This is the third post in my series on pension plan restructuring (for prior posts see April 12, 2012 and June 8, 2012). In this post, I will examine the basics of converting your defined benefit (DB) plan to a defined contribution (DC) plan.
To avoid the uncertainty inherent in the funding of a DB plan, where interest rates and volatile investment returns can drastically alter a company's funding obligations, and to achieve certainty going forward, employers may decide to convert their DB plan to a DC plan.
A total DB to DC conversion would involve not only the introduction of DC benefits on a prospective basis, but also the commutation of all members' accrued DB entitlements into account balances under the DC plan. However, because member consent is required by regulatory policy for any accrued benefit conversion, many conversions occur only on a prospective basis. This can be achieved either by setting up a new DC plan, but is more often implemented by adding a DC component to the existing DB plan for future service only — thereby allowing members to preserve their entitlements already earned under the DB plan.
Often members are given the option of converting their existing DB entitlement to a DC account. In designing the conversion an employer may decide to close the DB component to new entrants and "grandfather" existing employees by allowing them to continue accruing DB benefits. In this case the DC component would be mandatory only for new hires. Alternatively, an employer may choose to close and freeze the DB component such that all employees are required to join the DC component in respect of future service (see soft/hard freeze discussion below).
Employee Communications are Key
If members are given the option of joining the DC component or converting their accrued DB entitlements to DC account balances, employers should be very careful when communicating this option. Members must be properly advised of all changes, including the impact of replacing a DB entitlement with future DC accruals, so they can make informed choices relating to:
- any past service conversion option;
- any option allowing certain members to retain grandfathered DB benefit accruals; and
- their DC account investment choices.
Deficient or confusing communications may result in invalid elections and lead to member complaints down the road which, in turn, could result in regulatory action or litigation.
Administrator or Sponsor?
It's worth noting that while plan design changes are made by employers as "plan sponsor", when it comes time to communicate the changes for implementation, the employer will likely be acting as "plan administrator" and therefore will owe a fiduciary duty of care to all pension plan members. If communications are found to be deficient, members could make claims based on alleged negligent misrepresentation, breach of fiduciary duty, or breach of contract.
Collective Agreement Constraints
Of course, employers will always have to take into account any collective bargaining considerations when plan members are unionized. Depending on the relationship between the pension plan and the collective agreement, employers may be constrained as to the type of unilateral changes they can make during the currency of the collective bargaining agreement. Often an employer is only able to change the pension plan terms – or at least material changes affecting benefits – during collective bargaining.
"Soft" or "Hard" Freeze?
One issue that always arises when converting to DC is whether, and the extent to which, members' existing DB benefits will be frozen to exclude both future pensionable service and future pensionable earnings such that the DB benefits will not change beyond the effective date of conversion. This is called a "hard" freeze. Sometimes an employer will choose to freeze only DB service and permit the DB formula to continue to count future increases in pensionable earnings. This is called a "soft" freeze.
Regulatory policy in Ontario currently permits either a "hard" or "soft" freeze to be introduced. However, a recent decision of the Alberta Court of Appeal held that freezing future earnings amounted to a reduction of accrued benefits and, therefore, post-amendment earnings had to be included in the calculation of employees' final pension benefits. While this decision may be perceived as heightening the risk associated with implementing what is known as a "hard freeze", this Alberta decision has been questioned and is not necessarily determinative in Ontario.
No matter how the employer decides to implement a plan conversion (i.e., on a go-forward basis, giving the option to convert DB entitlements, or freezing future salaries for benefit calculation), it is important to remember that such a change would almost certainly be considered to be an adverse amendment under the Ontario Pension Benefits Act, which means that advance notice of the amendment would have to be provided to the members.
Stay tuned for Part IV of the Pension Plan Restructuring Series where I will examine other types of amendments which can be made to an existing DB plan.
James advises on legal issues relating to federally and provincially regulated pension and employee benefit plans.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.