SUPERANNUATION FUND TERMINATIONS: A REVIEW OF CURRENT ISSUES AND PRACTICE

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1 SUPERANNUATION FUND TERMINATIONS: A REVIEW OF CURRENT ISSUES AND PRACTICE David McNeice* BEc FIAA ABSTRACT During recent times many superannuation funds have been terminated due to three main forces: significant corporate merger and acquisition activity, conversion of some (typically smaller) independent corporate funds into multi-employer funds (master trusts and industry funds) and the rise of individualism and the associated trend towards defined contribution funds. In some cases of corporate acquisition, a full termination is not required but a partial termination is. This paper provides a review of practice in the area of fully or partially terminating superannuation funds. The issues that must be dealt with and the common means of doing so are discussed. The specifics of converting from defined benefit to defined contribution are considered. Finally, the paper assesses the conflicts that emerge. KEYWORDS Fund terminations, defined benefit conversions, successor fund transfers. TABLE OF CONTENTS 1. Introduction 2 2. Why do terminations occur? 3 3. Rules and Regulations 6 4. COMMON ISSUES FOR ALL FUNDS 8 5. The Specifics of Defined Benefit to Defined Contribution Conversions Special issues Conclusion References 21 Appendix A: Appendix B: terminations 22 Extracts from typical superannuation fund trust deeds relating to transfers out and Extracts from the Superannuation Industry (Supervision) Act 1993 Regulations26 Appendix C: Superannuation extracts from a typical agreement of sale of a business 35 Appendix D: Notes 37 * david_mcneice@watsonwyatt.com.au 1

2 1. INTRODUCTION 1.1 In Australia, the retirement incomes of individuals are funded by way of the so-called three pillars: The old-age pension, paid for by general tax revenue and subject to means-testing; Compulsory superannuation benefits at the Superannuation Guarantee i level in respect of employees, paid for by employers, and Voluntary savings, paid for by individuals and some employers. 1.2 There will continue to be increasing pressure on the old-age pension due to an ageing population and the associated change in the dependency ratio, meaning that proportionately fewer tax payers are funding old-age pensions for more pensioners. The savings performance of Australians is perhaps not at the level that it used to be, and there may be substitution away from voluntary savings in favour of compulsory superannuation benefits as the effects of the Superannuation Guarantee become apparent. ii Thus, even though the total amount of superannuation benefits is increasing, the aggregate level of savings may not be. 1.3 Therefore, superannuation benefits are taking on increased importance. This paper is concerned with employees being provided with benefits in independent corporate superannuation funds. The assets being accumulated for each employee are likely to be critical to that person s ability to finance their expected standard of living in retirement. 1.4 The recent past has seen many fund terminations and partial terminations. In a dynamic business environment, fund terminations are expected to continue as companies change shape, ownership and direction. Where employees are to be transferred from one fund to another at the instigation of the employer, how are the benefits of the employees affected? What issues emerge and how are they dealt with? What safeguards exist to protect the employees? How does the actuarial profession help employers, trustees and employees when such transactions occur? 1.5 The actuarial profession has a special role to play in balancing the needs of employers, trustees and employees to help ensure an equitable outcome so that society can maintain confidence in superannuation funds. 2

3 2. WHY DO TERMINATIONS OCCUR? Three current forces 2.1 Funds terminate for many different reasons. However, there have been three common forces at work in recent times that have caused a significant number of full terminations and partial terminations. The three forces are discussed in this section. A partial termination occurs where a significant number of a fund s members transfer out of the fund. Corporate merger and acquisition activity 2.2 In recent years, many large corporations have sold, purchased or restructured their businesses. Various economic catch-cries apply to different periods of time and the experience of the mid to late 1990s could be said to have been focus on your core business. This activity has led to many divestments (and associated investments). Some other corporate deals occurred due to an aggressive desire for growth. The financial and business implications of this activity are irrelevant for the purpose of this paper, but each transaction almost always changes the way in which superannuation benefits are provided for the employees involved. 2.3 The restructuring of a business can occur in two different ways. A subsidiary can be sold on-market, where the controlling shareholder sells its holding either on the market publicly or through a negotiated sale. This change in ownership of the shares of the business does not necessarily create any special requirements to restructure the superannuation benefits of the employees. The employees remain employed by the same company and that company could continue to utilise the superannuation fund it had been using before the transaction, if the new owner agrees. However, the new owner could also wish to rationalise the funds in which its employees are being provided with superannuation benefits. For example, an acquisitive company could very quickly find its subsidiaries contributing to many different funds, all with different benefit designs, names and identities, administration arrangements, investment performance and so on. For any given level of contributions, employees with otherwise similar terms of employment could be provided with significantly different superannuation benefits. 2.4 In these situations the acquirer will often try to rationalise its funds to help ensure, to the extent possible, that the employees in the corporate group are treated in a similar manner. It is also common that the acquirer will try to ensure that the corporate identity is consistently applied across all parts of its business. This may require that the employees all join the one fund with an identity clearly aligned with the corporation. Maintaining closed categories of membership with special terms of membership, benefits and contributions is a means of protecting pre-existing arrangements, if required. 2.5 The second type of restructure is the sale of a business and the assets associated with that business. The vendor will want to ensure that the employees of the business are offered equivalent terms of employment with the purchaser for two reasons: firstly, to avoid the costs of redundancy and, secondly, to protect the economic welfare of the employees and their dependants. Superannuation forms a major part of the benefits of the employees to be protected and restructured. Conversion of some (typically smaller) independent corporate funds into multi employer funds 2.6 The superannuation environment in Australia has endured many changes in regulatory environment. The superannuation benefit has proven to be remarkably resilient, clearly indicating that there are strong business reasons to provide such benefits. However, the vehicles used to deliver the benefit have varied over time. Prior to the introduction of the Superannuation Guarantee requirements (as an extension of the 3% award superannuation of the mid 1980s) and when publicly funded social security benefits were subject to less stringent means testing, lower-paid employees of many smaller to medium sized companies were often not directly provided with employer-funded retirement benefits. 3

