The Ontario Teachers’ Federation (OTF) and the Ontario Government, which jointly sponsor the Ontario Teachers’ Pension Plan, filed a funding valuation with the provincial pension regulator in September 2009. That valuation shows the plan has enough assets to cover liabilities (the cost of future benefits) as of Jan. 1, 2009. However, projections show funding shortfalls will recur, for the reasons outlined below.

Plan liabilities (the cost of future pensions) continue to grow faster than plan assets because of factors such as: 

• member demographics; 
• low real (after inflation) interest rates, which drive up pension costs; 
• projected modest investment returns; and 
• 2008 investment losses, which will be recognized over the next four years due to the effect of smoothing.

Pension plans are allowed to “smooth” investment gains and losses over five years. This avoids having to adjust contribution rates or benefit levels frequently because of volatile investment returns. Smoothing is common practice for pension plans because they pay benefits and invest over the long term.

Over the next four years, the Teachers’ pension plan must recognize $19.5 billion in losses held back in the smoothing adjustment in 2008.

Despite good long-term investment returns, members cannot rely on investment performance alone to turn the tide. Even if financial markets continue to improve, it is unrealistic to assume that investment returns alone will be high enough to cover the annual cost of pensions, plus make up for the $19.5 billion in losses that must be recognized over the next four years.

The OTF and the Ontario Government, in co-operation with the Ontario Teachers’ Pension Plan, will develop a plan by mid-2010 to deal with the pension plan’s recurring funding challenges. No change to contribution rates or benefits would be made before the next funding valuation is filed with the regulator. The next valuation is required by Sept. 30, 2012, although the sponsors could file before then. 

To address funding shortfalls, the OTF and government can:

•  increase contribution rates;
•  invoke conditional inflation protection for pension credit earned after 2009; 
• change benefits to be earned in future years; or 
• adopt a combination of these measures.

Pension benefits already earned by working and retired members cannot be reduced under Ontario’s Pension Benefits Act.

The funding valuation filed with the regulator in September 2009 assumes the Teachers’ pension plan will earn a slightly higher long-term rate of return on investments than assumed in a preliminary valuation conducted earlier. This change eliminated most of the estimated shortfall and other minor changes, reflecting recent plan experience, eliminated the rest.

Real interest rates for long-term bonds play a major role in the funding status of the pension plan. That’s because real interest rates – the returns above inflation – are used to estimate the cost of future pensions. If real interest rates remain low, as we predict they will, the cost of future pensions will remain high. If real interest rates increase, the cost of future pensions will decrease.

For more information on how real interest rates affect plan funding, see question 13.

Conditional inflation protection, which affects pension credit to be earned after 2009, can be invoked to help deal with shortfalls when they arise. However, it cannot prevent shortfalls from occurring. Conditional inflation protection was introduced to deal with funding challenges before financial markets dropped sharply in 2008. Over time, it will bring a greater degree of intergenerational equity to the pension plan because in future, pensioners and working teachers will share the burden of future funding shortfalls.

Higher contribution rates resolved the $6.1 billion shortfall reported in 2005, while conditional inflation protection paved the way for the elimination of the $12.7 billion shortfall in 2008.

But future shortfalls are projected because we lost money on our investments in 2008, real interest rates remain low, and pension costs continue to grow.

Conditional inflation protection was instrumental in resolving the 2008 funding shortfall because it allowed the pension plan to assume a higher rate of return in determining the fund’s long-term financial health. But because conditional inflation protection can apply only to the portion of a member’s pension earned after 2009, it will take a long time for this change – if invoked -- to have a meaningful impact on the cost of future benefits.

There are two sides to the pension equation – assets and liabilities (the cost of future pensions). The 2005 and 2008 funding shortfalls developed before the current economic downturn hit. During that period, the cost of future pensions grew faster than plan assets despite good investment returns. The growth in liabilities stemmed mostly from low real interest rates and increased life expectancy, both of which drive pension costs up.

Both figures are correct, they just reflect different things and are used for different purposes.

The financial statement valuation determines whether there is enough money to cover all pension benefits accumulated by members to the end of the reporting year. This disclosure is required to meet accounting standards.

The funding valuation determines whether the assets in the plan, as it exists today with current contribution and benefit levels, can fully cover the cost of accrued and future benefits for all existing plan members and their survivors over the next 70 years or so. The funding valuation is required under Ontario’s Pension Benefits Act.

The funding valuation is used by the OTF and government to determine whether changes are required to contribution or benefit levels.

When real interest rates – the returns above inflation – are low, the cost of future pensions is higher because the pension plan needs more money today to earn the amount required to pay pensions in the future.

As the chart shows, securing a typical $40,000 pension requires 30% more when real interest rates are at 2% vs. 4%.

Defined benefit pension plans all over the world have experienced funding challenges because of large investment losses and other issues similar to our own: people are living longer, there are fewer workers to a growing number of pensioners, and real interest rates are low. Some plans, such as the Hospitals of Ontario Pension Plan (HOOPP) and Colleges of Applied Arts and Technology Pension Plan (CAAT), have changed their inflation provisions to help manage funding challenges.

The government did not remove money from the plan: it used its share of surplus funds – about $9 billion – to eliminate special payments scheduled to address the plan’s pre-1990 unfunded liability. The surplus funds were used between 1993 and 2001.

The OTF used its share of the surplus (about $9 billion) to improve pension benefits. Among other improvements, it introduced a permanent 85 factor, lowered the CPP reduction and introduced a 10-year pension guarantee.