Converting from a DB to a DC pension

An inside look at how one firm made a smooth switch

With the debate raging around defined benefit (DB) versus defined contribution (DC) plans, a perception has arisen that DC plans are simpler and easier to design, communicate, finance and ensure regulatory compliance.

But it may not be that simple. Below is a real-life story of how one company managed a successful change from DB to DC. The case study highlights a wide range of factors that need to be addressed when considering the switch from a traditional DB plan to a DC plan.

The company and its business objectives

CoolEnt Canada (not its real name) is a subsidiary of a global leader in the entertainment industry. A medium-sized firm in Canada, it has knowledgeable local leadership in finance and HR who provide strategic direction and execution for the Canadian business, while still following the global organization’s lead on HR policies and strategies.

Until recently CoolEnt sponsored a fairly traditional non-contributory DB plan. But management started looking at the plan design and started asking questions about whether a DB plan was appropriate for the future and whether DC is a better approach.

While acknowledging that cost control and risk management are desirable, the company had other concerns, including:

•a desire to offer a plan design that fits the career patterns of a more mobile workforce that no longer spends a career with one employer;

•a concern employees do not fully understand DB coverage, therefore affecting the perceived value of the plan; and

•a desire to provide a plan that employees could more readily compare with competitors.

Setting an appropriate DC formula

In the past, selecting a DC formula seemed like a simple exercise. Employers and employees would make matching contributions, set at a level intended to provide a reasonable degree of pay replacement after a full career based on simple projections of sample employees.

But current best practices go far beyond this. Among other things, the DC formula needs to reflect:

•the employer’s competitive position with respect to the contribution level (how will current and prospective employees compare the employer’s plan against other plans?);

•its competitive position with respect to cost (is the employer spending more or less than its competitors?);

•the desired balance between various elements of the rewards package (is there a desire to increase or decrease the emphasis on pension and savings coverage versus other rewards?);

•the underlying message conveyed by the DC formula (does the formula imply saving for retirement is a joint responsibility by offering an employer contribution that matches the employee contribution, or does the formula simply provide an automatic employer contribution?); and

•the likely impact on employees currently covered by a DB design (are there any significant winners or losers under the new DC design?).

CoolEnt chose a DC formula that provides an automatic company contribution of three per cent of pensionable earnings, as well as an opportunity for employees to contribute up to three per cent of pay to earn an additional matching company contribution.

Adopting a DC design also gave management an opportunity to fine tune the definition of pensionable earnings to ensure an appropriate fit with other elements of the variable pay structure.

Interestingly, between the time CoolEnt had tentatively decided on this DC formula and the time it was implemented, it merged with a competitor. The competitor’s DC formula was identical to the one CoolEnt was planning. This made the post-merger pension integration process much easier.

Transition to DC coverage — treatment of current DB members

How should CoolEnt transition to the new DC coverage? The questions any employer needs to answer are:

•Will the change to DC coverage be voluntary or imposed?

•Will some or all plan members be offered a choice between DB and DC coverage for future service?

•Will plan members be offered a choice between DB and DC coverage for past service?

•Will the DB/DC choice be linked for past service and future service?

Based on employee feedback sought early in the design process, CoolEnt management felt comfortable mandating that future pension coverage (from 2006 onward) would be provided through the new DC formula. However, management was concerned about the cost of converting existing DB entitlements (for pre-2006 service) to DC account balances given the current low interest rates.

As a result, CoolEnt decided to retain the existing DB provisions for past service, and to adopt a new DC design only for service from 2006 onward. This also involved decisions on how the pre-2006 DB entitlements would be administered.

To address potential concerns for employees close to retirement, all employees who were eligible for retirement within the next six months were offered the option to continue DB coverage.

Regulatory requirements

For DB-to-DC conversions that apply only to future years of service, few regulatory restrictions apply. The key constraints that CoolEnt needed to keep in mind were:

•the conversion cannot reduce benefits already earned up to the date of conversion;

•members affected by the conversion must receive notice before the effective date; and

•the conversion, as with all pension plan amendments, is subject to approval by pension authorities.