4 Instead, it was commonly (but not universally) accepted that the Government would provide sufficient retirement income for these employees. The introduction of the Superannuation Guarantee has meant that all employees must be provided with a direct employer-funded benefit that meets or exceeds a prescribed minimum. This requirement has created a demand for a simple low cost means of compliance with the Superannuation Guarantee. 2.7 Master trust products allow employers to provide employees with a superannuation benefit without the need to establish and maintain an independent fund. These products were typically developed and refined by life insurance companies although now a variety of financial institutions offer such products. Employers that would previously have used endowment assurances to provide for their employees now use a master trust. 2.8 The increased regulation of superannuation funds through, firstly, OSSA iii and secondly, SIS iv, was a logical extension of the rise of compulsory superannuation. With the imposition of compulsory superannuation established by contributions in industrial awards and extended by the Superannuation Guarantee, the Government increased its supervision of funds with the aim of enhancing protection for benefits arising from the compulsory contributions. The increased regulation is often cited by smaller to medium sized employers as a reason for terminating an independent company fund in favour of an industry fund or master trust v. Rise of individualism and the associated trend towards defined contribution funds 2.9 Many companies have stated policies that retirement benefits should be provided through a defined contribution fund, where possible. Many employees, particularly at younger to middle ages, when given the choice of converting from a defined benefit fund to a defined contribution fund will willingly convert, even if there is no obvious incentive to do so. Different countries are at different stages in the gradual process of change away from defined benefit funds to defined contribution funds. In my view, we are experiencing this change for many reasons, such as: The view that superannuation is a contribution (i.e. deferred pay) rather than an endof-service benefit. This is a natural consequence of legislation such as the Superannuation Guarantee (which is written in defined contribution terms) and SIS which focuses on the protection of accrued benefits as belonging to the member and imposes minimum funding requirements. The investment returns of world stock markets in the last 20 years or so relative to price and wage inflation has been exceptionally good vi. This has resulted in large benefit increases for members in defined contribution funds relative to their peers in defined benefit funds and hence made defined contribution funds seem more attractive, where it is assumed that the past investment experience will continue into the future. The willingness of employers to transfer investment risk to the employees. The good investment performance in the recent past has meant that many employees willingly accept that transfer of risk. The further unbundling of services within defined contribution funds allowing members to choose their own investment strategy. The desire to package remuneration in flexible ways to take advantage of available tax concessions and better meet the needs of the individual employee. The introduction of compulsory equal representation (between the employer and member representatives) on the board of trustees. This has led to a reduction in employer control and therefore an increase in employer desire to limit liability to a defined rate of contribution. 4

5 2.10 These factors have combined to increase the popularity of defined contribution funds relative to defined benefit funds. This has led many employers that were providing defined benefits to begin converting to the provision of defined contributions. The method of converting can be chosen to allow the change to happen over a very long time or to encourage the change to happen more quickly by offering a generous incentive to encourage the employees to convert. Outcomes 2.11 The outcomes of the above three forces at work involve a transfer of members from one fund to another and/or the conversion of benefits from defined benefit form to defined contribution form. Many funds are then terminated completely, or reduced significantly in size. 5

