The Observer

ARTICLES OF INTEREST

Growth of the group annuity market in Canada and other DB risk transfer activities

by Marc Drolet, Morneau Shepell

Defined benefit (DB) pension plans are generally in much better shape now than they were after the financial crisis of 2008. Now that an increasing number of DB pension plans have reached a solvency ratio of 100%, a discussion about risk management and possibly risk transfer strategies has never been more pressing.

DB pension plan risks and risk management options

Two of the key risks facing DB pension plans are (i) investment risk (mainly market and interest rate risks) and (ii) longevity risk (risk that plan participants will outlive the expectations).  Sponsor’s objectives, plan features as well as member demographics are central to developing an appropriate risk management strategy.

A common approach to managing investment risk is to diversify investments and determine an appropriate allocation between return seeking assets and liability hedging assets. The latter is a liability driven approach to fixed income investing intended to minimize interest rate risk – by either duration or cash flow matching techniques.

Then there is longevity risk – the risk of having plan members living longer (and therefore receiving more benefits) than expected. I believe plan sponsors don’t typically perceive longevity risk to be significant in comparison to investment risk. This is understandable since it will take quite some time for the full impact to be realised (often this is spread over the future lifetime of the plan). However, this risk is not only theoretical, it’s real. The general life expectancy has increased significantly in the past decades. According to Statistics Canada, life expectancy at birth progressed about 10 years for males and 7 years for females from 1970 to 2009. Researches and studies in this field have led to many changes in mortality assumptions over the years, which has resulted in increases in liabilities and in turn led to higher funding requirements for sponsors. In the past 15 years, standard actuarial mortality tables changed at least 3 times resulting in increases in liabilities of up to 10% over that span.

In fact, a new improvement scale (scale MI-2017) published by the Canadian Institute of Actuaries has started to be used by Canadian actuaries.  This new scale increases pension liabilities by about 0.5% compared to the CPM-B. The estimated increase in life expectancy resulting from the change in improvement scale is shown in the Table below.

 
Increase in life expectancy resulting the change in improvement scale* (CPM-B to MI-2017)
 
Current Age Increase in life expectancy (years)
Male Female
20 1,1 1,1
30 0,9 0,9
40 0,7 0,8
50 0,5 0,6
60 0,2 0,4
70 0,2 0,2
80 0,1 0,1
 
* Using the CPM2014 mortality tables, sex-distinct

A plan sponsor has no control over the longevity of its underlying population, therefore longevity risk represent a systematic risk for plan sponsors. While systematic market risk is typically rewarded with higher returns for investors over the long run, we can’t say this reward/risk relationship holds for longevity risk. One way to address longevity risk is to use more conservative mortality assumptions. There is also the option to hedge longevity risk and retain investment risks by entering into a longevity swap agreement with an insurance company. In such agreements, a mortality table is set as a mortality benchmark and experience gains & losses with respect to this benchmark are exchanged between the sponsor and the insurer. These deals are commonplace in the U.K. but not yet popular in Canada. For plan sponsors who want to transfer longevity as well as investment risk there is also the option to purchase annuities. Under an annuity purchase contract, any difference between the expected investment returns and life expectancy is borne by the insurance company – effectively transferring risks from the pension plan to the insurer.

Annuity Purchase

Not too long ago, purchasing annuities was usually the result of a plan termination. Now, an increasing number of plan sponsors are purchasing annuities as a de-risking strategy. Insurers saw a need and provided solutions for plan sponsors. There have been many innovations in the risk transfer space since the market crash of 2008: longevity insurance, buy-in annuities, and combining plans with complementary indexing formulas to only name a few.

For annuity purchases, there are two broad categories: buy-in annuities and buy-out annuities. Buy-in annuities allow the plan sponsor to transfer investment and longevity risk to a third party, for a price, but retains the administration of the plan. From the pension fund perspective, a buy-in annuity is similar to an investment that will perfectly match the pension payments of insured participants – no more surplus, no more deficits. In other words, it’s the perfect LDI investment; no tracking error, no longevity risk. The buy-out annuity on the other hand, transfers not only the longevity and investment risks but also the administration to insurers.

The graph below shows the evolution of annuity purchase transactions in Canada since 2007.


 
There is significant growth in the Canadian annuity market since 2012 and I expect that trend to continue for some time. The improvement in funded status in the past few years and increased awareness of plan sponsors around risk management are certainly the main drivers of this trend.

There is currently a small number of insurers offering group annuity products, but there have been new entrants joining the market and I think others may follow suit. Even Air Canada is seeking finance ministry approval to form its own life insurance company.

Moreover, I think that the recent changes in pension legislation in Québec and Ontario may increase this trend. These provinces now provide, along with British Columbia, the option for companies to purchase buy-out annuities and get a full discharge of responsibility (i.e they have removed the boomerang risk). In addition, buy-out annuities may certainly be appealing for organizations that wish to reduce the size of DB plans on their balance sheet.

There is currently willingness and capacity from insurers to take on more volume. Insurers have significant assets and resources allowing them to invest in fixed income instruments such as private debt in order to get additional yield compared to some pension funds. I see organizations getting very good annuity pricing from insurers right now – not just for blue-collar groups, but white-collar groups too. It is also possible that this is because the supply currently exceeds the demand. There are cases where plan sponsors can purchase annuities and end up getting a greater implied rate of return than with a LDI strategy!

However, as more organizations turn to annuities and the demand increases, we may see reinsurers being more active in the market to help insurers increase their capacity, which may create additional friction costs that will be reflected in premiums. In addition, as demand increases, insurers may have difficulty sourcing enough quality assets to meet the demand. This in time could drive up costs for latecomers.
 
Early Adopters Advantage

Plan sponsors should carefully determine what type and amount of risk they are willing to keep and look effectively at how to manage that risk. An important step for every sponsor is to understand their mortality profile to take risk management decisions based on informed data, especially for larger DB plans for which mortality data might be available.

Some organizations believe that the higher expected return is worth the investment risk and can better handle the ensuing contribution and pension expense volatility. With the right risk management framework and boundaries, I certainly see merit in this. However, it may not be the case for longevity risk – the unrewarded risk. Plan sponsors that bear this risk should do so knowingly, as there are options available to transfer it to a third party.

For organizations that want to reduce the size of their DB plans on their balance sheet, or simply reduce volatility, an annuity purchase is definitely worth looking into. The annuity purchase market currently favors the sellers (plan sponsors), but as demand increases the tide may change in favor of the buyers (insurers). I think there is an early adopter advantage in play here and many plans are certainly capitalising on this.

We are now in the longest bull market in history and DB plans are in better shape than they have been in years. Many plan sponsors are deciding that their current risk management strategy has run its course and are adopting a new strategy going forward which involves transferring away some of that risk. Is it time for your plan to do the same?

Marc Drolet is a Principal in Morneau Shepell’s Asset and Risk Management department. He has more than 15 years of experience in pension consulting and risk management and is a key member of the Pension Risk Transfer team at Morneau Shepell. Marc has a Bachelor of Science degree in Actuarial Mathematics from the University of Québec in Montréal and is a Fellow of the Canadian Institute of Actuaries and the Society of Actuaries.