Even though the plan design change only affected future service, CoolEnt still needed to carefully consider the level and manner of providing DC coverage. If the DC coverage for future service was to be provided through a vehicle other than a registered pension plan (either through a group registered retirement savings plan or a deferred profit savings plan) and there were no further RPP accruals (DB or DC), provincial pension law may have required a windup of the DB plan. CoolEnt’s decision, however, was to provide future DC coverage through the existing RPP.

CoolEnt management also recognized that if the DC formula for future service was worth substantially less than the existing DB provisions, this might give ammunition to constructive dismissal claims under common law. Management was aware of potential employee concerns regarding their need to contribute under the new design in order to earn an employer matching contribution. The potential reaction was tested in advance through employee research.

Financial implications

For CoolEnt, the key financial focus was on accounting, rather than funding, implications. Early in the design process, a 10-year projection model was developed for the current and proposed plans illustrating the anticipated pattern of accounting cost, contributions and funded status under various design, demographic and economic scenarios. The key metric that drew CoolEnt management’s attention was the break-even point, measured from an accounting perspective. At what point would the initial one-time accounting charge, together with the ongoing accounting expense for the new design, balance against the projected ongoing costs of maintaining the current DB design?

Concerns regarding the potential size of any immediate accounting charge triggered by a DB-to-DC conversion played a significant role in steering management’s decisions.

One benefit of the 10-year forecasting process was how it showed that CoolEnt would not instantly “get out of the DB business” by adopting a DC design. Under virtually all approaches considered, some DB entitlements would be retained for existing staff (employees who might choose not to convert past service benefits to DC, or for grandfathered employees). And DB-to-DC conversions rarely extend to retired members, surviving spouses or beneficiaries and terminated vested members. For an employer to eliminate its DB coverage completely, it can consider buying annuities to cover remaining legacy DB entitlements. However, annuity purchases may be impossible for members whose legacy DB entitlements depend on future earnings levels and will be priced very conservatively if there are early retirement subsidies.

DC carrier selection

Selecting and implementing service providers and investment options for a new DC plan requires due diligence and careful planning. With CoolEnt’s merger partner already sponsoring a DC plan, the process was significantly streamlined. Therefore the implementation focused on setting and monitoring a detailed timeline for employee communication and education, adapting and testing the necessary payroll structures for calculating and remitting contributions and ensuring a seamless enrolment process.

Had CoolEnt’s merger partner not already had a DC plan in place, a significant amount of additional planning and effort would have been involved to select the DC record-keeper or custodian, investment managers and fund options.

Employee communication

Proper communication of the change is critical to its success. CoolEnt began the communicating process early, seeking employee feedback on several possible design variations. Once announced, the plan was embraced by employees who appreciated being included.

As part of the implementation, CoolEnt provided information in several formats — printed material, electronic announcements and employee meetings. Experts were drawn from a pension consulting firm, the DC carrier and an investment “coaching” firm to help employees understand the change, the options offered, their responsibilities to manage their DC accounts and what they can do with their DC balances when they retire.

With CoolEnt’s merger partner already sponsoring a DC plan, many of the processes suggested by the Canadian Association of Pension Supervisory Authorities were already in place. They simply had to be adapted.

If this had not been the case, CoolEnt would have needed explicit policies on:

•the responsibilities assumed by the plan sponsor and members;

•criteria for selecting and monitoring service providers and investment options;

•the option between providing investment advice or providing education; and

•plan governance and documentation.

Why the switch was successful

CoolEnt’s employees reacted positively when the new plan was announced. Was this because DC is more easily understood than DB? Not really. The credit goes to CoolEnt’s focus on seeking input in the early stages of the process, understanding the specific needs and perceptions of its workforce and providing clear communication and education during the roll-out.

Ian Genno is a Toronto-based principal of Towers Perrin. He may be reached at [email protected].

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