NEWS & VIEWS. Follow-up to the D Amours Report on. 1 Follow-up to the D Amours. 3 New Mortality Tables Will Affect Funding of Pension Plans

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1 NEWS & VIEWS IN THIS ISSUE 1 Follow-up to the D Amours Report on Pension Plan Reform in Quebec 3 New Mortality Tables Will Affect Funding of Pension Plans 4 Changes to Actuarial Guidance for Solvency Valuations: New Annuity Proxy and Alternative Settlement Methods 5 New Transfer Limits When Pensions are Reduced 7 Market Indices 8 Tracking the Funded Status of Pension Plans 9 Impact on Pension Expense Under International Accounting 10 About Us Follow-up to the D Amours Report on Pension Plan Reform in Quebec On September 17, 2013, after hearing from 42 groups and organizations and receiving 19 other briefs, the Quebec Committee on Public Finance submitted its observations, conclusions and recommendations on the D Amours report released in April The Committee stated that it supports the objectives and values of the report, but that most of the D Amours recommendations require further study. It separates the D Amours report proposals into three blocks, and even comments on new suggestions made by some groups during the hearings: Block A: Proposals that require further study 1. Longevity pension The Committee considers the idea interesting, but its impacts on businesses, the economy and government finances must be evaluated. There is also the issue of harmonization with the federal government and the other provinces. 2. Expansion of the Quebec Pension Plan This is a new item proposed by several of those who spoke before the Committee. The Committee recommends that it be studied, given that other provinces are looking at a possible expansion of the Canada Pension Plan. However, in early summer, the other provincial finance ministers indicated that given the current economic conditions, it was not the right time to act. 3. Pension plan funding and the enhanced funding method The Committee welcomes this innovation, but points out the negative impact the enhanced funding method would have on the already significant actuarial 2013 Morneau Shepell September 2013 Volume 10, issue 9 1 of 10

2 deficits in public sector pension plans. It notes the need for a longer adjustment period for this sector. The Committee also questions the use of a discount rate based on corporate bonds and suggests instead using a federal and/or provincial bond index that would mitigate cost fluctuations. 4. Multi-Employer Negotiated Contribution Pension Plans (MNCPP) and treatment of orphans The Committee agrees that a remedy must be found for the fact that, unlike the situation of such plans in the rest of Canada, in Quebec the benefits from a multi-employer negotiated contribution pension plan cannot be decreased when the plan s financial position is no longer viable. This threatens the long-term survival of such plans. The situation is similar in the case of members whose employer stops participating in a multi-employer plan; it is not fair that the deficit associated with those members should fall on the other employers who remain in the plan. 5. The stabilization and indexation fund This proposal comes from the Canadian Union of Public Employees (CUPE) of Quebec and not the D Amours report. It has been used by the blue-collar workers and the City of Montréal. The Committee finds the idea interesting and thinks it should receive further study. Block B: Proposals that could be enacted by amending legislation or regulations 1. Transfer values The Committee recommends the use of a higher discount rate, which would decrease the value of benefits transferred outside the plan. It encourages discussions on this with the Canadian Institute of Actuaries with a view to Canada-wide application. 2. Purchasing annuities from an insurer It recommends that this option be examined to clearly identify liability with respect to funding commitments to retirees and beneficiaries, with guidelines to cover possible insurer insolvency. 3. Separate accounts The Committee finds the idea of setting up separate accounts for active and inactive members interesting, subject to certain guidelines for specific situations. 4. Voluntary Retirement Savings Plans (VRSP) It recommends quick implementation of such plans. The legislative process is already underway and, in fact, the Committee already held hearings in early September on Bill 39 (see our May 2013 News & Views). 5. The position of municipalities The Committee is sensitive to the issues facing the municipalities that are experiencing serious pension funding problems, and who want more power to solve them. It also notes that the unions are opposed to any reduction in accrued benefits. Given this wide divergence of opinions, the Committee does not take a position. Block C: Proposals the Committee did not address 1. Restructuring defined benefit plans The Committee observes that, as with the municipalities, the groups heard had presented diametrically opposed positions on all of the recommendations regarding plan restructurings. It, therefore, referred the whole issue to the government in the hope that the government will find a solution to the important problem of defined benefit plan deficits. Another important suggestion raised during the hearings, but which was not mentioned in the Committee s report, is the introduction of target benefit pension plans to permit a new risk-sharing approach to future service and possibly even to past service. It is likely that this would come under Block C, even though the government recently adopted new rules for such plans, but only for two pulp and paper companies. All parties agreed that the problems are major and that prompt action is required. Despite the consensus about the need to act quickly, it appears that the Committee preferred to postpone several decisions 2013 Morneau Shepell September 2013 Volume 10, issue 9 2 of 10