6 3. RULES AND REGULATIONS 3.1 Where a full or partial termination is to occur, there are rules and regulations to comply with, depending on the nature of the transaction. Trust Deed or governing rules of the Terminating Fund 3.2 Appendix A includes extracts from the transfer out and termination clauses of trust deeds of some corporate superannuation funds. The clauses are typical of corporate fund trust deeds. 3.3 The trust deed will generally give some guidance as to the amount to be transferred out in respect of any given member. Common aspects of the trust deeds are that the employer must give approval to any amount in excess of a minimum amount (eg. the vested benefit or actuarial reserve) to be transferred. This is to prevent the trustee transferring out any surplus without the prior approval of the employer. 3.4 Trust deeds typically require the actuary of the fund to determine amounts such as equitable share, actuarial reserve or interest in the fund as being the maximum amount to be transferred. These terms are not defined; instead, common actuarial practice would be relied upon to determine the values. Commonly, the actuary would determine a value of the accrued benefit, allowing for service completed to the date of calculation only, but allowing for future salary increases and discounting applying to the expected date of benefit payment. 3.5 There is scope for debate on the method of determining the value of accrued benefits. Generally accumulation benefits will be valued as the face-value of the accumulated contributions. However, defined benefits are more complex to value and require assumptions for discount rates, salary inflation rates and rates of decrement. 3.6 Where the fund s assets differ in value from the total value of accrued benefits, then the question arises as to whether to distribute a share of such surplus or deficit to the members. There is no one clearly accepted response to this question. However, since the recent environment has been one of small surpluses, rather than deficits or large surpluses, the issue has not proven particularly problematic recently. This has not always been the case and there are still some funds with surplus issues to be resolved. In Garner (1986) and Solomon (1987) surpluses were a particular cause for concern. A typical approach in current practice has been not to include any share in surplus, unless the trust deed has specifically required it, or unless the employer specifically wants to share the surplus with the members. 3.7 Other trust deeds require the trustees to determine the amounts to be transferred, perhaps after having sought the advice of the actuary, and without any need for employer approval. Superannuation law 3.8 The superannuation law, imposed through SIS, provides little guidance in terminations. Extracts from SIS, as they relate to full terminations, are included in Appendix B. In the case of partial terminations, ie. significant transfers out of the fund, there is no specific section of SIS that is relevant. Instead, the benefits payable are governed by the normal rules relating to members leaving a fund. Defined Benefit Funds 3.9 SIS does not provide much guidance to trustees of funds when considering how to allocate assets on termination. The assets must firstly be used to meet the administration costs of winding up. Thereafter, it is essentially the minimum requisite benefit (MRB) that must be provided in respect of all members. Where a fund is technically insolvent vii, the benefits of all members must be between 100% of the MRB and that MRB reduced in proportion to the fund s deficit. SIS does not specify the allocation of assets in excess of the MRB. 6

7 Defined Contribution Funds 3.10 Similarly, little guidance is given to trustees of defined contribution funds. After setting aside assets to meet the expenses of wind up, then it is the guaranteed minimum benefits (the same as the MRB, in concept) of the members that must be allocated. SIS does not specify the allocation of assets in excess of the guaranteed minimum benefits. Sale Agreement 3.11 This will apply in the case where a company is selling part of its business assets to a purchaser, or selling an associated company. Extracts from a typical sale agreement as it relates to the superannuation benefits of the employees are included in Appendix C. This particular agreement requires that the Vendor s actuary determine a transfer value to be paid in respect of each member, either to the fund of the member s choice or in accordance with the successor fund requirements. It does not attempt to impose any method or basis of determination on the vendor s actuary Sale agreements are generally effected by the two companies and have no legal application to the trustee. If the sale agreement requires something different to what the trustee actually does, then the difference should be taken into account by the vendor and purchaser. Meeting members reasonable benefit expectations 3.13 The fact that SIS requires only that members receive their MRB (reduced in proportion if the fund is insolvent) is not unreasonable. After all, SIS was established shortly after the Government had introduced a compulsory minimum to the benefits to be provided and an important purpose of SIS was to help protect that minimum benefit. However, insolvency cannot be legislated against. Typically, corporate funds invest a significant portion of their assets in investments that, while they have higher expected relative returns, have an element of risk of loss of value attached. Consequently, these funds can become temporarily insolvent. SIS deals with this issue by requiring regular financial monitoring and reporting of financial positions and specifying actions to be taken if funds cannot maintain a level of solvency that meets or exceeds the MRB level. However, SIS also purports to protect members interests and there is possibly a mis-match between the protection actually afforded by SIS and that which members would expect Similarly, an agreement of sale between two companies does not have any power to affect how the trustee of a vendor s fund determines benefits, as the trustee is generally not a party to the sale agreement. Also, a significant degree of flexibility must be retained in a trust deed since the Trustee must protect the interests of all members, not just those transferring out How then, is the member of the superannuation fund, the employee who is accruing a retirement benefit and being forcibly ejected from the fund, protected? How is the confidence of fund members to be retained when there is so little by way of legal requirements specifying how their benefits on transfer will be determined? It is here the actuary has a crucial role to play, through the position of adviser to companies and trustees. How actuaries fulfil this role depends on our responses to the issues in this paper. 7

