’t involve predictable risks and to permit sponsors to withdraw excess funds once solvency is assured. But the end result would be more secure benefits for plan members and plan sponsors knowing exactly what they are paying for.

Tuesday, November 3, 2009

Fire prevention

In a recent article Lord Skidelsky, who is Emeritus Professor of Political Economy at the University of Warwick, made the following comments on Keynes, forecasts and economic models:

"Keynes’s major contribution to economic theory was to emphasize the “extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” The fact of their ignorance forces investors to fall back on certain conventions, of which the most important are that the present will continue into the future, that existing share prices sum up future prospects, and that if most people believe something, they must be right.

This makes for considerable stability in markets as long as the conventions hold . But they are liable to being overturned suddenly in the face of passing bad news, because “there is no firm basis of conviction to hold them steady.” It’s like what happens in a crowded theater if someone shouts “Fire!” Everyone rushes to get out. This is not “irrational” behavior. It is reasonable behavior in the face of uncertainty. In essence, this is what happened last autumn."

I think the implications for pension actuaries are clear - we need to spend much more time on fire prevention.