Making the switch from a defined benefit to a defined contribution plan
In the last few years, many organizations have considered converting from a defined benefit pension plan (DB) to a defined contribution (DC) plan. In doing so, it is crucial that plan sponsors understand what is involved — to ensure the conversion is understood and well received by members, and the process and associated costs are managed properly.
Type of conversion
The development, communication and implementation of a plan conversion depend on the type of conversion being contemplated. For the purpose of this article, we will assume all new hires will be entitled to join a DC pension plan only. In this case, the plan sponsor must decide what options to provide to its current active members:
*Will they be permitted to stay in the DB pension plan for future service?
*Will they be permitted to convert their DB pension earned to the conversion date and transfer the value to the new DC plan?
After settling on answers to those questions, sponsors should take seven steps to ensure a smooth transition from DB to DC.
Steps to setting up a new DC pension plan
Conversion committee: At the very early stage of the conversion process plan sponsors should establish a committee to make recommendations to senior management and the pension committee. Where applicable the conversion committee must be responsible for making decisions delegated to it. The responsibilities of this committee may be handled by the existing pension committee or a newly formed group.
For the committee to be truly effective, its role, responsibilities and decision-making powers must be clearly defined.
Plan design: To determine the new DC plan provisions for new and current members, plan sponsors must define retirement goals, taking into account corporate objectives, human capital strategy, current and future employee demographics, competitive positioning, legal and legislative requirements, financial considerations and the total rewards commitment. These goals are used in the development of the new plan and as a checklist to ensure the chosen design meets the defined retirement goals.
For current employees, an analysis can be performed to evaluate the proposed design against the current pension program and determine how certain groups of employees would be affected.
Record-keeper selection: Once the design is determined, the plan sponsor must select a record-keeper for the new plan. Even if a record-keeper is already used for another existing DC plan, organizations should determine whether it is appropriate for the same record-keeper to manage both the new plan and the existing one.
A number of criteria must be considered in the selection of the new record-keeper, including fees, administrative capabilities, knowledge of administrators and educators, online services, member and plan administrator reporting, employee communication and education materials and the organization’s stability. These criteria will be used to develop a Request for Proposal (RFP) and evaluate responses.
Investment manager(s) and funds selection: Most plan sponsors take a bundled approach and use investment managers and funds offered by the selected record-keeper. In this case, the plan sponsor must ensure the selection criteria reflect its intent. If the pension fund is large enough, plan sponsors may consider using different record-keeper and investment manager(s) to best fit the needs of the DC plan, as the funds are large enough to warrant the higher fees associated to these unbundled arrangements. Again criteria need to be established for the selection of the investment manager(s) and trustee.
The selection of the fund options to be offered should take into account the investment knowledge and risk tolerance of the members and the plan sponsor, and the time commitment needed in monitoring the funds. Customized portfolios may be considered. A default fund must also be selected for members who do not make the required fund selection.
Employee communication and education: Communication and education is a major component of a plan conversion. For some employees, converting to a DC pension plan may not be beneficial. Many employees may also feel overwhelmed at having to make investment decisions and worry about the impact poor decisions may have on retirement income.
An effective communication strategy can be more powerful in securing acceptance of the conversion by employees than a higher DC contribution formula. For this reason a good communication strategy must be developed at the early stage of the conversion. Legal and legislative considerations, stakeholders, communication challenges and other initiatives that may be happening in the organization must all be taken into account.
Since the investment risk is transferred to the employee, an effective communication program helps minimize the risk of future employee litigation.
If members are given choices regarding whether to convert their DB benefits, joining the DB or DC pension plan for future service, they must be provided with sufficient information to allow them to make the right decisions. In addition to the description of the options and the pros and cons of each option, some plan sponsors provide statements with various projection scenarios showing how a member’s retirement benefit would differ depending on the option.
It is important to ensure that members understand that these are only projections and that their actual pension entitlement at retirement or termination of employment will depend on a number of factors, such as their earnings growth, investment returns, termination or retirement date, and annuity rates at retirement. Plan sponsors should consider a combination of group and one-on-one sessions, as well as Q & A material, depending on the complexity of the choices required.
Information sessions need to be held for members or new employees required to make decisions on how to invest their pension contributions. These sessions generally explain the funds available, the risks attached, the tools employees can access to help make investment decisions and the actions they must take and associated deadlines.
Plan documentation: All plan documents, including amendments to the current plan, changes to the trust agreement and record-keeper and investment manager(s) contracts, must be prepared, reviewed, approved and filed with regulators as applicable. A new investment policy must also be prepared to reflect the new DC plan and any changes to the existing DB fund.