8 4. COMMON ISSUES FOR ALL FUNDS 4.1 This section considers some common issues that trustees and employers must deal with when terminating or rationalising funds. Level and type of benefit in respect of future service for existing employees 4.2 SIS imposes no restriction in this case and does not attempt to protect the level of the benefit in respect of future employment that applies for existing employees. Similarly, trust deeds of funds generally impose protections on accrued benefits only and do not usually attempt to prohibit amendments that reduce future service benefits. However, in the few cases where such restrictions do exist, there is typically another clause that the employer may use to effect a change (or reduction) in future service benefits, for example by winding up the existing fund and contributing to another fund. 4.3 Sometimes the change in benefit is clearly to the advantage or at least neutral to the employee, for example, when transferring from a fully vested defined contribution arrangement to another where the rate of employer contribution is the same or higher. However, it is still necessary to consider the level of death and disability benefits, the allocation of costs of administration and insurance or self-insurance and investment options available to confirm that no employees are being made worse off. 4.4 Where employees have previously been accruing defined benefits and the employer wishes to provide future service benefits in defined contribution form, the comparison of the two benefits becomes a matter requiring actuarial judgement. 4.5 Aside from any legal restrictions, for example in relation to employment law, most employers will not want to disrupt or disadvantage their employees and so will often want to provide benefits that are at least no worse than before and possibly improved. Treatment of the accrued benefit 4.6 The treatment of the accrued benefit creates an additional set of complications. Where the benefit is changing from defined benefit form to defined contribution, it is possible to devise a method of conversion that protects the accrued benefit from any reduction at the time of conversion. However, from that point on, the converted value will be subject to investment returns, positive or negative, as distinct from increases through salary inflation. Thus, the benefit accrued to the date of conversion has its value inflated in the future using a different means of increase and therefore will be different in value, relative to what it would have been had no conversion occurred. 4.7 The basis used to convert from defined benefit to defined contribution format requires special consideration. Firstly, the benefit that has accrued to date needs to be defined. This is not always a simple decision. Take, for example, benefits that accrue with a maximum period of service to count, or benefits with cliff vesting. Secondly, a value needs to be placed on the accrued benefit. This is a matter for actuarial judgement, discussed in the next section. 4.8 While it is very much simpler to transfer a benefit from one fund to another when the benefit is already in defined contribution form and remaining that way, there are still similar issues to be considered. Vesting scales that apply to accumulated contributions in excess of the Superannuation Guarantee requirements will produce issues similar to those arising in defined benefit funds, that is, the determination of the value of the accrued benefit. Other issues that arise in defined contribution funds include the treatment of reserves, such as investment fluctuation reserves, forfeited benefit reserves, expense reserves etc. Continuation of death and disablement benefits 4.9 Continuity in death or disablement benefit during the transition from one fund to another is critical. Whether the fund insures externally or self-insures the risk, the issues are the similar. The employer will be concerned that employees remain covered for benefits at the same or improved level and under the same terms and conditions. 8

9 The receiving fund (or insurer) will wish to ensure that the risk being taken on is subject to appropriate risk controls, such as limited anti-selection scope. Also, the receiving fund (or insurer) will wish to ensure that liability for any potential disablement claim arising from employees not at work on the day of the transfer remains with the first fund until such time as the employee returns to work. The investment strategy 4.10 This aspect of a merger or termination is particularly important when changing from defined benefit funds to defined contribution funds. Often, such a change is associated with the introduction or expansion of member investment choice. Defined contribution to defined contribution 4.11 In this transaction, the nature of the liabilities is remaining unchanged. There is no reason to interrupt the investment strategy simply because the fund being used to provide the retirement benefits is changing. It is desirable that the assets remain invested through the transaction, to the extent possible. It is also a practical solution to transfer ownership of assets from one fund to another, rather than liquidating and transferring cash If a change in investment strategy is to occur in the new fund, perhaps with member investment choice, then it is critical that the transferring members be informed of how the change in investment strategy will be implemented. One way is to cash up all assets on the effective date of transfer and hold them in cash until paid to the new fund. This might be consistent with the fund s normal benefit payment process. However, it does disrupt the investment s strategic asset allocation. It is often preferable to keep the accrued benefit invested until payment, avoiding such disruption to the strategic asset allocation. Maintaining the asset allocation is critical for maximising long term expected investment returns. Defined benefit to defined contribution 4.13 In this case the nature of the liabilities is changing. Unless the members are told otherwise, the expectations of most would be that the accrued benefit, in defined benefit format, would be protected from investment market volatility until after it had been invested in the new fund. Once the sponsoring employer knows that the relevant members are transferring out, the liability being funded for becomes short-term. An appropriate response is to protect against short-term asset losses, by cashing up. Costs 4.14 The cost of re-arranging and transitioning assets is significant and, although outside the scope of this paper, it is worthwhile devising a strategy to re-arrange the assets in a cost efficient and tax efficient manner, while always minimising any mis-matching risks. Surplus 4.15 During the course of the 1990s, many funds have seen a reduction in the significance of their defined benefit liabilities. In addition, where many defined benefit funds were in surplus viii at the start of the 1990s, there were much fewer significant surpluses at the end of the 1990s. This reduction in excess assets has been achieved largely through benefit improvements and reduced employer rates of contribution. Benefit improvements have typically been implemented at younger ages and shorter durations of membership to comply with the requirements of the increasing Superannuation Guarantee. Reduced rates of employer contribution have occurred as companies have tried to improve the short-term return on shareholders equity and after realising that surplus assets can cause their own set of problems. Consequently, under current conditions, it is not often that an employer and trustee will be faced with any significant degree of surplus in the fund that is to be terminated. To this extent, the termination is made easier. 9