3 by stating that further analysis is required. It will be interesting to see if the current minority government acts quickly on the proposals that are supported by the Committee (block B) and initiates the additional studies that the Committee still considers necessary. New Mortality Tables Will Affect Funding of Pension Plans On July 31, 2013, the Canadian Institute of Actuaries (CIA) published a draft report on Canadian Pensioners Mortality which concludes that Canadians covered by a defined benefit pension plan are living longer. It also concludes that we can expect mortality improvements to accelerate faster than previously anticipated. For many plans, this means that current funding levels will need to increase to reflect the fact that members will receive payments over a longer period of time. The draft report includes new mortality tables (collectively known as the CPM RPP2014 tables) which are the culmination of several years of study. The cost of public sector pension plans will be affected more than that of the private sector since the CPM-RPP2014 tables show that public sector plan participants live longer. This is illustrated in the table below that compares the cost of providing an immediate life annuity of $1 (based on a 4% discount rate) under the new CPM-RPP2014 mortality tables versus the cost under the mortality tables that are currently being used for the purposes of determining commuted values, the UP-94 generational tables. This illustration shows that a public sector plan would need to have in its fund $17.70 to pay a 55-year old male an annual lifetime pension of $1. A private sector plan would need only $ Both the private and public sector plans would need quite a bit more under the new CRM-RPP2014 tables than they would using prior mortality tables. For example, they would need $16.70 if they used the UP-94 generational mortality tables to fund the plan under their previous actuarial valuation. The CIA study also found that mortality varied according to the size of the pension. As such, actuaries may need to apply size adjustment factors for plans whose average pension payable is larger or smaller than the average size in the data. This will increase liabilities for more generous plans or salary-related plans with a significant proportion of higher-income earners. Present Value of a $1 Pension Based on Different Mortality Tables (at an Interest Rate of 4%) UP-94 1 CPM-RPP Private Sector CPM-RPP Public Sector % +3.0% +8.7% +4.7% +10.7% +5.3% +3.4% +5.2% +4.4% +7.0% +7.8% +4.3% Age 55 Age 60 MALE Age 65 Age 55 Age 60 FEMALE Age 65 1 Generational table with scale AA improvements 2 With scale CPM-A improvements 2013 Morneau Shepell September 2013 Volume 10, issue 9 3 of 10

4 How the new tables will affect any particular plan will depend on whether the plan is in the public or private sector, population demographics (age and sex), the type of death benefit, whether the plan is indexed or not, and the discount rate used to value the benefits. The range of the anticipated increases is quite wide, with most increases ranging between 4% and 7%. Improvements in longevity are not a surprise as the CIA had released preliminary observations last year (see our News & Views issue of November 2012). Some plans have already moved towards reflecting at least some improvement in longevity, usually by making adjustments to the UP-94 tables with the AA projection scale. The release by the CIA of its July 31st draft report is important, however, in that concrete mortality tables have been published as part of the official due process. Even though the tables are currently in draft form, it should be noted that actuaries must use best estimates when valuing the liabilities and normal cost (cost of service accruals in the next year) on a going concern basis. In the absence of credible mortality experience that indicates otherwise, the information in the CIA draft report represents a best estimate of mortality for use in future valuations of most pension plans. Some plans may prefer to conduct a mortality experience study on their own group in order to confirm whether these new tables reflect their group s mortality. (This would be feasible only for large groups, in order to have enough data to allow sufficient credibility.) If, for example, the experience study for a particular group shows that these tables overestimate longevity, then the actuary would be able to make appropriate adjustments so that funding better reflects the group s own mortality experience. Note that these mortality tables will not affect the solvency position of pension plans or transfer values that may be payable upon termination until such time as the Actuarial Standards Board makes changes to the Standards of Practice on Pension Commuted Values. At that time we will see both solvency funding requirements and commuted values increase. Until then, cash contributions for sponsors of plans that continue to have higher solvency deficiencies than going-concern deficiencies will likely increase at their next valuation, but only with respect to contributions towards the normal cost. There is very little chance that the standards on commuted values will be updated in time for a December 31, 2013, valuation. In the unlikely event that they are updated in time, the solvency deficit (and related cash contributions) would be significantly higher than otherwise; this would offset improvements observed so far this year as a result of bond yield increases. Accounting obligations and expenses will likely be affected by these new tables as well. The CIA is requesting comments on the draft report by September 30, Changes to Actuarial Guidance for Solvency Valuations: New Annuity Proxy and Alternative Settlement Methods Based on extensive research, the Canadian Institute of Actuaries (CIA) has refined the guidance that actuaries use for estimating defined benefit pension liabilities for solvency and hypothetical wind-up valuations, where it is assumed that life annuities will be purchased to settle pension obligations. This guidance is effective June 30, We can expect solvency liabilities (and the payments required to amortize the solvency deficit) to be higher under this guidance than under the prior guidance that was effective March 31, In calculating solvency liabilities, immediate annuities are normally assumed to be purchased to settle all retiree benefits. Also, depending on applicable legislation, deferred vested and active members close to retirement are often assumed to elect a pension option instead of a lump sum transfer option, with their liabilities assumed to be settled through the purchase of insured annuities Morneau Shepell September 2013 Volume 10, issue 9 4 of 10

