In her article (Managing Risk Through Transition), Laura Lynch examined the decision tree leading to directional strategies for exiting a closed defined benefit (DB) plan. A closed DB plan does not permit new members, and it may or may not permit existing members to continue to accrue DB benefits. A plan sponsor who is operationally prepared to exit its closed DB plan, and can accept the accounting and economic implications of exiting the plan, is positioned to move forward to implement the exit strategy over the short term.

In addition to exiting the DB plan, the plan sponsor must decide (and implement) the replacement pension arrangement, if any, for members currently accruing DB pensions. A common approach is to enroll these members in a capital accumulation plan (CAP), such as a group RRSP or deferred profit sharing plan (DPSP). This can take the form of a new CAP or by extending an existing CAP to these members. However, in certain jurisdictions, replacement of a DB plan with a defined contribution (DC) plan does not constitute a plan termination, so a registered DC plan may not be a viable option. The new tax-free savings accounts (TFSA) available in 2009 may also provide some interesting options for CAP development, but are beyond the scope of this article.

Once the decision to exit the DB plan has been made, what steps should a sponsor take to terminate the plan and settle the existing DB entitlements? First, a word of warning: the steps involved are often interconnected, and can cause an unprepared sponsor a few headaches along the way. Planning ahead, particularly with respect to member communications and management of expectations, is critical. This is especially true if a DB surplus may exist at the time of termination, or may surface thereafter.

Due to regulatory requirements, the need to contact each member and the obligation to collect settlement elections, the process invariably takes more time than the plan sponsor expects or desires. Sponsors who navigate this process effectively will see the time from plan termination decision to full settlement minimized.

Although there can be additional administrative tasks in certain jurisdictions, the main steps are:

  • Declare the plan wound up and prepare the requisite amendments and notices;
  • Review and, where appropriate, revise the plan’s investment policy to reflect the shorter settlement horizon;
  • Prepare an actuarial valuation report setting out the windup financial status of the plan and any funding requirements;
  • Communicate member options and obtain member elections;
  • Determine a target settlement date;
  • Obtain an annuity quote for all members who elected (or were deemed to elect) an annuity;
  • Arrange for any final funding, if required;
  • Purchase the annuities and settle commuted value payments following final regulatory approval; and
  • Once all basic entitlements and eligible plan termination expenses are settled, if assets remain, settle the surplus.

What are some common pitfalls?

  • Many sponsors rush the employee communications and option forms out the door, only to face increased pressure from members and advisors when delays in distributing assets are encountered. While regular communications with employees is encouraged, detailed options forms should generally not be distributed until the sponsor is sure that settlement is imminent.
  • As settlement approaches, sponsors cannot determine the final contribution amount until the annuity quote is selected, which often leaves little time to make the contribution and get regulatory approval to disburse plan assets. To the extent possible, ensure that the annuity quotes are designed to allow for a long settlement period (the time between the selection of the winning quote and payment to the selected insurer). This will also ensure that the insurance company has sufficient time to set up any monthly pension payments.
  • Occasionally, plan sponsors will make a final contribution and then find the plan in surplus after all benefits have been settled. To minimize the likelihood of this situation, try to wait for all member elections (annuity vs commuted value), decide on a settlement date, and select the winning annuity quote, before making the final contribution.

What about the sponsor who is not yet operationally prepared to exit the closed DB plan, or cannot currently accept the accounting or economic implications of exiting the plan, but expects to be in that position at some point in the next five to seven years? What can this sponsor do to manage the risks of their closed DB plan for the next few years? We’ll explore this further in the next article, which will be published on Oct. 1.