Closed, But Not Forgotten

The key issue in developing a financial management strategy for the closed plan is whether there will continue to be a valuable way to use surplus in the future as it emerges. Possible ways to use surplus include:

• paying for the defined benefit current service cost (while this lasts);
• paying for the defined contribution current service cost (for plans with a DC component, if allowed by the plan terms and subject to legal risk as mentioned above); and
• payment of expenses (if allowed; again, subject to legal risk)

Allowing unusable surplus to accumulate in the plan is generally not desirable. Ultimately the sponsor will be required to share these excess assets with plan members, whether through negotiated benefit improvements or through distribution on plan wind-up, especially where entitlement to surplus cannot be proven.

If surplus cannot be used…

The ability to use emerging surpluses will be low and/or declining in many cases, particularly where the ongoing DC current service cost, if any, is not sufficiently large. If the sponsor cannot profitably use surpluses, it is not appropriate for the plan to bear investment risk if there are no associated rewards to compensate the sponsor for bearing that risk. This will affect the optimal financial management of the plan, particularly the investment policy. The plan sponsor’s best bet will be to drive the plan to a fully funded status (for plans with a deficit, most likely through elevated contributions over an amortization period), then immunize the assets so that little further “management” is required other than ongoing monitoring. Any exposure to risk once the plan is fully funded would not be rewarded, since any deficits would need to be made up by the sponsor, while any surpluses would have little or no value.

In this context, immunizing the plan will usually mean identifying a lowest-risk asset mix, where the impact of equity returns and interest rate changes on the funded status are minimized. The most straightforward way to approach this may be to simply invest in fixed income investments matching the duration of the plan’s liabilities; further decreasing the mismatch risk will require more complicated solutions. It will not be possible to completely eliminate investment risk, other than by completely offloading the plan’s liabilities by purchasing annuities. Also, as the plan matures, the lowest-risk asset mix will change over time, so monitoring and periodic adjustments will continue to be needed.

Beyond immunization, there are a number of ways to further reduce the risk profile of the plan, including:

• purchasing annuities for existing retirees and/or for active members as they retire;
• allowing portability (the ability to elect a lump sum transfer in lieu of a pension) at retirement;
• allowing members with past service DB entitlements to transfer conversion values to their DC accounts; and
• as an extreme solution, fully winding up the plan

On the other hand, it may be preferable to avoid a wind-up if possible, especially for plans where grow-in benefits would be triggered or where annuities are not available at attractive prices.

If surplus can be used…

On the other hand, the ability to use surplus may not be an issue if the plan has an ongoing DC component with employer contribution requirements that are large enough to absorb surplus as it emerges. In this situation, analysis regarding the financial management of the plan may not be much different than if the DB provision was not closed, and investment risk may be worth taking.

The ability to profitably use surplus should be monitored on an ongoing basis, to ensure that bearing investment risk continues to make sense. All plans will have some threshold level of surplus above which the assets, if immunized, will sustain zero contributions indefinitely. As that level is approached, the most effective way to curtail the development of unusable surplus beyond that point is to immunize the assets.

There may be other reasons to reduce the investment risks borne by the plan, even in cases where unusable surplus is not yet an issue. For example, in cases where risk reduction was one of the driving factors to close the plan in the first place, continued risk-taking in the DB plan may no longer be attractive. In this case, risk-reducing strategies such as those described in the previous section would be appropriate.

In summary

Whether the DB plan has already been closed or a plan close is still being contemplated, plan sponsors will be well served to adopt a systematic approach to understanding and planning for the ultimate “endgame.” Specifically:

• Will a wind-up be required, or can the plan be allowed to wind down over time?
• What is the plan’s remaining time horizon?
• Can current and future surplus be profitably used, and how does that affect the financial management strategy, given the funded position of the plan today?

Taking some time up front to develop and implement a solid strategy for the winding down of the plan will help avoid unpleasant surprises down the road, and allow the sponsor to concentrate on moving forward with the “new” benefit arrangements.

Alyssa Hariton is a Principal in the Retirement business in Mercer’s Vancouver office.