Canadians now are living longer and healthier lives than the generations past. According to Statistics Canada, Canadians are already living about 20 years past age 65 and the number of centenarians has increased by more than 25% since 2006. And, the number of seniors aged 65 and over increased by 14.1% since 2006.
Canadians rank health as their top priority for New Year’s resolution according to the Sun Life Canadian Financial Checkup 2011. But if staying healthy means longevity, then longevity may also mean receiving pension payments for longer. Are Canadian DB plans ready for the heavy lifting?
The last few years have been a real struggle for DB plans. Falling interest rates, volatile stock markets and increasing life expectancies have made keeping a DB plan in good shape an uphill battle. For example, Government of Canada long bond yields have fallen from 4.33% at October 31, 2008 to 2.27% at October 31, 2012.
Unfortunately, most Canadian pension plans are using life expectancy tables that were developed close to 20 years ago to calculate how much money they have to set aside to pay future pensions. So, they may be underestimating the life expectancies of their plan members and, consequently, their liabilities.
The exact cost of underestimating life expectancy will depend on the plan’s characteristics. A simple rule of thumb is that an additional year of life expectancy for a 65-year-old results in a 3% to 4% increase in pension liabilities.
The good news is that there are several solutions available in Canada to help plan sponsors manage longevity risk.
| Longevity insurance | Insurance against the possibility that plan members live longer than expected, with the insurer covering the resulting extra cost of additional pension payments. |
| Annuities | An insurance contract that transfers all the risks, including longevity risk, to an insurer’s balance sheet. Annuity buyouts can be used to transfer all risks and all administration to an insurer. Annuity buy-ins can be used to increase flexibility for plan sponsors. An annuity buy-in is an investment of the plan that requires no additional cash contribution and triggers no accounting settlement (Plan sponsors should confirm this with their auditors if they need an accounting settlement.) It is also invisible to plan members. |
| Plan design changes | Changes to future benefits or cost-sharing arrangements for all members or new members only. |
Learning from the experts
U.K. plan sponsors have been working on de-risking programs for almost a decade. Since 2006, more than £40 billion of U.K. DB pension liabilities have been transferred to insurance companies, including 12 longevity risk deals covering more than £14 billon of liabilities.
Plan sponsors in North America are starting to get their plans in shape. In 2011, a record C$1.4 billion of pension liabilities were transferred to Canadian insurers. In 2012, General Motors and Verizon announced jumbo annuity deals to help manage their pension risk.
Demand for de-risking solutions is increasing, and there may be a first-mover advantage for plan sponsors that get on the treadmill quickly.
Toning your plan
Hidden longevity costs can be a heavy weight. Longevity risk can have material financial consequences. This hidden longevity cost could be especially large for a pension plan with a high proportion of young members or female members, perhaps as much as 5% to 10% of liabilities.
Getting in shape is becoming more affordable. Research conducted by Sun Life in 2012 shows that an annuity can provide a higher rate of return than a matching bond portfolio. This means that the longevity and investment risk protection provided by annuities can be free.
De-risking can improve corporate muscle. Research from Kelvin Wilson at Grant Thornton UK LLP in 2011 found empirical evidence that U.K. companies that have de-risked their pension plans enjoyed an average increase of more than 10% in their share price. Why? Because removing pension risk reduces future earnings volatility and allows management to concentrate on the core business.
Create a DB fitness plan
To get their DB plans in shape, plan sponsors should follow these key steps:
- educate key stakeholders and decision-makers;
- understand the characteristics of the plan that will impact the life expectancy of members;
- contact a pension consultant to help evaluate available solutions; and
- contact an insurer for a quote showing the cost of risk transfer.
The path to fitness begins with a solid plan. Make a New Year’s resolution for your DB plan now and get in shape for the future.
Heather Wolfe is assistant vice-president, defined benefit solutions, with Sun Life Financial. heather.wolfe@sunlife.com