10 Successor Fund Transfers 4.16 The SIS law permits trustees to transfer the benefits of members between funds without the need to obtain member consent provided that the terms of the transfer satisfy the definition of a successor fund transfer. In addition, the Trust Deed of the transferring fund must permit the transfer. SIS defines a successor fund transfer as one where the trustees of both funds agree that the receiving fund will provide equivalent rights in respect of the benefits as the transferring fund. APRA circular I.C.2 gives some guidance as to what may constitute equivalent rights. APRA Guidelines 4.17 In Circular I.C.2, APRA states that: the member s rights in respect of their benefits should be equal in value, measure, force and effect to their rights in the original fund. Any judgement of whether rights are equivalent should not be assessed solely on an individual change to a specific right but on the equivalency of the bundle of rights provided to the member by each fund, although special consideration should be given to significant rights. The Circular goes on to suggest trustees consider at least: withdrawal benefits; the circumstances in which the member may become entitled to benefits and the method of calculating those benefits; preservation; the extent to which a member bears investment risk; the provision and conditions of insurance, and the method of calculating insurance benefits; the right to be credited with reserves that might arise from time to time; the basis upon which investment earnings are credited or debited to members; the basis of valuation of assets; and the conditions of release permitted under the governing rules of the fund. Some of these issues were further discussed in APRA Circular I.C.4. Practical uses 4.18 Defined benefit conversions to defined contribution form are not likely to satisfy the equivalent rights test. Therefore, successor fund transfers are generally reserved for: defined contribution to defined contribution funds, where any differences are easily identified and can be shown to satisfy the successor fund transfer rules; and defined benefit to defined benefit transfers where the benefits are replicated in the new fund. Assessment of the transfer 4.19 It is essential that no immediate benefit (ie on death or disablement and on voluntary leaving service) reduce on transfer. In addition, it is arguable that the future service accrual of benefits must continue at a rate no less than that applying immediately prior to the transfer. 10

11 4.20 In addition to the above, there are other aspects of the new fund compared to the old fund that should be assessed: no increase in the compulsory rate of member contribution (if any) should be imposed; any special entitlements available after satisfying an eligibility requirement must be retained; there must be no changes in definitions, such as Total and Permanent Disablement and the salary definition, that would disadvantage the member; and where options are available to members, for example by way of member investment choice, a similar range of options should be provided in the new fund Other aspects of the transfer that need to be considered are expense rates, amendment powers and wind-up provisions. Expense Rates Where a fund has no power under the Trust Deed to distribute expenses among the members and the employer has agreed to meet all expenses separately, but the receiving fund can and will distribute expenses among the members, then, other things being equal, the transfer would not represent a successor fund transfer. Much more common is that both funds have the power to distribute expenses among the members, but the expense rates will differ between funds. In practice, such a difference between expense rates is often ignored, provided the difference is relatively small. Where differences are significant, then there may need to be other benefit improvements to offset the increases in expenses. Actuarial judgement is required to make such assessments. Amendment powers and wind-up provisions The terms of these provisions should be similar. For example, under what circumstances can benefits be amended and at whose discretion? What restrictions on amendment are imposed? Are residual assets on wind-up distributed among the members or returned to the employer? Where it is not possible to confirm that the terms of the transfer meet the successor fund requirements, then member consent for transfer will be required. Communication with employees 4.22 Superannuation benefits can be complex. A well-designed fund that communicates poorly with its members will not be appreciated. In situations of termination and partial termination, the communication programme is central to the overall success of the re-structure. Successor fund transfers 4.23 These transfers are the easiest to communicate since the central message is no change. However, the members will require sufficient evidence of that. A major re-structure often prompts many members to review carefully their benefits, perhaps for the first time, and hence there is a need to re-communicate the nature of the benefits. Transfers where member consent is required 4.24 Defined contribution to defined contribution These re-structures can be very similar to successor fund transfers. The fact that member consent is required means that the benefits are changing in some way, or, the fund s trust deed does not permit transfer without consent. In these cases, the communication will need to include details of any changes in benefits. 11

