In recent years, a number of Canadian companies have closed their defined benefit (DB) pension plans, setting up defined contribution (DC) arrangements for new hires. Often, the change is prompted by a realization that the company no longer wants to bear the cost and risks associated with DB plans. Once the “old” plan is closed, the sponsor may have optimistic expectations of a rapid elimination of those risks, and may be tempted to focus all energies on the “new” plan, which reflects the company’s benefit strategy going forward.
The reality is that the DB plan will likely need continued monitoring and management as an ongoing source of risk for many years to come. Having a good understanding of that remaining time horizon, and how the size and risk of the plan will diminish over time, would be beneficial. Most importantly, the sponsor will need to have an idea of how the closed plan will eventually wind down, in other words a target “endgame” and a strategy for how to get there.
The endgame: wind-up or wind down?
There are two general scenarios for the process towards the ultimate end of the closed plan, depending on whether the new DC arrangement has been established as a component of the existing DB registered pension plan, or as a completely separate plan (for example, as a group RRSP).
For a closed plan with no ongoing DC component, eventually there will be no further accruals of service under the plan (this could happen immediately if all employees are covered under the new plan for future service). Once this happens, no further employer current service contributions will be made and the pension regulator will at some point require the plan to be wound up.
A plan with a DC component, on the other hand, can simply “wind down” the (closed) DB component of the plan. Over time, the DC component of the plan will have a greater share of the accruals and liabilities, until eventually there are no further pensions being paid from the DB component. Under this scenario, the plan sponsor will be responsible for the ongoing maintenance of the DB provision for much longer than under the wind-up scenario.
Both of these scenarios carry attendant uncertainties and potential risks. In the wind-up scenario, there is timing risk related to what point the regulator will require the wind-up. In a wind-down scenario, there may be legal uncertainties, depending on wording in the plan documentation, regarding the ability of the plan sponsor to make DC contributions from any DB surplus.
Developing a strategy
Once the sponsor has a handle on the likely evolution of the plan over the remaining time horizon, a strategy can be developed for the financial management of the closed plan over this period. The funded status of the plan can be driven by two levers at the sponsor’s disposal: contributions (funding policy) and asset mix (investment policy). These funding and investment policies should not be considered in isolation; rather, the financial management strategy of the plan is defined as how the two components are used in concert depending on emerging experience, and as the plan matures over time.
In general, the level of contributions will have a greater impact when funding levels are low (since investment returns are realized on a smaller asset base), and investment policy will have a greater impact when funding levels are high (since even reducing contributions to zero may not be sufficient to prevent a runaway surplus). So, the most effective way to correct a deficit is to make additional contributions, while the most effective way to hamper unwanted surpluses is to invest in a low-risk asset mix which will move in tandem with the plan liabilities (i.e., “immunization”).