DB to DC conversions - a legal Pandora's box
Misleading communications or insufficient information pose a potential legal risk for sponsors undertaking DB to DC conversions.
Employers, often looking to contain their pension costs and cash flow risks, have been switching to DC, PRPP, RRSP, TFSA (CAPs) programs vs. Defined Benefit (DB) plans: more money is now going into DC plans than DB plans.
A DC or RRSP pension programs however is in fact a personal DB plans managed by the employee. By moving to CAPs employers are shifting all the responsibility and risks for managing pension outcomes, to their employees: A CAP sponsor has a significant fiduciary role and responsibilities. Juris prudence suggests that sponsors will be held to very high fiduciary standards, must always act in members’ best interests and, must disclose all relevant information’.
Read: Ontario Court of Appeal Ruling and Dawson vs Toko Industries Ltd.
The fiduciary responsibilities include providing members with tailored communications, education, investment information and tools and, overseeing the fees paid by members.
DB to DB conversions – higher risk
The likelihood of litigation and class action suites is greatest when employees were forced or opted to move from a DB to DC plan. Members relied on the employer, actuaries and other service providers to provide all relevant information about taxes, costs and their future pension income. They also relied on the sponsor to ensure the amount transferred from the DB plan to their DC account and subsequent sponsor contributions were would be adequate.
With low interest rates, volatile equity markets, increasing longevity and inflation, retirees are faced with the possibility of not having enough in their DC account to provide an adequate pension. For example, the recent market crash has put a huge dent in most DC and other CAP accounts.
The critical issue from a legal perspective is whether all ‘highly relevant’ information was provided when employees converted from a DB account to a DC account. Equally important, did members understand the information.
Read: DC plans arere fatally flawed - Canadaian Investment Review - Feb 2012
Managing a pension plan is a challenge, even for seasoned pension and investment industry professionals. Sponsors are faced with the tsk of ensuring the average ‘unsophisticated’ employee transferring to a DC plans has all the relevant information, education and tools needed to achieve a retirement income equivalent to their DB income.
Managing a retirement program
CAP members that are reminded they are “in it for the long term” with respect to investing for retirement. This is long-term focus is particularly significant when employees transfer from a DB to a DC plan.
The value (commuted value) of the amount transferred from the DB to a DC account is based on a long-term interest (discount) rate. This represents the future expected return in determining the transfer value (commuted value) i.e. a DB plan employee’s (and spouse’s) future projected pension income is assumes a long-term investment return, similar to this discount rate, will be achieved.
DB to DC conversions - Communications
In converting from a DB to a DC plan member needs information, education but also to acquire a bit of pension expertise. The onus however is on the sponsor to provide all relevant information and ensure that members understanding it. Sponsors also be aware of OSFI recommendations for converting a DB to a DC.
Read: OFSI - Guidelines for converting plans from DB to DC – August 2001
Examples of relevant information in making the decision to switch to a DC plan is shown below.
a) Has the importance of the discount rate used in determining the transfer amount been disclosed and clearly explained.
b) Does the discount rate reflect and reasonably compensate for the key risks assumed by the member i.e. interest rate risk, longevity risk, 6 sigma events, and investment risk.
c) Does the transfer amount take into account both the employee and spouse.
d) Are members aware that the discount rate is based on the long term (2-30 years) and was used to determine their account transfer value (future pension funding requirement).
e) Has the short- and long-term impact of volatility on returns and ‘time’ been explained.
f) Are members aware they need to take advantage other tax assisted savings programs as part of creating an adequate pension e.g. maximizing RRSP contributions.
g) Are members aware that investment losses in a DC plan cannot be made up by making additional contributions with offsetting tax deductions (as is the case in a DB plan).
h) Has the impact of fees been clearly explained re: the impact on asset accumulation before and after retirement. Are members aware they have no control over fees.
i) Are enough investment options available to allow for diversification and different needs of members.
k) Do members understand investment and benchmark information? Is long-term term (20 year +) vs short term (1-5-10 year) investment information provided.
Communications - Guidelines
Legislation, regulations and juris prudence with respect to a CAP sponsor’s responsibilities are limited in Canada but the CAPSA Guidelines provide recommendations that are likely be a part of litigation.
The CAPSA Guidelines recommend that a sponsor:
· administer the plan in accordance with all applicable legislation;
· provide investment information, education and decision-making tools;
· consider relevant factors when selecting the investment options;
· select and monitor the investment options; and,
· monitor the activities and performance of the administrator and service providers.
The guidelines recognize that different information, communications and tools are needed in different circumstances e.g. during the accumulation vs. the payout phases. Legislation also requires that prescribed information must be communicated to beneficiaries if they are responsible for making investment decisions.
While the sponsor may delegate the tasks of providing communications, information and tools, to recordkeepers and other service providers responsibility for overseeing the actions of service providers remains with the sponsor: few sponsors have the expertise to do this.
Errors, omissions or misleading information or communication have been the subject a source of litigation in both Canada and the USA.
Missing Investment and Performance Information
A Cap sponsor should offer investment options, education, communications, and tools that reflect the demographics of the membership and type of CAP accounts provided.
Read: Why CAPs should get passive – Canadian Investment Review - September 2012
In the case of DB to DC conversions, the transfer value and estimated future pension income are determined using a long term going- concern discount rate. Long- term performance data (more than 10 years) however, is seldom provided. In many cases only 1-10-year performance data is presented which limits a members’ likelihood of effectively managing their investments and, retirement savings.
Summary - Risks and Potential Litigation Issues
Sponsors may oversell the benefits and understating the risks when offering or forcing a DB to DC conversion. Even in the best case, the risks of inadvertent misrepresentations or errors are high. The underlying legal issue is whether all relevant information was clearly communicated:
1) were the risks and responsibilities assumed by the member clearly explained;
2) was enough education and training provided and did members understand it;
3) were members (and spouse) adequately compensated in determining the transfer value;
4) was the importance achieving an investment return like the discount rate understood;
5) is long-term investment performance data provided; and,
6) was the impact on savings and responsibility for overseeing fees clearly explained.
Failure to provide this information could be the reason member seek redress through the courts.
Many 401K and DC plans in the USA are involved in legal actions: this is expected to become more common in Canada. The courts may well sympathize with CAP plaintiffs because of their reliance on the sponsor and lack of sophistication and understanding of financial and pension matters.
G. Wahl, Managing Director, The PensionAdvisor