Canada: More pension troubles seen

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Canada: More pension troubles seen

By ELIZABETH CHURCH, The Globe and Mail

July 15, 2003

Canada's top companies are being overly optimistic in the assumptions they use for their troubled corporate pension plans, spelling further funding troubles down the road, a new study by UBS argues.

The funding shortfall at Canada's largest companies with defined benefit pension plans on the S&P/TSX 60-stock index ballooned to $16.6-billion last year from $3.5-billion in 2001, the study notes. While these growing pension deficits have captured headlines, it says the assumptions behind these numbers are still too rosy. That means there is even more pension pain to come in the form of rising deficits and growing contributions in future years.

"In our view, more disturbing than the sheer size of these pension obligations and funding deficits is the yawning gap between assumptions and reality," says the UBS report, which was released yesterday.

While most companies have reduced their assumptions on the two key figures that affect the size of pension obligations and expenses -- the discount rate and the expected return on pension assets -- the study's authors say it has generally been a case of too little, too late.

"The realities have changed at a pretty rapid rate, but the assumptions are lagging behind," said George Vasic, chief economist and strategist with UBS in Canada.

At the end of last year, for example, the average return on assets assumption at the 49 companies in the sample was 7.66 per cent -- a drop of 31 basis points over two years.

(A basis point is 1/100th of a percentage point.)

"I find that quite a startling figure," Mr. Vasic said.

The study argues 6 per cent is a realistic target for a portfolio comprising 55-per-cent stocks, 40-per-cent bonds and 5-per-cent cash.

The study also takes issue with the average discount rate -- a key calculation used by plans to determine the money needed now to meet future pension obligations. The discount rate is linked to the yield on corporate bonds. Falling bond yields in the first half of this year mean that rate needs to be lowered too, the study says, to 6 per cent from the average 6.52 per cent for its sample at the end of last year.

Steve Bonnar, a pension specialist with consultants Towers Perrin in Toronto, agrees that conditions have deteriorated for most pension plans in the first half of this year, but takes issue with the argument that companies' past assumptions were misguided.

The return on equity assumptions, he said, have been moving lower and are likely to continue to drop, but he does not agree that 6 per cent is a fair long-term rate of return.

"It's absolutely low in my mind," he said.

Mr. Bonnar also said there is "no question" discount rates need to come down, given the drop in bond yields this year.

But he said it would be wrong to infer that the rates used by companies at the end of last year were incorrect. Conditions have merely changed since then, he said.

Either way, the end result will be more bad news for Canadian plans, he said.

Preliminary figures from Towers Perrin show that the funding deficit at a benchmark pension plan grew by a further 5 per cent in the first six months of the year.

While plans likely made more on their assets because of a rise in equities, falling bond yields meant that they also needed even more assets to cover their pension obligations, he explained.

"The net result is that we are in worse shape than we were at the end of last year," Mr. Bonnar said, unless firms have made major contributions to their plans.

While pension results continue to decline, the UBS study highlights that not all companies will share this pain in equal measure.

A handful of companies, it notes, account for the lion's share of the funding shortfall. Just eight companies in its sample account for 70 per cent of the total pension shortfall -- $11.6-billion out of the $16.6-billion.

The pension deficit at these eight companies also is greater than 10 per cent of their market capitalization as of July 7 of this year.

Despite this, the study finds it "most alarming" that pension contributions at these eight companies account for just 38.9 per cent of contributions in the sample.

"For a small number of companies, this is a significant issue," Mr. Vasic said. "Among all the other things, this is something investors have to consider . . . it's like an extra debt."

Mr. Vasic said contributions have only just begun to respond to what have become huge funding deficits in some cases. But he said they likely will have to continue and increase.

Only a strong sustained market rally, combined with rising interest rates will erase some of the current shortfalls, he said. And that is not "a highly likely prospect."

Major shortfalls

The eight largest pension deficits relative to market capitalization represent 70 per cent of the S&P/TSX 60's total.

.......................2002 pension

                                      obligation 2002 funding deficit

S&P/TSX 60                   as a %                       C$,           As a % of

companies                market cap                   millions               market cap

Bombardier                     66.8%     	-$2,653.50     	30.5%

Inco                                65.5       	-1,270.00        	24.3

Abitibi-Consolidated       83.1                   -791.00           	20.0

Quebecor World            38.9         	-639.60          	19.5

Cdn. Pacific Railway       122.4                 -863.50           	17.6

Alcan                               84.9        	 -2,241.80       	16.8

Nortel Networks             55.9        	 -2,817.60       	16.2

Noranda 68.7 -331.00 10.3