Pensions? Let’s just wing it.

During this holiday time many of you may be flying around the country visiting family and friends.  There’s a good chance you are flying on Air Canada so I thought this post may interest you.  We’ve talked about pensions before, mainly related to universities.  A quick reminder: defined benefit pension plans (like most of Air Canada’s) involve a massive liability since the company agrees to pay each retiree a set amount per month and a large pot of money handled by a third party trustee.  The pot of money is intended to fund that massive liability.  The company is supposed to put substantial amounts of money into that pot of money held by the trustee each year so that the pot of money is equally massive as the liability.  When I say “massive” how big are we talking?  Well in Air Canada’s case the liability was $14.4 Billion at the end of 2011 (see Note 10 of the 2011 financial statements).  To put that in perspective, the province of BC’s debt is about $34 Billion.

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Air Canada’s liability isn’t really that big because they have been putting money away for years to help pay those pensions, and its the net liability (liability-assets) that’s key. In a perfect world, the pot of money would be equal to the liability.  Then retirees could relax, knowing that no matter what happens to the company, they will be receiving their pension payments.  Like virtually every other defined benefit plan out there right now, Air Canada’s is “under funded” meaning that the pot of money (or “plan assets”) is less than the pension liability (or “pension obligation”).  There are two main reasons that so many (~93%) defined benefit plans are underfunded right now: (1) the financial market melt down of 2008 that decimated plan assets and (2) the incredibly low interest rates for the past 5 years.  Wait … what do interest rates have to do with this?

The pension obligation is an interesting liability that demonstrates quickly so many measurement problems in accounting.  Imagine the defined benefit plan for just one current employee.  Let’s assume that the employee and employer agree on a pension of $1,000 per month once the employee retires (after 67) until the employee dies.  First we need to estimate how long the future retiree will live for, then we need to calculate a present value of the annuity that we will be paying them from the time they retire until they die.  Then we need to take the present value of that annuity back to today to calculate today’s value of that liability.  Obviously those two present value calculations involve some discount rate.  The higher the discount rate, the smaller the present value.  As interest rates have fallen, appropriate discount rates for pension calculations have also fallen.  So the pension obligations have risen.  So its the perfect storm for pensions – the plan assets have taken a loss due to the market fall and the pension obligations have risen due to falling interest rates.  The end result?  93% of defined pension plans are currently underfunded.

Now, back to Air Canada.  How bad is Air Canada’s situation?  Well at the end of 2011, they had an unfunded pension balance of $4.5 Billion!  I know that we lose sight of the scale of numbers these days, but remember that Air Canada has about $11 Billion of revenue each year combined with about $11 Billion of operating expenses.  Their net income is rarely positive.  If I was a current or future retiree of Air Canada I’d be wondering where my pension payments were going to be coming from.  Is Air Canada worried about this situation?  Absolutely.  So is the Canadian government.  Under federal rules, Air Canada is supposed to be making extra payments to be closing that gap.  They recently asked the federal government for an extension that reduces their catch-up payments.  Air Canada was lucky to get a bit of a pension contribution holiday a few years ago, it is an interesting political situation to see what the government does this time.  On one hand the government wants to protect current and future retirees which means that Air Canada has to pony up the cash.  On the other hand the government can also read financial statements so they know far too well that Air Canada really doesn’t have the capacity to pay the necessary money.  Forcing Air Canada to make the necessary payments doesn’t make a ton of sense since that would basically mean bankruptcy.  Then you’ve got the competition issues – is a break for Air Canada fair to the other national airline, Westjet?

As you take flight this holiday season give this some thought.  There is no easy answer but jot your thoughts down as a comment and I’ll be happy to pass them along to Jim Flaherty, the finance minister who will have to deal with this.  Best of the holidays to you and have a fantastic 2013!

Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)