Within Canada and around the world, the conversion of DB plans to DC plans has been accelerating as plan sponsors look to reduce their pension risk.
Most newly established pension plans in Canada are DC, which include DC registered pension plans (DC RPPs), group RRSPs and deferred profit sharing plans (DPSPs). In addition, many DB plan sponsors have also introduced a DC plan, including some large employers such as Air Canada, Bell and Canada Post.
If you’re looking to make the switch to a DC arrangement, here’s how to make it as smooth as possible.
Plan sponsor objectives
Before you begin the DC transition, review your objectives. These may include the following:
- corporate-related objectives (e.g., the impact on culture, attraction/retention and competitiveness);
- employee-related objectives (e.g., the comparability of old and new benefits, benefit adequacy, tax-effectiveness and simplicity); or
- cost-related objectives (e.g., the level, certainty and sharing of costs).
The first, most important target in any DC transition is to have a clear objective and solid weighing and measuring of the impact on your organization’s culture, competitiveness, attraction, retention, benefit adequacy and cost. Determining why you’re moving to DC will help direct you in setting the plan design and in facilitating the decision-making and approval processes.
Action plan
A typical DC transition plan includes the following tasks:
- establishing the plan design, which includes preparing the cost analysis and selecting the funding vehicle;
- choosing the recordkeeper;
- reviewing the investment structure and selecting the fund managers;
- preparing the legal documents; and
- developing a communication and education strategy.
Establishing the plan design – One of the key design considerations is eligibility for the new DC plan. Typically, all new entrants must join the DC plan; however, it is possible to allow a choice of DB or DC upon entry or at a future date. More options for current employees include:
- maintain DB only (no change);
- maintain DB for past service and allow a choice of DB or DC for future service;
- maintain DB for past service and require DC for future service;
- allow choice for past and future service;
- allow choice for past service and require DC for future service; or
- require conversion to DC for past service (the plan sponsor must provide an option to maintain DB, usually through the purchase of an annuity) and DC for future service.
In some cases, plan sponsors can provide different options to selected groups: for example, only long-service employees are permitted to remain in the DB plan; all others must join the DC plan. In addition, for earnings-related plans, plan sponsors may elect to freeze the past service DB benefit (where permitted) or allow it to increase with future earnings increases.
Part of DC plan design is selecting the funding vehicle. Options are a DC RPP, a group RRSP or a DPSP. Group RRSPs and DPSPs generally provide more flexibility to plan sponsors and employees, but the DC RPP is the only vehicle that ensures that accumulated funds are used to provide retirement income. If you choose to implement a DC RPP, then you need to decide whether to create a DC provision within the existing DB plan or keep it separate.
Plan sponsors will usually want to compare the benefits provided under the new DC plan with those provided by the existing DB plan. They can accomplish this by reviewing anticipated replacement ratios (the portion of pre-retirement income replaced by income from the pension plan) for both the DB and DC plans for sample new entrant profiles. Often, these are reviewed on the basis of total benefit and also employer-provided benefit.
If existing employees are moving to the DC plan (or have a choice to do so), then a “winners and losers” analysis is useful. This compares the anticipated benefit provided by the combination of the DB plan for past service plus the DC plan for future service to the benefit provided by the DB plan for past and future service. “Winners” are those whose anticipated benefit from the former is greater than the benefit from the latter; it’s vice versa for “losers.”
Analyzing the cost of the new DC plan compared to the existing DB plan is also important. The DB plan funding cost, expressed as a percentage of earnings, tends to remain stable if the average age of the participants remains constant. Once a DC plan is introduced, the average age of those participating in the DB plan tends to increase, and, as a result, the DB plan funding cost will increase as a percentage of earnings but will eventually decrease in absolute amount as the number of participants falls. Multi-year projections of the anticipated funding costs for the options under consideration are highly recommended. The anticipated impact on the pension expense and financial reporting will also be included where appropriate.