Actuarial valuation: An actuarial report must be prepared to reflect the plan changes, and approvals of the conversion report must be provided to regulators before the conversion of the DB benefits can be processed. The conversion values must take into account minimum standard legislation related to the conversion assumptions. If the plan sponsor’s goal is to have more members convert their DB benefits, it may consider providing enhanced conversion values to encourage more conversions.
Other considerations
Plan sponsors may also need to consider the following when dealing with a conversion.
Annuity purchase: If the plan sponsor’s objective is to eliminate any DB liabilities, it may consider purchasing annuities for those active members who choose not to convert their DB benefits for past service, as well as for pensioners and deferred vested members. The plan sponsor should weigh the benefit of eliminating its DB liabilities and the related costs attached to the annuity purchase versus maintaining the DB liabilities and the volatility and costs attached to its DB plans.
Surplus: If a surplus remains after the conversion, the plan sponsor must decide whether the surplus will be distributed to members or used to pay for future contributions or expenses. Requirements under the various regulatory bodies and plan documents must be considered when determining how to deal with the surplus.
Immunization: If conversion of past DB benefits or the purchase of annuities is being considered, the plan sponsor will need to review its investment policy for the DB funds in preparation for possible cash flow needs for the conversion and/or annuity purchase.
Accounting implication: Converting DB pensions or purchasing annuities may result in a settlement of the plan sponsor’s DB liabilities, while stopping accrual of DB service may result in a curtailment. These events may be significant to the company’s financial reporting and need to be reviewed during the conversion decision-making process.
CAP Guidelines: The Joint Forum of Financial Market Regulators released its Guidelines for Capital Accumulation Plans (CAP Guidelines) in May 2004. Plan sponsors and plan administrators must ensure that throughout the establishment and communication of the new DC pension plan the appropriate processes have been followed and appropriate documentation and approvals made. Reviewing the CAP Guidelines prior to the start of a conversion can help ensure compliance with the guidelines. The guidelines also provide plan sponsors with information on the requirements for ongoing monitoring and communication of the new DC pension plan.
Converting from a DB to DC pension plan can be an extremely complex undertaking. However, by following the key steps outlined above, plan sponsors can help ensure the transition not only goes smoothly, but also benefits both the organization and plan members.
Lydia Maldonado is a senior consultant in Watson Wyatt’s pensions practice. She can be contacted at (416) 874-4157
or [email protected].
Type of conversion
The development, communication and implementation of a plan conversion depend on the type of conversion being contemplated. For the purpose of this article, we will assume all new hires will be entitled to join a DC pension plan only. In this case, the plan sponsor must decide what options to provide to its current active members:
*Will they be permitted to stay in the DB pension plan for future service?
*Will they be permitted to convert their DB pension earned to the conversion date and transfer the value to the new DC plan?
After settling on answers to those questions, sponsors should take seven steps to ensure a smooth transition from DB to DC.
Steps to setting up a new DC pension plan
Conversion committee: At the very early stage of the conversion process plan sponsors should establish a committee to make recommendations to senior management and the pension committee. Where applicable the conversion committee must be responsible for making decisions delegated to it. The responsibilities of this committee may be handled by the existing pension committee or a newly formed group.
For the committee to be truly effective, its role, responsibilities and decision-making powers must be clearly defined.
Plan design: To determine the new DC plan provisions for new and current members, plan sponsors must define retirement goals, taking into account corporate objectives, human capital strategy, current and future employee demographics, competitive positioning, legal and legislative requirements, financial considerations and the total rewards commitment. These goals are used in the development of the new plan and as a checklist to ensure the chosen design meets the defined retirement goals.
For current employees, an analysis can be performed to evaluate the proposed design against the current pension program and determine how certain groups of employees would be affected.
Record-keeper selection: Once the design is determined, the plan sponsor must select a record-keeper for the new plan. Even if a record-keeper is already used for another existing DC plan, organizations should determine whether it is appropriate for the same record-keeper to manage both the new plan and the existing one.
A number of criteria must be considered in the selection of the new record-keeper, including fees, administrative capabilities, knowledge of administrators and educators, online services, member and plan administrator reporting, employee communication and education materials and the organization’s stability. These criteria will be used to develop a Request for Proposal (RFP) and evaluate responses.
Investment manager(s) and funds selection: Most plan sponsors take a bundled approach and use investment managers and funds offered by the selected record-keeper. In this case, the plan sponsor must ensure the selection criteria reflect its intent. If the pension fund is large enough, plan sponsors may consider using different record-keeper and investment manager(s) to best fit the needs of the DC plan, as the funds are large enough to warrant the higher fees associated to these unbundled arrangements. Again criteria need to be established for the selection of the investment manager(s) and trustee.