12 4.25 Defined benefit to defined contribution This re-structure generally requires most effort in communication. An understanding of the changing nature of the benefits and how to manage the investment risk is critical. Actuaries can add significant value here in helping members understand the change in benefits through: Helping set an appropriate framework of assumptions about future experience to make comparisons meaningful and credible; Helping members understand the sensitivity of their benefits to future experience; Helping members understand the links between contribution rates, investment strategies, investment horizons, disinvestment strategies and the resulting retirement income. Communication media 4.26 Communication programmes will generally use most of the following media: Introductory flyers. Brochures, post-cards, posters and intranet sites can be utilized to let employees know about impending change. The aim is to raise awareness and help build confidence that benefits are being properly attended to. Written material, distributed individually. This material contains detailed written explanation of all the changes being implemented, for example: Booklets describing the new fund; Details of how transfer benefits will be determined; Explanation of choices that are required to be made by members, and the defaults that apply if no choice is made; Appropriate forms to allow members to effect their choices and authorise the transfer of benefits (where necessary). (c) (d) (e) Personalised comparison calculators. These are generally only required where members are being converted from defined benefit to defined contribution. The comparisons could be on a fixed basis or variable. Intranet or internet-based calculators are ideal to allow members to change the basis of comparison, within limits, to effect sensitivity testing. If an intranet calculator is not available, a printed page can show a comparison of projected benefits on two different bases. The greater the flexibility built into the comparison, the more sophisticated the audience must be to obtain meaningful results. Group discussions. Presentations with question and answer sessions with small groups of members are a highly effective means of communications. It is often only after such a session that members can review the written material with a clear understanding of the context and the consequences of the change. Telephone or hotlines. For those members unable or unwilling to ask questions at group meeting, a telephone or hotline is a valuable feature. It is essential if there are employees at remote sites. 12

13 5. THE SPECIFICS OF DEFINED BENEFIT TO DEFINED CONTRIBUTION CONVERSIONS 5.1 This section considers specific issues that arise when members of defined benefit funds are converted to a defined contribution arrangement, because of a fund termination or transfer. Determining the Future Service Benefit Retirement and resignation benefits 5.2 The first step is to establish the best estimate of the cost of the retirement and resignation benefits currently being provided. There are various different data sources that are typically considered to help finalise the actuary s assessment of the cost of the current defined benefits: The most recent actuarial review report may give an indication, although this will depend on the funding method that is being adopted. An accrued benefit funding method such as the projected unit credit method will report the normal cost of the benefits as that arising in the year following the valuation date. This rate will generally be lower than a rate reported by a projected benefit funding method, such as the attained age normal method. Also, the basis that has been used in the actuarial valuation may not be suitable for determining, on a member-by-member approach, the equivalent cost of the defined benefits. The actuarial certificate used for determining each member s notional contributions for surcharge ix purposes. Depending on the format of the certificate, it may be possible to get a view as to the average future service cost of any particular member, expressed as a percentage of salary. Again, this is determined using an actuarial basis that may not be considered to be appropriate for the current exercise. Finally, a special valuation could be conducted to establish an individual rate on a member-by-member basis. Under this approach, the actuary will have freedom in setting the basis so that it can be truly a best estimate basis. It also has the advantage of producing a rate unique for each individual member, thus removing the averaging effects of some of the other methods. This method will allow the actuary to be most confident that the costs of the current benefits are reasonably accurately estimated on a member-by-member basis. 5.3 The above sources of data will allow the actuary and employer to devise an appropriate defined contribution rate, per member, to be paid in respect of future service that would be expected to provide a benefit equivalent in value to that being accrued prior to the transaction. 5.4 However, this is not the only approach that could be adopted. Other methods include providing a uniform rate of Company contribution in respect of future service for all members. Differences on a member-by-member basis could then be allowed for: by adjusting the transfer value; or by adjusting salary. Expenses 5.5 Whether any allowance is made for the cost of expenses will depend on the terms of the new benefits to be provided. If the employer is to continue to meet expenses then there is no need to load the defined contribution rates. However, if expenses will be deducted from the members benefits in future, then it would be appropriate to build in an expense assumption in costing the defined benefits. This could come from the most recent actuarial valuation, which will be based on the actual expense experience. However, the expense assumption of the new fund may differ. For example, when transferring members into a master trust from a typical corporate fund, it is important to check the various different types of expenses that are levied on members. 13

