Letters of credit (L/Cs) can now be employed by private pension schemes of companies in Canada struggling with hundreds of millions of dollars in shortfalls in their defined-benefit pension plans.

Permitting the use of L/Cs in this way is one of a set of major changes to how plan deficits can be paid off by companies announced by Canada's new Conservative government in its first ever 2 May 2006 budget.

Worldwide problem

Canada's new legislation responds to the problem of shortfalls in pension funds that promise to pay a defined amount of benefits on maturity. Some of these funds are significantly depleted due to poorly performing investments on stock markets and declining long-term interest rates. There are concerns that some pension funds will simply not have sufficient funds to pay the fixed benefits promised.

Tougher rules have also been introduced in Canada to protect pension fund members from companies using pension funds to finance activities elsewhere in the company - a practice that is highly dangerous to pension fund members if the company collapses without paying back funds appropriated from the pension fund.

Easier terms

Canadian companies with pension shortfalls had been required to meet new solvency requirements within five years, but under the new legislation they will be allowed 10 years to meet these requirements.

Companies are also now able to use certain kinds of L/Cs to meet the solvency requirements rather than having to put cash straight into the pension fund, a demand that some companies complained was starving business operations of funds for working capital and re-investment.

Benefits

Using L/Cs as pension assets that count in the new solvency requirements has several benefits, according to Toronto-based TD Bank Financial Group.

It says L/Cs would provide a relatively inexpensive form of borrowing and would serve a useful temporary bridging gap to enable pension committees to put into place a plan to ultimately reduce any unfunded obligation.

Flexibility

Allowing L/Cs to be treated as plan assets would also, according to TD Bank, provide sponsors with additional flexibility to eliminate a solvency deficiency over time without the imposition of a rigid system to divert needed funds away from business operations.

The financial group adds that the use of L/Cs would serve as a means to prevent the pension fund sponsor from making excess payments that could result in a surplus.

This article represents the views of the author and not necessarily those of the ICC or any of the other partners in DC-PRO.