Letters Of Credit – A Modest Proposal1
By: Ian J. McSweeney & Anna Zalewski
While solvency funding protects pension plan members in the event their employer, for example, goes bankrupt, the funds required to cover a deficit can cause financial difficulties for an employer and they are not recoverable if a plan goes into a surplus position. Letters of credit may provide a workable alternative, say Ian J. McSweeney and Anna Zalewski, of Osler, Hoskin & Harcourt LLP.
After several years of low interest rates and low investment returns, many pension plan sponsors are being required to fund significant solvency deficiencies.
Solvency funding is intended to protect pension benefits in the event of plan termination at a time when the plan sponsor may be bankrupt or insolvent. In most Canadian jurisdictions (other than New Brunswick where solvency funding amortization has recently been extended from five to 15 years) solvency deficiencies must be paid off over no more than a five-year period2. This can divert cash away from maintaining or expanding business operations or, as we have all seen in such cases as Air Canada, cause major financial difficulties for the plan sponsor.
Recently, plan sponsors have become increasingly wary about putting too much money into their pension plans. Over the last decade or so, developing case law in the areas of surplus ownership, contribution holidays, plan partial wind-up declarations, plan mergers, and plan expenses – culminating in the 2004 Supreme Court of Canada decision in Monsanto3 – have demonstrated the asymmetry of the current system which requires sponsors to bear the entire risk of deficit funding, but to share or often abandon pension surpluses. Since, in the cyclical marketplace, today’s deficits are tomorrow’s surpluses, and vice versa, it is easy for a sponsor to get caught fully funding a deficit one day and then paying out contributed monies as surplus a relatively short time later in conjunction with a partial or full plan wind-up.
Despite calls for reform from the judiciary, and legitimate concerns voiced by many in the industry over the future of Defined Benefit pension plans, governments have been slow to respond. Some sponsors have become quite cynical as to whether the political will exists to address these problems. Many have adopted, or are considering, pension funding strategies which are set at the minimum level required by legislation while they search for alternative solutions to address funding concerns and pension security. In addition, some sponsors are rethinking the design of their pension plans and whether expensive ancillary benefits should be eliminated or whether they want to continue offering DB pensions as part of employment compensation.
While collective bargaining agents and pension plan members may take a contrary view to that of employer sponsors by pointing out member risks in under-funded plans and arguing in support of the continuation, or even expansion, of member surplus rights, they too have become increasingly concerned about the impact of solvency deficits and the adequacy of pension protection.
Unions, for the most part, continue to support DB (as opposed to Defined Contribution) pension plans for their members and have begun to call for government intervention to improve pension security and increase protection by granting priority to pension deficits so that they rank ahead of the interests of the plan sponsor’s other creditors.
Perhaps there is at least a partial solution to sponsor and member concerns over pension funding/security issues through the use of irrevocable and renewable letters of credit (LOCs). However, the impact of LOCs on actual pension plan funding from a regulatory perspective remains unclear.
In Butler Brothers Supplies Ltd. v. British Columbia (Financial Institutions Commission)  B.C.J. No. 1580 (S.C.), the employer, Butler Brothers, obtained a letter of credit from a Canadian chartered bank in the amount of its pension solvency deficiency and deposited it with the pension plan trustee as a plan asset in lieu of amortized funding. The B.C. Superintendent of Financial Institutions objected and the matter ended up before the courts. In the words of the judge, the LOC “was a practical and eminently sensible way to protect the plan in the circumstances.” However, the B.C. superintendent disagreed on the basis that the LOC was not a legitimate plan asset, but merely a contingent obligation to pay at a future date. The superintendent maintained that the employer had to make solvency instalment payments as required under B.C. pension legislation.
Butler Brothers maintained that the deposit of the LOC under the plan was not, in any way, inconsistent with B.C. pension legislation and that the plan, with the LOC, should be considered fully funded. The employer quite correctly argued that since the terms of the LOC required the full face amount to be immediately and irrevocably paid into the plan on plan termination or other default, the interests of the members were fully protected. The judge expressed regret about the legislative regime, but sided with the B.C. superintendent. The court found that the B.C. legislation required actual contributions to the plan to fund a solvency deficiency and that the LOC, because of its conditional nature, did not meet these requirements.
From a policy perspective, the use of LOCs to fund solvency deficiencies seems both a pragmatic and reasonable approach to dealing with an issue that is sensitive to the interests of both plan sponsors and members.
