Head to head: Should plan sponsors buy annuities via insurers or go DIY?

Although annuity purchases have become an important pension risk management option over the last decade, a countertrend is emerging for plan sponsors that wish to keep the annuity purchase premium, including associated profit margins, within their plan. How? By applying the same proven and tested recipe that’s been used by insurers.

Read: Bulk pension annuity purchases reign supreme in the U.K.

A do-it-yourself annuity strategy has two main objectives. The first one is to insulate the plan from interest rate and cash flow risks — which I’ve seen as a top reason for defined benefit pension plans deficits over the last few decades, through fixed income products (similar to typical liability-driven strategies). The second objective is generating returns in excess of liability growth through sufficient exposure to credit (i.e., corporate bonds, mortgages) and illiquidity premiums (i.e., private debt). This can lead to 50 to 100 basis point spreads.

Among the potential candidates for implementing DIY annuity strategies are plan sponsors with moderate deficits wishing to reach fully-funded positions without having to make additional contributions. Given recent reforms in many Canadian jurisdictions to relax solvency funding requirements, these plan sponsors may be able to achieve their objectives through a DIY approach in a framework with a very limited risk exposure.

Read: A do-it-yourself approach to buy-in annuities

While purchasing annuities is a well-understood strategy and will remain an optimal choice for many plan sponsors, it’s an irrevocable decision, requiring sponsors to consciously elect to sell what could be an asset — their plan — in order to eliminate ongoing plan costs and risks. On the other hand, some plan sponsors may be able to do it by themselves by operating their plan under the same limited risk exposure framework that insurers employ and keep the associated return.

Benoit Labrosse, partner of asset and risk management at Morneau Shepell Ltd. (now LifeWorks Inc.)

Each solution has its merits and the characteristics and specifics related to an organization or its pension plan need to be carefully analyzed before concluding that a solution or an approach is superior to another.

The arguments that would often favour proceeding with group annuities are numerous but they boil down to the plan administrator’s willingness to take on risk. Purchasing annuities means that you effectively transfer the investment — the actuarial basis and the longevity risks, to name a few — to a third-party insurer that can invest without worrying about tracking the plan solvency liabilities that many pension plans are subject to, now or at time of exit.

Read: GM Canada transferring $1.8BN in pension liabilities via group annuity buyout

A group annuity can be deconstructed into a solution that combines a minimal investment risk strategy, (i.e., a liability-driven investing strategy) and a longevity insurance product. In order for this equation to hold, investment risk will need to be assumed to earn a return, which will not only cover the longevity insurance cost but also the incremental yield over the solvency rate the insurer can achieve with its investment strategy.

Public and private investors don’t expect that an organization’s pension plan will be the vector of growth or value creation. Well-rewarded risks are likely better taken elsewhere than in the pension plan and, as such, greatly reducing or even eliminating pension risks is often desirable.

An attractive yield for less risk is what makes group annuities a sound proposition that has caught the eye of many plan sponsors and administrators of closed plans. Another non-negligible argument favouring group annuities is peace of mind in a period of market turbulence, which has occurred more frequently in the last 20 or so years.

Read: FSRA issues new guidance for pension plans transferring commuted values, purchasing annuities