A number of organizations have closed their defined benefit plans to new entrants over the last decade or two. Closing the DB plan represents an implicit business decision to exit DB plan sponsorship, whether in 50 days or 50 years. Once a company has made the first decision to exit the DB plan by closing it, how will it proceed to make further decisions regarding the exit strategy? Few companies with closed DB plans will want to wait 50 years before winding up. How will an organization know when to “pull the plug” on the plan?

Many sponsors closed their DB plans due to the risks inherent in sponsoring a DB pension plan under the current Canadian pension system. These risks include financial risks which affect the volatility and magnitude of the funded status of the plan and its impact on the corporate financial statements:

• market risk posed by the investments held in the pension fund (equity volatility, credit risk, currency risk, etc.) that affect the asset values; and
• interest rate/inflation risks such as changes in bond credit spreads and yield curve movement that cause the liabilities to fluctuate and can impact the asset values

A pension plan also exposes an organization to non-financial risks that can influence the ultimate cost of the plan, including the potential for costly litigation:

• demographic risk such as longevity risk and embedded options in the pension plan (e.g., lump sums and early retirement subsidies);
• regulatory and litigation risk particularly with respect to the ownership and use of surplus; and
• operational risk created by poorly managed governance processes and the potential for errors in administration and member communications

Given the myriad risks posed by sponsoring a DB plan, and the costs associated with running the plan, why do sponsors not wind up the whole plan instead of just closing the plan to new entrants? For some organizations the cash cost and balance sheet impact of winding up the plan may not have been acceptable. In other cases, the key reason for maintaining the plan relates to the value of the current human capital of plan members. In many industries, the closed DB pension plan continues to play an important role in the total rewards of existing DB members, and is key to engaging and retaining critical talent, especially in light of labour shortages in an aging population.

Related Links

At what point do the risks, and costs, associated with the pension plan outweigh the benefit to the business from a workforce perspective? What should a company do to recognize that point and be prepared to act? What steps should the company proactively take to maximize the likelihood that there will there be sufficient assets in the plan to cover the cost of settling the benefits, while minimizing the chance of having excess assets? What steps should a company take to make sure that the accounting impact of winding up the plan will be palatable?

The best way to answer these questions is to project the expected development of the plan under various scenarios, and examine the HR/workforce, economic and accounting impact of potential exit strategies. It may be too early to think about pulling the plug on the plan, but a directional long-term strategy can be developed. The following decision tree illustrates, at a high level, the process that a company should follow to develop a directional exit strategy.

If an immediate exit is not feasible, a dynamic approach can be developed to optimally balance the desire to exit the plan with the potential costs, including the cost to the company of either losing human capital or retaining the remaining DB participants by making an attractive transition offer. A time horizon and trigger points can be developed for settling the obligations in an orderly, and possibly segmented, fashion.

For example, under what conditions is it palatable to settle the terminated vested obligations? The retiree obligations? The remaining active DB members? If trigger points have been identified for when the company may wish to settle the obligations, tactical approaches can be developed before reaching the stated trigger points. In addition to thoughtful planning about trigger points and settlement tactics, a plan sponsor should take steps to mitigate the plan risks prior to implementing the exit strategy.

Do not allow lack of “end-of-life” planning for the pension plan to wreak havoc on corporate financial statements or to unduly monopolize internal resources for the maintenance of a dying plan. Identify the plan’s key risks and their implications, take steps to mitigate risks, and establish a thoughtful exit strategy. The result will be a pension risk management policy consistent with corporate financial objectives that ultimately leads to an exit from plan sponsorship while addressing interim risk tolerances and constraints.

Laura Lynch is a principal in the retirement practice in Towers Perrin’s Calgary office. She specializes in providing pension and actuarial consulting advice, particularly in the design, financing, administration and communication of pension and savings plans. Laura is responsible for the management of the retirement practice in Calgary. She is filling in for Steve Bonnar, who is on vacation.

If you’d like to comment on this story, click here.

Copyright © 2020 Transcontinental Media G.P. Originally published on benefitscanada.com

Join us on Twitter