Using LOCs to protect pensions is not new. LOCs have long been in use as one method of securing the liabilities of unregistered supplementary pension plans (SERPs) through the retirement compensation arrangement (RCA) rules under the Income Tax Act. SERPs are not subject to the funding requirements under pension benefits legislation. When SERPs are secured by this method, an irrevocable LOC with a face amount equal to 100 per cent or more of SERP liabilities is typically deposited with the SERP trustee. The LOC is generally renewed annually by the sponsor in an amount that accords with an actuarial valuation of SERP liabilities. The trustee may call on the LOC if any of a number of specified events of default occur prior to the LOC renewal date. While events of default differ, depending on the arrangement, they always include the bankruptcy or insolvency of the sponsor, as well as any failure to renew the LOC within a specified period prior to its expiry date. In this way, once the LOC is issued, the plan can count on at least the face amount being contributed if anything goes wrong. The concept would be identical for registered pension plans.
From a plan sponsor’s perspective, the use of LOCs permits the sponsor more flexibility in directing cash flow to business needs, although LOCs do use up available credit and can be expensive, depending on the sponsor’s credit-worthiness and prevailing market conditions. The main advantage of LOCs to sponsors under the current registered pension plan regime may be the ability to better control plan funding and avoid the build-up of large surpluses, without compromising pension security.LOCs would certainly be a useful tool in addressing some of the asymmetry issues pending a more permanent legislated solution.
From a plan member’s perspective, the use of LOCs provides security in the event of the termination of an employer’s business and consequently the pension plan. The LOC on deposit with the plan trustee would be dedicated solely to fulfilling the solvency funding obligations under the pension plan.
LOCs also provide a neat answer to union concerns over enhancing the priority of pension deficiencies as against the rights of a sponsor’s other creditors. LOC arrangements, if properly structured, can provide an absolute first priority interest in the entire LOC face amount when the LOC is triggered, causing immediate payment into the plan in the hands of the trustee as holder. This would provide significantly more security for members and pensioners than traditional provisional funding of solvency deficiencies over a legislated amortization period.
From a general public policy perspective, the use of LOCs seems to make perfect sense. Indeed, as a practical matter, the availability and expense of LOCs to any particular sponsor may act as a useful, market- based barometer of the sponsor’s financial health. LOCs are likely to be unavailable, or prohibitively expensive, to plan sponsors who are experiencing financial difficulties. This would require cash funding from at-risk sponsors, while allowing those with stronger balance sheets to manage their statutory funding obligations over a longer period of time. As such, LOCs serve the public policy goal of improving the funded position of pension plans while not tying the ‘hands’ of financially stable plan sponsors.
While it is not being suggested that LOCs would be an appropriate substitute for plan funding generally, or in all circumstances, a very strong case can be made for LOCs to have a useful role as a flexible tool through which cyclical swings in pension plan funding requirements can be addressed without forcing sponsors to bear the risks of over-funding and without putting members at increased risk by compromising pension security. This would arguably relieve some of the current negativity towards DB pension plans.
LOCs could be structured to provide greater pension security today under most Canadian pension jurisdictions, as long as they are not being used as a substitute for compliance with minimum funding rules. For example, the plan sponsor would still be obligated to make required plan contributions.
In Québec, Bill 1024 contemplates the use of LOCs as one way of qualifying for extended 10-year solvency deficiency amortization absent member/beneficiary consent (deemed if less than 30 per cent object).
Most, if not all, Canadian pension regimes have requirements that are similar to the B.C. requirements considered in the Butler Brothers case in that the pension regulator would likely take the position that while LOCs may possibly be used to enhance plan security, they cannot be directly treated as a contribution or a plan asset. Therefore, to add certainty and to properly encourage the use of LOCs to their full potential, including plan funding purposes, legislative change is required. A number of considerations may be relevant, including:
- the extent to which employers would be permitted to fund solvency deficiencies for any year through one or more LOCs
- LOC duration and conditions of removal
- designation of the LOC holder (presumably the plan funding agent or trustee)
- required events of default such as a failure to renew the LOC or to make required statutory contributions in respect of the plan
- institutions qualified to issue LOCs for the purposes of solvency funding
- the extent to which LOCs would be included in valuing the plan assets (presumably LOCs would not be included for the purposes of going concern valuations or normal cost calculations)
- circumstances justifying a reduction of the LOC face amount (employer additional contributions)
- the frequency of actuarial valuations to determine solvency funding requirements may need to be increased while the LOC remains in place given that LOCs are typically renewable annually the treatment of LOCs for the purposes of determining a plan’s solvency or transfer ratio
LOCs should be considered by governments and their pension regulators as one possible way to begin the process of restoring balance to the pension industry while at the same time addressing sponsor and member solvency funding concerns and preserving pension security.
Ian J. McSweeney and Anna Zalewski are with Osler, Hoskin & Harcourt LLP.
1. With apologies to Jonathan Swift, circa 1729
2. Under Bill 102 (first reading May 5, 2005) the Québec government also proposes to relax certain funding rules permitting 10-year solvency deficiency amortization in qualifying circumstances
3. Monsanto Canada Inc. v. Ontario Superintendent of Financial Services  3 S.C.R. 152 - requiring surplus distributions on partial plan wind-up
4. See endnote 2.
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