Restricting Contribution Holidays is Good Step but Prohibition and Amortization of Surplus and Deficits is Better

Increasing the minimum level of surplus above which the plan sponsor may take a contribution holiday from 0% to 5% of pension liabilities is a step in the right direction, but too small a step to reduce the high solvency risk continuously affecting defined benefit pension plans. The right step for an optimal reduction in this risk is the full prohibition of contribution holidays, coupled though, with the amortization of emerging pension surpluses and deficits over a period of at least five years. Such measure would stabilize the contribution rate, prevent the building up of unduly large surpluses or debts and essentially eliminate the need for separate contingency funds that unnecessarily increase pension costs.

In my view, contribution holidays are the leading cause of recurrent pension deficits and therefore chronic solvency problems for DB plans. Contribution holidays allow DB plan sponsors to withdraw immediately from the pension fund any surplus as soon as it emerges, while any emerging deficit is generally amortized, if ever, only over a long period of time.

Fortunately, the Income Tax Act (ITA) was amended last year to increase from 10% to 25% of pension liabilities the level of pension surplus that may be held in a pension fund without incurring tax penalties – the necessary first step to addressing the chronic solvency concerns of DB plans.

The next step is to simply prohibit plan sponsors from taking contribution holidays. The Office of the Superintendent of Financial Institutions Canada recently increased from 0% to 5% of pension liabilities below which a pension surplus may not be withdrawn in the form of contributions holidays. As a matter of consistency with the ITA, OSFI’s rule should have been changed from 0% to 25%. Otherwise, the new ITA 25% rule is useless.

Contribution holidays under DB pension plans should be totally prohibited at both the federal and the provincial levels. Private DB pension plan sponsors generally oppose such drastic measure because they inappropriately proclaim that pension plan surpluses would thereby reach unreasonable levels. But this would not be the case if the prohibition of contribution holidays were coupled with a prescribed amortization of emerging pension surpluses and deficits over 5 or more years.

Even if a plan sponsor finances the pension plan properly in accordance with the actuarially determined contribution rate, pension surpluses and deficits still emerge every year due to fluctuations in the market value of the invested pension fund.
Amortization of emerging surpluses and deficits over a fixed period instead of contribution holidays is a much reliable recipe for:

• optimizing the stability of the pension contribution rate level;
• avoiding major pension solvency problems;
• preventing at any time the pension plan from becoming overly underfunded or overfunded
• avoiding the need to maintain any earmarked contingency fund within or outside the pension fund;
• optimizing intergenerational equity among successive cohorts of contributors.

Bernard Dussault
1992-1998 Chief Actuary of the CPP, OAS and federal public sector pension plans

Keywords: pension reform