5 Non-indexed annuities As there is evidence that the cost of annuities varies with the duration of the pension liabilities being settled, the interest rate assumption for non-indexed plans will now be set with reference to duration of the liabilities. Duration varies based on the age and sex of the members and the mix of immediate and deferred annuities being purchased. A plan with no deferred members will tend to have a low duration. The inclusion of deferred annuities will increase the duration. The previous guidance required actuaries to add 0.7% to the CANSIM V39062 index when estimating annuity prices. For valuations with effective dates between June 30, 2013, and December 31, 2013, the adjustment drops to 0.6% for a typical duration of approximately 10.2 years. The adjustment for a low duration of 7.8 years is just 0.4% over the CANSIM index, reflecting lower interest rates available on shorter term investments, and resulting in a higher estimated cost of annuities. For a plan with a high duration of 12.5 years, the guidance recommends an adjustment of 0.7%, which is the same as before. Based on these adjustment factors, the difference in estimated cost between a low duration plan and a high duration plan would be about 3%. Indexed Annuities Very few indexed annuities actually come to market. However, it has been recognized that the previous guidance regarding fully indexed annuities understated the cost that is actually experienced in the market, simply because the basis made no allowance for an insurer s risk, expense and profit margins. The guidance effective June 30, 2013, now requires the use of the CANSIM V39057 real return bond index reduced by 1.2%, whereas previously there was no such adjustment. For a plan with fully indexed benefits and a duration of 10 years, we would expect the revised liabilities to be 12% higher than indicated by the previous guidance. Note that as the CIA had less data available from which to draw conclusions, the guidance in respect of indexed annuities makes no adjustment for duration at this time. Alternative Settlement Methods Very large plans and plans indexed to the Consumer Price Index may have difficulty purchasing annuities on the market if they were to wind-up. In these cases, or for other cases where permitted by the jurisdiction overseeing the plan, actuaries may use alternative settlement methods. On September 18, 2013, the Actuarial Standards Board (ASB) released revised standards of practice regarding such an approach and the CIA released an Educational Note to guide actuaries. This Note describes four possible methods that could be used in lieu of the annuity proxy guidance described above. These methods include: 1. The purchase of a series of annuities over a period of a few years; 2. The establishment of a replicating portfolio to provide for the payment of pension benefits over an extended period of time; 3. Lump sum payments to plan beneficiaries; and 4. An assumed modification to the terms of the benefit promise (e.g. substituting fixed rate increases for benefits indexed to CPI increases). Other settlement approaches, including combinations or variations of the above approaches, may be appropriate in certain situations. Note that some jurisdictions do not allow alternate settlement methods to be used, and even where permitted there may be some restrictions. New Transfer Limits When Pensions are Reduced On August 23, 2013, the Department of Finance Canada issued a comfort letter concerning subsection 8517(3) of the Income Tax Regulations. According to that letter, the Department recommends amending section 8517 of the Income Tax Regulations to permit calculation of the transfer limit for a registered pension plan member based on the member s unreduced pension benefits, in a context other than 2013 Morneau Shepell September 2013 Volume 10, issue 9 5 of 10

6 the employer s insolvency (which is already permitted since 2011), such as when a multi-employer plan is wound up with a reduction in members pension benefits. The following conditions must be met at the time of the transfer: 1. The benefits promised under the registered plan have been reduced due to plan underfunding; 2. Where the plan is a registered plan other than an individual pension plan (as defined in subsection 8300(1)), the benefit reduction is approved pursuant to the applicable pension benefits standards legislation; 3. Where the plan is an individual pension plan, the transfer of the commuted value of the member s benefit entitlements is the last payment made from the plan; and 4. The use of this special rule for any particular pension plan is approved in writing by the Minister of National Revenue. Finally, the comfort letter also recommends that these amendments only apply to transfers made after We may expect such an amendment to the Income Tax Regulations soon Morneau Shepell September 2013 Volume 10, issue 9 6 of 10

