Defined Benefit Versus Defined Contribution Pension Plans: The Basics
When purchasing an existing business, many buyers are understandably reluctant to assume obligations under a target’s defined benefit (DB) pension plan. Under a traditional DB plan, members (i.e. plan participants) are entitled to a guaranteed pension amount calculated by a formula. While active employees may contribute to such plans, each Canadian jurisdiction’s laws place the employer squarely on the hook if the plan’s assets are not enough to fund the promised benefits – and, as many of us have now seen, DB plans’ current funding woes are well-publicized. In addition, DB plans are subject to a complex regulatory scheme and accounting rules that often have a negative effect on financial statements. For these reasons, many buyers undertake careful due diligence of a target’s DB plans and, if appropriate, work with their lawyers to minimize these liabilities.
One alternative to the traditional DB plan is the defined contribution (DC) pension plan. Under a DC plan, employer (and, if applicable, employee) contributions are fixed, but the ultimate retirement benefit is not. At retirement, members are entitled to the sum of those fixed contributions over their working years, plus whatever investment return their accounts have achieved. Members, not employers, bear the investment risk and longevity risk (i.e., the risk that their plan account is insufficient to fund an adequate retirement income and the risk that they will outline their savings).
Owing to their financial predictability and apparent straightforward nature, some potential buyers may be tempted to pay less attention to a target’s DC plans than they would to a target’s DB plans in the due diligence process; however, as I will explain in my next post, this could be a costly mistake. Stay tuned.