The current economic environment is particularly challenging for defined benefit pension plans. Many plans have to fund according to the solvency test, using asset market values and long-term bond rates to discount liabilities. The current 30-year Government of Canada bond yield is 2.5%, which is close to its historical low. Mark to market pension accounting rules result in volatile financial statements in the private sector. Plan sponsors are looking for new ways to invest plan assets to achieve two key objectives:

  • Generate a reasonable investment return
  • Reduce asset-liability mismatch risk

The result has been a big increase in liability-driven investment ( LDI) strategies: investing assets to better match liabilities thereby reducing interest rate and inflation risk. LDI can mean many things, but common outcomes from LDI include:

  • Longer duration bond portfolios
  • Higher bond weightings and lower equity weightings
  • Bonds that match liabilities closely, either by duration or cash-flow

One LDI strategy that has started to get more attention recently is the purchase of annuities. Purchasing annuities is the ultimate LDI strategy. You remove plan liabilities altogether and shift them to an insurance company.

When considering an annuity purchase, you should compare annuities to the fixed income part of your portfolio instead of your total portfolio. Over the last 10 years annuity purchases for pension plans have not been that popular due to the perception that annuities are “expensive” compared to the alternative of investing in bonds (insurance companies are conservative investors and also build in their expense and profit margins).

Is this true though? In many cases the answer is no. A switch from a typical fixed income portfolio to annuities could result in a higher expected return, with the added benefit that the plan also removes the longevity risk of its retirees. Longevity risk should not be ignored. Canadian life expectancy for retirees has been increasing by one year per decade since the 1960s. According to analysis performed by Sun Life, over the last five years the yield advantage of annuities over bonds has varied between 0.5% and 1.5% per year.

The main reasons why annuity purchase rates could exceed bond portfolio yields, even after allowing for insurance company conservatism, expenses and profit are:

  • Insurance companies may invest in longer duration bonds than the typical pension plan, resulting in a higher yield (note that this impact is reduced for pension plans investing in long-term bonds already).
  • Insurance companies generally do not invest much in federal or provincial bonds. Instead they earn a credit spread by investing in bonds with a higher yield: mortgages, corporate bonds and infrastructure bonds.
  • Insurance companies can earn an illiquidity premium by investing in private debt instead of liquid (i.e. tradeable) securities.

The comments above don’t apply to the pricing of inflation-indexed annuities, i.e. annuities that provide for full CPI increases. These annuities will still look expensive compared to the typical investment alternative of real return bonds. The reason is that the insurance companies don’t have the same choice of investments to back inflation-indexed annuities. The options for plan sponsors to take advantage of potential favourable annuity pricing include:

  • Buy non-indexed annuities and keep the inflation risk in the plan
  • Buy indexed annuities for a fixed rate of indexing such as 2% per year

One issue to consider with an annuity purchase is the concentration of credit risk in the insurance company. If the insurer goes bankrupt your retirees may have their pensions cut in future. To reduce the credit risk you should carefully review insurer credit ratings and financial strength before making an annuity purchase. Also, you could spread a large annuity purchase across multiple insurers.

Assuris is the non-profit insurance industry organization that protects policy-holders if their insurance company fails. They provide protection to retirees in the event of insurer bankruptcy. The amount of protection provided by Assuris is the higher of 85% of the monthly pension and $2,000 per month.

I recommend that pension plan sponsors build annuity purchase strategies into their asset mix decisions and asset-liability modelling. Since annuity pricing can vary significantly over time it is worthwhile to regularly monitor the annuity market by getting quotes from the large Canadian insurance companies. The Canadian Institute of Actuaries also publishes a monthly survey of generic annuity quotes that can be used as a reasonable proxy for annuity prices.

Insurance companies are working to increase their capacity to take on larger annuity purchases, e.g. up to $1 billion in a single deal. However, for larger pension plans (i.e. in excess of $5 billion in assets), an annuity purchase may not be practical. There is a potential solution that we will discuss in a future blog. Here’s a hint: invest like an insurance company to match your retiree liabilities.