Policy Reflection: Letter of Credit Usage by Defined Benefit Pension Plans in Canada

19 Pages Posted: 6 Jul 2017

See all articles by Norma L. Nielson

Norma L. Nielson

University of Calgary - Haskayne School of Business

Peggy L. Hedges

University of Calgary - Haskayne School of Business

Date Written: May 3, 2017

Abstract

There is an argument to be made for letting corporations hold off on contributing to their employees’ defined benefit pension plans, as long as there is a guarantee the cash will come eventually. That is the reason that provincial governments began allowing creditworthy companies to instead provide a letter of credit, backed by a Canadian bank, guaranteeing the cash deposit, and secured by the company’s line of credit or some similar facility. Sometimes circumstances are such that a company needs all the cash it can get to grow, or perhaps to manage through tough economic times.

Given the sluggish recovery from last decade’s financial crisis and the difficulty for pension funds to grow amid persistent low interest rates, it perhaps is understandable that more companies are using standby letters of credit as IOUs for their employee pensions. The letters provide the companies more flexibility with their capital, and diminish the risk that, should returns to pension funds rise again to more normal rates, there could be “trapped surplus.”

It is, however, harder to make a case for why public sector companies and Crown corporations have begun using letters of credit in place of cash deposits to pensions. They certainly do not face the same pressure for capital flexibility, given their revenue is frequently assured, and they face no competition that would pressure them to redirect capital for strategic purposes. And yet, research shows that this is happening, at least to some degree. That should give policy-makers pause.

Unfortunately, there is a troubling lack of data available as to which organizations have been using letters of credit in place of cash contributions to pension funds. Clearly they are proving useful for some companies, and that the exact reasons vary widely. We observe some companies using the letter of credit option that would appear to have plenty of capital flexibility, so the rationale for their use might not be what the policy anticipated. Meanwhile, it is unclear why so many other companies have chosen not to avail themselves of this temporary pension-funding relief, despite the advantages it offers for avoiding the risk of trapped surpluses. There also remain restrictions on who can underwrite these credit guarantees — regulations do not consider foreign banks and insurance companies acceptable, for example — raising the cost for companies that arrange letters of credit.

Taken together, it would seem that there are signs that the policy changes allowing pension-funding relief might be serving their purpose and might be helping companies that could use it, but there is a worrying lack of information to be sure how well they are working and what problems may loom. It certainly seems like a close review is in order. When a Crown corporation is writing IOUs to its defined-benefit pension fund, that is surely a sign that policy-makers are not keeping a close enough eye on the outcomes this policy has led to.

Keywords: IOU, employee pensions, defined pension plans

Suggested Citation

Nielson, Norma L. and Hedges, Peggy L., Policy Reflection: Letter of Credit Usage by Defined Benefit Pension Plans in Canada (May 3, 2017). SPP Research Paper No. Volume 10 • Issue 8 • May 2017. Available at SSRN: https://ssrn.com/abstract=2997147

Norma L. Nielson (Contact Author)

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada

Peggy L. Hedges

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada

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