14 Insurance costs 5.6 The current fund s insurance benefits will need to be separately costed if they have not already been included in the employer cost above. The cost of insurance benefits are typically a relatively small proportion of the total cost of benefits and so a simple practical approach is often taken by adding a flat percentage of salary to the defined contribution rate being determined. Dealing with Member options in the current defined benefit fund 5.7 Some funds offer members the option to change their rate of accrual by changing their rate of member contribution. This means that the current level of benefits being provided differ in employer cost according to the rate of member contribution. There are broadly three ways of handling this in practice: By treating every member as if they were contributing at the highest possible level. This is clearly the most generous approach. By treating everybody according to his or her rate of contribution as at the transfer date. This is the harshest approach and is likely to be considered by some members to be disadvantageous to them, owing to the removal of potentially higher benefits available to those not already contributing at the maximum level. To continue the concept of providing higher company funded benefits for increasing rates of member contribution. This is a more complicated approach and does have some other disadvantages. For example, it reduces the certainty of the employer s superannuation costs. It means that the employer s cost still varies with experience, as in a defined benefit fund, although not to the same extent. However, it could be considered to be the most fair and equitable approach. An assessment of the extra employer cost for the extra rates of member contribution would be required. Ideally, the additional costs would be capable of being expressed in round numbers, with a scale of increase consistent with the relevant scale of increasing rates of member contributions. Tax 5.8 The costs of the benefits so determined are then grossed up to allow for contribution tax, usually by simply dividing by 85%. Surcharge tax is unpredictable and almost universally paid for by the members. Therefore, no adjustment is generally made in respect of surcharge tax. Parities 5.9 Frequently more than one benefit category of member will be involved in the assessment of costs. It is necessary to compare the raw costs that have been calculated by category from following the steps above to ensure that differences between categories are appropriate and justifiable to the members. Also, the rates so determined must comply with the Superannuation Guarantee requirements and any other requirements imposed by the employer. Sensitivity analysis 5.10 Once the scale of defined contribution rates has been determined, it is then tested for sensitivity to changes in the actuarial basis used to determine it. The degree of sensitivity depends on the terms of the benefits being assessed. A defined benefit fund that provides a defined contribution style benefit on resignation (eg a multiple of accumulated member contributions) is much less sensitive to changes in the actuarial basis than a pure defined benefit payable on all forms of exit. Benefit designs in Australian defined benefit funds typically include such a defined contribution benefit on resignation. 14

15 With increased rates of vesting being imposed by the Superannuation Guarantee, and with the requirement since 1 July 1987 that contribution accumulations be credited with net fund earnings rather than an artificial rate of interest (eg. 4%pa), the sensitivity of costs to changes in experience has reduced. However, an understanding of this sensitivity is essential in order to have confidence in the final scale of defined contributions. Margins 5.11 There will be three factors to be considered in determining the extent of any margins for conservatism to be built into the actuarial basis. The degree of sensitivity to changes in the basis, as tested above. A typical margin will be a reduction in the discount rate used to value the current benefits. For example, the actuary may assume a 3% pa differential between the assumed rate of salary inflation and net of tax discount rate, where the best estimate margin for a typical investment portfolio may be of the order of 4% pa. The benefit design to be provided after conversion. There is scope to provide a benefit design after conversion in respect of former defined benefit members that reduces the need for margins of conservatism. One method is to provide a supplementary accumulation in respect of each member, payable only on attainment of the first age at which the former defined benefits would have been paid. This is in recognition of the fact that many Australian funds already provide defined contribution benefits on resignation and it is only those members that survive to a certain age (eg age 55) that receive a defined benefit. An additional accumulation, only vesting on attainment of that age, can allow more freedom in setting the post conversion rate of defined contribution. As an example, a typical resignation benefit being up to twice the accumulated member contribution (5% of salary) subject to a minimum of the current net of tax superannuation guarantee minimum benefit x (in defined contribution form) will cost the employer: MAX ( 8% of salary, 5%/(1-15%) of salary) ie. 8% of salary, net of expenses, regardless of experience. The only assumption required is that member contributions are accumulated with interest at the net fund earning rate. No margin is required in this case. However, the benefit payable on attaining age 55 may be the order of X% x Final Average Salary x completed membership and so the prospect of protection from poor investment returns becomes important. The desire of the employer to make the conversion a more attractive proposal. An employer sponsoring a fund with defined benefit liabilities may be very keen to rationalise its funds or convert the remaining defined benefit liabilities into defined contribution liabilities. So keen, in fact, that it will specifically want the conversion basis to be skewed in the members favour. This will help to encourage members to voluntarily agree to convert to the new benefit. Practical means of creating an enticement include increasing all conversion values by a fixed proportion, eg 5%, dependent on the ability of the employer to fund it. Another common approach is to have the employer meet all future costs of insurance and administration. This benefit can be restricted in provision to those converting members or it can be extended to include new employees. 15