The selection of the fund options to be offered should take into account the investment knowledge and risk tolerance of the members and the plan sponsor, and the time commitment needed in monitoring the funds. Customized portfolios may be considered. A default fund must also be selected for members who do not make the required fund selection.
Employee communication and education: Communication and education is a major component of a plan conversion. For some employees, converting to a DC pension plan may not be beneficial. Many employees may also feel overwhelmed at having to make investment decisions and worry about the impact poor decisions may have on retirement income.
An effective communication strategy can be more powerful in securing acceptance of the conversion by employees than a higher DC contribution formula. For this reason a good communication strategy must be developed at the early stage of the conversion. Legal and legislative considerations, stakeholders, communication challenges and other initiatives that may be happening in the organization must all be taken into account.
Since the investment risk is transferred to the employee, an effective communication program helps minimize the risk of future employee litigation.
If members are given choices regarding whether to convert their DB benefits, joining the DB or DC pension plan for future service, they must be provided with sufficient information to allow them to make the right decisions. In addition to the description of the options and the pros and cons of each option, some plan sponsors provide statements with various projection scenarios showing how a member’s retirement benefit would differ depending on the option.
It is important to ensure that members understand that these are only projections and that their actual pension entitlement at retirement or termination of employment will depend on a number of factors, such as their earnings growth, investment returns, termination or retirement date, and annuity rates at retirement. Plan sponsors should consider a combination of group and one-on-one sessions, as well as Q & A material, depending on the complexity of the choices required.
Information sessions need to be held for members or new employees required to make decisions on how to invest their pension contributions. These sessions generally explain the funds available, the risks attached, the tools employees can access to help make investment decisions and the actions they must take and associated deadlines.
Plan documentation: All plan documents, including amendments to the current plan, changes to the trust agreement and record-keeper and investment manager(s) contracts, must be prepared, reviewed, approved and filed with regulators as applicable. A new investment policy must also be prepared to reflect the new DC plan and any changes to the existing DB fund.
Actuarial valuation: An actuarial report must be prepared to reflect the plan changes, and approvals of the conversion report must be provided to regulators before the conversion of the DB benefits can be processed. The conversion values must take into account minimum standard legislation related to the conversion assumptions. If the plan sponsor’s goal is to have more members convert their DB benefits, it may consider providing enhanced conversion values to encourage more conversions.
Other considerations
Plan sponsors may also need to consider the following when dealing with a conversion.
Annuity purchase: If the plan sponsor’s objective is to eliminate any DB liabilities, it may consider purchasing annuities for those active members who choose not to convert their DB benefits for past service, as well as for pensioners and deferred vested members. The plan sponsor should weigh the benefit of eliminating its DB liabilities and the related costs attached to the annuity purchase versus maintaining the DB liabilities and the volatility and costs attached to its DB plans.
Surplus: If a surplus remains after the conversion, the plan sponsor must decide whether the surplus will be distributed to members or used to pay for future contributions or expenses. Requirements under the various regulatory bodies and plan documents must be considered when determining how to deal with the surplus.
Immunization: If conversion of past DB benefits or the purchase of annuities is being considered, the plan sponsor will need to review its investment policy for the DB funds in preparation for possible cash flow needs for the conversion and/or annuity purchase.
Accounting implication: Converting DB pensions or purchasing annuities may result in a settlement of the plan sponsor’s DB liabilities, while stopping accrual of DB service may result in a curtailment. These events may be significant to the company’s financial reporting and need to be reviewed during the conversion decision-making process.
CAP Guidelines: The Joint Forum of Financial Market Regulators released its Guidelines for Capital Accumulation Plans (CAP Guidelines) in May 2004. Plan sponsors and plan administrators must ensure that throughout the establishment and communication of the new DC pension plan the appropriate processes have been followed and appropriate documentation and approvals made. Reviewing the CAP Guidelines prior to the start of a conversion can help ensure compliance with the guidelines. The guidelines also provide plan sponsors with information on the requirements for ongoing monitoring and communication of the new DC pension plan.
Converting from a DB to DC pension plan can be an extremely complex undertaking. However, by following the key steps outlined above, plan sponsors can help ensure the transition not only goes smoothly, but also benefits both the organization and plan members.
Lydia Maldonado is a senior consultant in Watson Wyatt’s pensions practice. She can be contacted at (416) 874-4157
or [email protected].