7 As at August 31, 2013 Market Indices The following table shows the Morneau Shepell monthly summary of returns from various market indices. It also includes returns from benchmark portfolios used by pension funds. RETURNS Monthly Quarter to date Year to date 1 year TSX GROUP/PC BOND Indices DEX Universe Bond -0.6% -0.4% -2.1% -1.1% DEX 91 Day Treasury Bill 0.1% 0.2% 0.7% 1.1% DEX Short Term Bond -0.1% 0.3% 0.6% 1.4% DEX Mid Term Bond -0.7% -0.3% -1.8% -0.6% DEX Long Term Bond -1.4% -1.7% -6.5% -5.5% DEX High Yield Bond 0.3% 1.2% 2.8% 7.9% DEX Real Return Bond -1.3% -0.3% -11.3% -10.5% CANADIAN EQUITY Indices S&P/TSX Composite (Total Return) 1.5% 4.8% 3.9% 9.3% S&P/TSX Composite Capped 1.5% 4.8% 3.9% 9.3% S&P/TSX 60 (Total Return) 1.9% 5.0% 4.0% 9.8% S&P/TSX Completion 0.4% 4.1% 3.5% 7.7% S&P/TSX Small Cap 2.1% 6.2% -1.0% -0.1% BMO Small Cap Unweighted 3.7% 8.5% -3.7% -0.2% BMO Small Cap Weighted 2.6% 7.3% 0.3% 3.7% U.S. EQUITY INDICES S&P 500 (US$) -2.9% 2.0% 16.2% 18.7% S&P 500 (C$) -0.5% 2.2% 22.9% 26.8% FOREIGN EQUITY INDICES 1 MSCI ACWI (C$) 0.5% 2.6% 15.3% 23.4% MSCI World (C$) 0.4% 3.0% 18.3% 25.7% MSCI EAFE (C$) 1.3% 3.9% 14.6% 26.8% MSCI Europe (C$) 1.3% 6.0% 14.7% 27.6% MSCI Pacific (C$) 1.2% 0.1% 14.4% 25.9% MSCI Emerging Markets (C$) 0.9% -0.6% -4.6% 7.8% OTHER Consumer Price Index (Canada, July 2013) 0.1% 0.1% 1.6% 1.3% Exchange Rate US$/C$ 2.5% 0.1% 5.8% 6.8% MORNEAU SHEPELL BENCHMARK PORTFOLIOS 2 60% Equity/40% Bonds 0.4% 2.2% 5.6% 9.7% 55% Equity/45% Bonds 0.3% 2.0% 5.0% 8.7% 50% Equity/50% Bonds 0.2% 1.7% 4.3% 7.8% 45% Equity/55% Bonds 0.1% 1.5% 3.7% 6.9% 40% Equity/60% Bonds 0.1% 1.3% 3.0% 6.0% ASSET & Risk MANAGEMENT In Asset Management, we provide objective advice on all aspects of asset management for pension funds, including investment policy statements, portfolio manager searches, investment performance measurement and investment strategy. In Risk Management, we provide a structured, comprehensive approach to pension risk management, including implementation of liabilitydriven investment strategies, advice on allocation of the risk budget within an asset-liability framework and execution of continuous and dynamic processes for risk reduction. Jean Bergeron, FSA, FCIA, CFA, Partner Tel.: Fax: jbergeron@morneaushepell.com Robert F. Boston, CFA, Partner Tel.: Fax: rboston@morneaushepell.com 1 Returns net of taxes on dividends, except for MSCI Emerging Markets. 2 The returns are compounded monthly Morneau Shepell September 2013 Volume 10, issue 9 7 of 10

