The Age of Annuities

Through 2013, however, plan sponsors saw some respite due to a slight increase in interest rates, strong stock performance and large cash contributions. The combined impact of these factors meant that, for many plans, solvency deficits were cut in half. There was light at the end of the (underfunded) tunnel.

During the years of underfunding, sponsors became increasingly aware of the risks their plans exposed them to and wanted to make changes. But the primary challenge to implementing such strategies was related to cost. If the higher returns expected from equity investments were switched for lower-returning (but safer) bonds, the only way to close the funding gap was higher contributions.

With substantial improvements in funding positions through 2013, many plan sponsors finally managed to put de-risking strategies into action. Those that had implemented dynamic strategies may have seen trigger points reached that led to movements away from equities and into bonds.

Reading the Signs

To date, plan sponsors implementing de-risking strategies have focused on managing key investment risks. But many are now realizing that a new risk is looming: longevity.

In February, the Canadian Institute of Actuaries introduced new mortality tables to help actuaries estimate the future life expectancy of Canadian pension plan members. Research shows that Canadians are living longer than ever (life expectancy at birth has increased by close to 20 years since the 1930s, to over age 81, on average), and these improvements in longevity are expected to continue for some time. While it’s good for society in general, longer life expectancy is not typically good for pension plans, as it means an increase in pension liabilities and contribution requirements. The new mortality tables will have an immediate effect on accounting and going-concern valuations— and, for some, the impact could be material.

With de-risking strategies under way, and funding positions finally seeing some upward movement, some sponsors are now planning for the next de-risking step: what to do with the pension plan once it is fully funded. For many sponsors that set out with an end-state objective of reducing risk to an acceptable level, this mission has been, or could soon be, accomplished as they realize the benefits of their own individual de-risking strategies.

For others that set out with an end state of risk elimination, discharging liabilities to insurance companies (i.e., settling liabilities) is the obvious next step. With plans as close to fully funded as they have been in a number of years, could plan sponsors see various longevity management strategies—including settlement solutions—as more appealing?

Evolving Options

Settling the pension liability means eliminating part or all of the risks associated with the pension promise. For many years, the only time sponsors would enter the insurance market to off-load or settle pension obligations was during voluntary or involuntary plan windup. Today, solutions exist that may now be considered appropriate for a variety of plans in different situations, including the following:

• plans in which an active benefit is still being accrued for many members (as a way of reducing the size of the pension plan and, hence, the impact of worstcase events on the sponsor’s business); • plans that want to unpack the risks (e.g., interest rate and longevity) to pick and choose which risks they will eliminate; and
• plans for which, ultimately, the sponsor wishes to wind up and fully discharge its obligations.

The options available vary by provider. Some solutions (e.g., buyout) are available from all of the traditional insurance companies providing group annuities, while others (e.g., longevity insurance/swaps) are offered by only a handful of organizations, often with support from the reinsurance industry.

1) Buyout – The annuity buyout is the easiest option to understand. In such a transaction, the plan sponsor transfers assets to an insurance company. In return, the insurance company takes on full responsibility—and all associated risks— for paying a group of covered (or deferred) pensioners. Such a transaction could be considered “clean”, in that monies transfer hands once, and the insurance company assumes full responsibility (i.e., both the assets and the liabilities are removed from the pension plan for the covered group).

The primary downside to such a transaction is that it can occur only if the group that is “bought out” is fully funded. Such an action may also trigger a settlement in an organization’s financial statements. While the results of a buyout may be appealing, the hurdles are often too great.

2) Buy-in – An alternative to the buyout is the annuity buy-in. A buy-in has many of the same characteristics as a buyout, in that assets are transferred to an insurance company that takes on responsibility for the risks associated with the insured population. The major difference is that with a buy-in, the annuity remains part of the plan assets, so the plan continues to pay pensioners. In effect, the pension plan holds an asset that corresponds exactly to the liability held for the insured population.

The appeal of such an approach is that there is no contribution top-up required, nor is it likely to cause settlement accounting. The buy-in can be considered a natural stepping stone to a full buyout.

3) Longevity Swap/Longevity Insurance – An annuity provides full protection against all investment risks but also guards against longevity risk (the risk of people living longer than expected). This final solution—the longevity swap or longevity insurance—is not yet fully tested in Canada, but it decouples the investment risk from the longevity risk. With such a strategy, the pension plan insures itself against the covered population living longer than expected with an insurance company or other intermediary, leaving the plan to manage the investment risks.

It’s worth pointing out that, in all options, the actual level of risk transfer can vary not only by solution but also by province of registration and plan type. It is important to weigh the residual risks to the sponsor with any transaction before proceeding.

Out of Sight?

It is commonly thought that annuities are too expensive. And when plan sponsors look at the implied cost of annuities in actuarial valuations (representing a proxy to the annuity market) and compare this with long bond or corporate bond returns, it’s easy to see why. It’s worth remembering, however, that insurance companies are using what they consider to be more realistic life expectancy assumptions than pension plans and are accepting all of the longevity risk and administration of the covered group, so such a comparison can’t really be considered “apples to apples.”

Ultimately, whether annuities are truly expensive will not be known for many years, when the last payments are made from these contracts. Through careful planning, preparation and an understanding of the annuity market, it’s possible to ensure that the sponsor understands the value proposition of settling the benefit.

Global View

It’s still too early to know what will happen to the pension settlement market in Canada—whether plan funding positions will continue to improve or whether the capacity and appetite to provide these solutions will increase. However, plan sponsors can examine how other markets have developed and what these developments might bring to Canada.

For example, in the U.S., GM and Verizon both executed jumbo-size annuity transactions in 2012. GM transferred its pension risk to an insurer, reducing pension obligations by $26 billion. And Verizon off-loaded a quarter of its obligations—$7.5 billion. These events completely blew out of the water the perceived size of the annuity market. It may be only a matter of time before there is a comparable deal in Canada.

The U.K. is the forerunner of longevity solutions: annuity buy-ins and longevity swaps were “invented” in this market in 2009, and many sponsors see such solutions as part of their ultimate objectives. In fact, 2013 alone saw longevity swap deals covering £9 billion of pension liabilities.

The size and sophistication of the U.K. and U.S. markets may seem like a distant world from Canada today—but go back to 2005, and you will see a U.K. market that was dominated by only a few companies writing annuity business primarily to plans in windup.

Now, doesn’t that sound like Canada just last year?

Tom Ault is an associate partner and risk settlement consulting leader with Aon Hewitt’s retirement practice.