16 Avoiding spurious accuracy 5.12 In practical terms, it is impossible to come up with a benefit that is based on a defined contribution arrangement that perfectly matches the benefit previously being accrued on a defined benefit basis. The final rate selected will often be rounded to the next higher ½% or 1% of salary to avoid the impression of spurious accuracy. Past Service Benefit 5.13 It is common practice to determine the value of the defined benefit member s past service benefits as the greater of the actuarial reserve and the vested leaving service benefit. The actuarial reserve could be calculated on a basis similar to that used in the most recent actuarial valuation or a simplified approximation to that Owing to the increasing rates of vesting that have applied over recent years, it is now quite common that a member s vested benefit is very close to or sometimes could exceed the theoretical actuarial value of their past service benefit, depending on the actuarial basis of measurement. For this reason, it is fairly common that a simplified means of calculating the actuarial value is adopted. A typical formula would be the accrued retirement benefit multiple multiplied by current final average salary multiplied by a discount factor, where the discount factor would be, for example, 2% pa compound for each year prior to age 65. In comparing the value of the actuarial reserve and the vested benefit, rollovers and voluntary contributions would be excluded from both. The approximation formula adopted will depend partly on the design of the benefits being valued. For example, if the fund provides an undiscounted early retirement benefit from age 60, then discounting from age 60, rather than 65, would be appropriate An alternative approach could be adopted for determining the actuarial value of the past service benefit based on a full valuation of projected cash flows, including assumed decrements. This would be consistent with a normal actuarial valuation. In practice, this can add a significant amount of work for limited gain. Firstly, the result may be similar to that arising from the simplified approach. The extent of the difference will depend on the actuarial basis and the benefit design. Secondly, it is a much more complex basis to explain to the interested parties, particularly the members. In particular, it would be very difficult to justify to members an assumed resignation decrement The resulting value of the accrued benefit may then be further increased depending on the exact terms of the conversion and the trust deed and the employer s desire to make members better off. For example, part of the surplus could be shared as a way of increasing the accrued benefit and improving the chances that the members will be no worse off as a result of the conversion The extent of any sharing of surplus will depend on affordability, the employer s objectives, and the terms of the trust deed. 16

17 6. SPECIAL ISSUES Participation periods 6.1 In the event of a partial termination of a fund where some of the members are to be transferred to a new fund, sometimes there is no new fund readily available. This frequently happens when an international company establishes a business in Australia by buying a business from an existing Australian company. Since the commercial deal can move very quickly, it is often unrealistic to expect the purchasing company to be able to set up a new superannuation fund at the same time. Also, even if there is an existing fund, the purchaser may need to establish a new category to replicate the benefits of the employees and hence will require time to make such changes. In these situations, a participation period is a useful and practical solution. 6.2 A participation period refers to a limited period of time where the purchaser participates in the vendor s superannuation fund. It is intended to give the purchaser a reasonable amount of time to establish its own superannuation fund. The members continue to accrue the benefits that they were accruing prior to the sale. It requires three parties to agree: the vendor, the purchaser and the trustee of the vendor s superannuation fund. In order to achieve such agreement, it is necessary to specify the details of the participation period in an appropriate document. 6.3 The document governing the period of participation will be mainly concerned with specifying the contributions that are to be paid by the purchaser and how to deal with any surpluses or deficits that arise during the period of participation. Other matters detailed will include the meeting of expenses of administration, benefits to be accrued during the period of participation and amounts to be paid out of the fund at the end of the period of participation. 6.4 A common way of handling any surpluses or deficits that emerge during the participation period is to define the aggregate asset value to be paid out in respect of the relevant members at the end of the participation period as being the sum of: (c) transfer values calculated as at the effective date of changing employment, plus, actual contributions paid by the purchaser and employees of the purchaser since the change, plus, actual investment returns over the period since the change, less the expenses, tax and any benefits and surcharge paid during the participation period. 6.5 This approach means that the purchaser and the employees of the purchaser will remain exposed to investment risks during the participation period. However, it also means that the vendor and the vendor s employees are protected from any surpluses or deficits arising in respect of employees of the purchaser. 6.6 During the period of participation, the purchaser will be establishing its own superannuation fund in preparation for receiving the transferring assets and benefits. 6.7 Particular care must be taken in measuring the investment return during the period of participation. The period of participation will bear no resemblance to the normal fund financial year and so there may not be readily available asset valuations or revenue statements over the appropriate period. In such cases, it is necessary to make suitable estimates of the investment performance. Where the fund has a significant portion of its assets invested in a unitised pooled superannuation trust, that trust s manager will have a method of valuing units on a regular basis thus permitting the easy calculation of investment returns, provided that the trust s manager s unit pricing methodology is acceptable and sufficiently frequent. In respect of assets held directly, the trustee will need to make its own valuations. It is possible that the fund s normal policy for crediting interest on an interim basis could be adopted for this purpose, but it will again be necessary to check that policy for appropriateness. 17