8 As at August 31, 2013 Tracking the Funded Status of Pension Plans This graph shows the changes in the financial position of a typical defined benefit plan since December 31, For this illustration, assets and liabilities of the plan were each arbitrarily set at $100 million as at December 31, The graph shows the impact of past returns on plan assets and the effect of interest rate changes on solvency liabilities The Evolution of the Financial Situation of Pension Plans since December 31, 2007 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q Assets ($M) Solvency Liabilities ($M) In August 2013, Canadian bonds showed negative returns while the Canadian equity market as well as most global equity markets rose, with the exception of the U.S. market, which showed a slightly negative return. Assets increased by 0.3% to about $122.0 million. However, the effect of a decrease in transfer value rates combined with an increase in the annuity purchase rate and in bond yields, all used in the calculation of solvency liabilities, caused liabilities to increase by 0.5% to approximately $146.4 million. This increase in assets was offset by the slightly larger increase in liabilities causing the solvency deficiency to rise to $24.4 million. Since the beginning of the year, the funded status of this typical pension plan has improved. The deficiency has decreased by $18.8 million and the solvency ratio rose to 83.3% (compared to 73.0% as at December 31, 2012). Comments: Canada Bond Yields YIELD (CLOSING) CHANGE DEC Aug Overnight rate target 1.00% 1.00% 0 bp 3 months 0.92% 0.99% 7 bps 2 years 1.14% 1.19% 5 bps 5 years 1.38% 1.95% 57 bps 7 years 1.55% 2.24% 69 bps 10 years 1.80% 2.61% 81 bps 30 years 2.36% 3.07% 71 bps Source: Bank of Canada 1. No consideration has been made for contributions paid to the plan or for benefits paid out of the plan. 2. Solvency liabilities are projected using the rates prescribed by the Canadian Institute of Actuaries for the purpose of determining pension commuted values. Early application of the 2009 standards is not reflected. 3. The underlying typical defined benefit plan is a final average plan with no pension indexing. 4. Solvency liability calculations take into account revised CIA guidance on the solvency valuation assumptions (annuity proxy). 5. Assets are shown at full market value. Returns on assets are based on those of the Morneau Shepell benchmark portfolio (55% equities and 45% fixed income). Please contact your Morneau Shepell consultant for a customized analysis of your pension plan. 1 This estimate of the solvency liabilities does not reflect the new CIA guidance published in September 2013 for valuations effective June 30, 2013 or later Morneau Shepell September 2013 Volume 10, issue 9 8 of 10

9 As at August 31, 2013 Impact on Pension Expense Under International Accounting Every year, companies must establish an expense for their defined benefit pension plans. The following graph shows the expense impact for a typical pension plan that starts the year at an arbitrary value of 100 (expense index). The expense is influenced by changes in the discount rate based on high quality corporate and provincial (adjusted) bonds and the median return of pension fund assets. Please contact your Morneau Shepell consultant for a customized analysis of your pension plan (In %) Discount rate Return on assets (55% equities) n/a The pension expense has decreased by 24% (for a contributory plan) since the beginning of the year, mainly due to the increase in the discount rate. The table below shows the discount rates for varying durations and the change since the beginning of the year. A plan s duration generally varies between 10 (mature plan) and 20 (young plan). DURATION Expense Index from December 31, 2012 Contributory plan Discount rate DECEMBER 2012 Non-contributory plan August CHANGE IN % 4.32% 71 bps % 4.56% 76 bps % 4.69% 77 bps % 4.78% 78 bps Comments: 1. The expense is established on the basis of the revisions made to IAS 19, applicable on January 1, The key change concerns the finance cost on plan assets which is now calculated with the discount rate instead of the expected return on plan assets. For more information, please refer to the News & Views of July 8, Please note that the discount rates shown reflect the educational note published by the Canadian Institute of Actuaries entitled Accounting Discount Rate Assumption for Pension and Post-employment Benefit Plans (September 2011). 3. The expense is established as at December 31, 2012, based on the average financial position of the pension plans used in our 2012 Survey of Economic Assumptions in Accounting for Pensions and Other Post-Retirement Benefits report (i.e. a ratio of assets to obligation value of 83% as at December 31, 2011). 4. The return on assets corresponds to the return on the Morneau Shepell benchmark portfolio (55% equities and 45% fixed income). 5. The actuarial obligation is that of a final average earnings plan, without indexing (two scenarios: with and without employee contributions) Morneau Shepell September 2013 Volume 10, issue 9 9 of 10

10 About Us Morneau Shepell is the largest Canada-based human resource consulting and outsourcing firm focused on pensions, benefits, employee assistance program (EAP) and workplace health management and productivity solutions. We offer business solutions that help our clients reduce costs, increase employee productivity and improve their competitive positions by supporting their employees financial security, health and Calgary London Québec Fredericton Montréal St. John s Halifax Ottawa Toronto Kitchener Pittsburgh Vancouver info@morneaushepell.com morneaushepell.com Contributing Editors Lyne Duhaime, LL.B. Pension Legislation Rick Kular, FSA, FCIA Retirement Consulting Danielle Lamarche, FSA, FCIA Retirement Consulting Francine Pell, FSA, FCIA Retirement Consulting Please contact your Morneau Shepell consultant for additional information about this newsletter Morneau Shepell September 2013 Volume 10, issue 9 10 of 10