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  • KPB & Co Research


The Trudeau led liberals have been selling themselves to the Canadian public as the government that is friendly towards the little guy as opposed to rich corporations. With an election coming up, the liberals had to act fast on one key issue to save its reputation as the government for the people. The issue of pension reform has been on the lips of many Canadians, especially after the hit that over 20K workers took post bankruptcy of Sears and Nortel. The 2019 budget gave a us a glimpse into how the government is thinking about approaching the issue, but one wonders whether these ideas have enough steam in their engines the travel beyond the election. In this article we examine the rhetoric behind the liberals' approach to solving the pension problem, and the state of pension plans in publicly listed Canadian companies.


Before we dive in let us clear up a few definitions. Defined benefit pension plans are those plans where the benefits that workers will receive upon retirement is based on a formula determined by an independent board of trustees. With the benefit defined contractually, it then becomes a liability that must be funded by those who agreed to it - that being the corporation. As with all liabilities including corporate debt, and preference shares, defined benefit pension liabilities are funded from the operating cash flows of the company and the assets owned by the company. In some respects it can be seen as capital that has been contributed by the workers of the company. Defined contribution schemes are structures where the corporation's responsibility stops at its contribution to an independent third party that manages the funds for the benefit of all workers.

DEFINED BENEFIT PENSION PLANS ARE ON THE DECLINE BUT IS STILL THE MAJORITY

It is no secret that corporations have been trying to move away from a defined benefit structure because of the inherent conflicts of interests that exist when they have discretionary control over the capital that workers contribute. In defined benefit pension plan schemes the corporation can make one of two choices. They can allow the growth (or lack thereof) in the corporation's assets or free cashflow take care of the pensioners' needs, or they can contribute money to a fund managed by an independent third party and hope that the funds return will cover pensioners' needs, either way the corporation will be on the hook for the lability. In this context, most corporations would want to exert some level of influence over how pension money is managed, given the consequences to the corporation if pensioners' capital is managed improperly.




Issues with Defined benefit Schemes

Therein lies the problem. Senior executives of corporations should have a right to exert influence over how pensioners' capital is managed, and this legal right is more concrete in a defined benefit set up. It is expected that senior executives should also act in good faith to secure the capital that pensioners contribute. Nevertheless there will be instances where the two goals don't go together, because of the incentive structure under a defined benefit arrangement. The problem here is similar to the principal agent problem that exists between shareholders (another group of capital providers) and corporate executives, where corporate executives are often incentivized to act in their own self interest at the expense of shareholders. The same exists for lenders whether banks or bondholders. The difference in these other cases is that there exists real tools that can be used to minimize the principal agent problem, and in most cases these principals are experts. Shareholders can appoint an independent board of a directors that look out for shareholders' rights, banks have loan agreements that give them priority in the capital structure and monitoring rights, and bond holders have indenture agreements that give them various rights to secure their interest. To be fair, defined benefit pension schemes often have board of trustees to secure workers' capital, but in reality these trustees are usually "living in the lion's mouth" and are only independent on paper.



The structure of defined benefit pension schemes often leads to corporate executives putting themselves or the short term needs of the company above the long term needs of the workers. The cost of the conflict of interest is often exposed during bankruptcy proceedings, where funds closes off large deficits which lead to forced curtailment of benefits. In the case of sears Canada, filings with the Ontario Courts show that the Sears Canada pension fund was underfunded to the tune of C$267Mn in 2015, and this is after members had their benefits frozen since July 1, 2008. Along with an unfunded pension plan, terminated employees got no severance pay, and their health and insurance benefits were cancelled. At the same time over 43 executive was scheduled to take home C$9.2Mn in bonuses during the bankruptcy process. In the case of Nortel Networks the non-negotiated pension plan had a deficit of approximately C$98Mn while the negotiated plan had a C$7Mn surplus. It was alleged that senior executives made off with C$12.8Mn in bonuses and stock payments. Wabush Mines and Indalex were other companies that took advantage of workers and unions that had limited powers in holding management's feet to the fire in the administration of worker pension funds.


Canada's 10 Most Indebted Pension Schemes


What is the Morneau and Trudeau Team Suggesting

The Trudeau and Morneau tag team has started out by reducing a tax break that executives of large corporations earn on employee stock options. This was done through a cap on the annual amount that executives can earn on the value of their stock options. The current system is such that only half of the benefits from stock options is taxable, similar to how capital gains are tax today. The government will limit the use of that benefit to C$200k for employees of large, long established, mature firms. According the government that benefit:


disproportionately accrue to a very small number of high-income individuals.


The government is also getting stricter with way private companies and public listed companies in particular manages their defined benefit pension schemes. The government is devoting over a million dollars to come up with laws that support workers who happen to be in pensions of corporations that file for bankruptcy protection. The government is looking at legislative changes to the Companies' Creditors Arrangement Act, the Bankruptcy and Insolvency Act, the Canada Business Corporations Act, and the Pension Benefit Standards Act in order to reduce irresponsible decision making in the administration of pension assets.


This is to be done through:

1) Giving the courts more power to review executive pay in the lead up to insolvency.

2) Requiring publicly traded corporations to disclose their policies regarding workers, pensioners, and executive compensation, or explain their absence.

3) Requiring publicly traded corporations to hold and disclose the results of non-binding shareholder votes on executive compensation.

4) Allowing defined benefit plans to fully transfer pension assets and liabilities to a regulated life insurance company through the purchase of an annuity, and

5) Clarifying pension law to emphasize the idea that a pension plan should provide the same benefits before and after it is wound-up.


While we do acknowledge the importance of strengthening bankruptcy laws around the handling of pensioners' capital in the event of bankruptcy, there is evidence that suggest that a lot of problems that pensioners face when a company goes bankrupt started when the pension plan was designed. There are defined benefit pension fund schemes out there that has been carrying a deficit for years while workers complain everyday. In the case of sears, it is alleged that union executives have been drawing attention to the deficit for a number of years to no avail. In these cases independent third parties should be given more rights to implement a change in the administration of the fund in instances where the fund falls short of return requirements.


In concluding, there are a couple of things that are clear to us that we would like to point out. First, the issue of pension reform has been debated for years, but very few actions were taken to implement change. Today, we are in election season and obviously a lot projects that were once shelved will be given the spotlight. In this context, we do like the fact that government is finally coming up with way to secure pensioners' savings. On the other hand it is likely that if pension reform is not done soon, it make take more time to see real change.


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