Some Canadian companies, their pension funds hit with a one-two punch of low interest rates and increased employee life expectancy, are looking to insurers to take on all or part of their defined benefit (DB) pension risks.
In turn, Canadian life insurers are hoping this relatively new business of “derisking” – or transferring of risk – will turn into a thriving segment of their operations by charging a premium for the annuities they set up to maintain the pension funds as well as fees for their investment expertise.
“We’re really bullish on this business; we certainly see this as a growth market,” said Brent Simmons, senior managing director, DB solutions, Group Retirement Services at Sun Life Financial.
Nowadays, with retirees living longer, fewer active members than retirees and investments not meeting expectations partially because of low interest rates, a number of pension plans are falling into deficit position. For some, cash that had been earmarked to grow the business is now being diverted to fund the pension plan, causing significant ramifications for their bottom lines.
“It’s coming to the point where some employers are on the verge of not being in existence because of their pension liabilities,” said Clark Steffy, Industrial Alliance regional vice president, sales Ontario, Atlantic and Western Canada.
Some senior executives of publicly traded companies find they’re spending a lot of time explaining their lower earnings per share numbers to investors and analysts – not because of anything wrong with their core business, customers or products – but because of their pension plan’s financial problems, said Mr. Simmons.
“Over the past few years, employers with defined benefit pension plans have had a lot of headaches; [after all], it’s the employer who is responsible for keeping all the pension promises,” said Mr. Simmons. “[But] management just wants to get back to running their core business. They don’t want to be distracted by having to put more cash in the plan and having to explain earnings per share numbers.”
Under derisking, all or some of the pension obligations of an employer are transferred to an insurance company, which generally takes out an annuity to pay the pension obligations – something insurers already do as part of their regular business.
“You look at what an insurance company does and it manages mortality and longevity risk,” said John Aiken, insurance analyst with Barclays Capital. “By taking on the longevity risk of a pension plan, it dovetails in exactly with what they do in terms of their core life products – life insurance and annuities. So from that standpoint it is just a natural extension of their business model trying to fill a need in the marketplace.”
The annuities act as a kind of “super bond” to back retirees, explained Mr. Simmons. Sun Life determined that the rate of return it was offering on its annuities was higher than what the average plan sponsor could get on a typical bond portfolio.
Insurers also have more actuarial expertise and greater economies of scale than smaller employers managing their own pension funds. And insurers are often able to find and use more profitable investments than small employers. Sun Life’s “secret sauce,” said Mr. Simmons, is that it is the originator of one of the largest infrastructure funds in Canada. “So we have this wonderful stream of infrastructure deals coming through and we can share some of the returns with the plan sponsors/employers and offer a higher return than they might otherwise get.”
Derisking has been a thriving business outside of Canada for a while now. In Britain, the market has skyrocketed to £10 billion a year from about £1 billion a year in just a few years, said Mr. Simmons.
The process has taken on greater dimensions in the U.S. with two recent high-profile transactions. This past June, General Motors said it would reduce its pension obligations by US$26 billion by handing over all assets and requirements of its salaried retiree pension program (those who didn’t opt for a one-time payment) to Prudential Financial through the purchase of a group annuity contract. And in October, Verizon Communications Inc. announced it would be transferring $7.5 billion in pension obligations, also to Prudential, removing a quarter of its long-term employee retirement responsibilities.
In Canada, derisking is just “on the cusp,” said Simmons. The Canadian market is standing at close to $1.5 billion, but he believes the Canadian market will take off in 2013 as it has in Britain.
In 2011, Sun Life completed the largest risk-transfer deal in Canadian history – $400 million in pension assets covering 2,000 people. Sun Life took over the entire pension – from administration to portfolio management, sending out tax forms and providing education. For all 2011, derisking accounted for $750 million in pension assets at Sun Life, said Mr. Simmons. A similar amount was expected for 2012.
Mr. Steffy said Industrial Alliance, which is holding talks with a number of pension plans, agrees the next few years will see substantial growth in the derisking market, particularly important among smaller pension plans which face greater mortality risk just by virtue of their size.
Most of the larger pension plans – those in the area of $100-million – often have trust companies as their custodians. “The smaller plans are better off in insurance platforms where they can have access to a number of different fund managers and can easily move from one money manager to another,” said Mr. Steffy.
Some firms with DB plans are fearful that if they get a total buyout of their plans from the insurers, they will have to fund up their deficits as required by law, a situation that could prove to be very costly.
“So what we’re trying to find are ways for companies to get out of DB plans more opportunistically,” says Mr. Steffy. “So, for example, if interest rates bump up briefly there are gains to be had and we want to capture those gains before they disappear. This is difficult to do if you’re a small company. But we can set up a system that automatically triggers the gains before they disappear. Most pension committees aren’t nimble enough to do this.”
While some employers opt to give over the workings of the entire pension to insurers, there are a number of different strategies available. “We are coming to the table with a very customized approach,” said Mr. Steffy. “For some companies, derisking can mean just a tinkering or a dampening of risk and that’s often where it gets started. The next step is to get rid of equity risk by moving to fixed income. After that, getting rid of interest rate risk is accomplished by matching the duration of the bond portfolio to the liabilities. And, if the plan wants to get rid of longevity risk, it can purchase annuities. So it can mean a tweaking of a strategy or a full-scale immunization against risk.”
Insurance companies have a number of tools they bring to the table, such as the group annuity buy-in, which allows companies to protect against interest and equity market risk, but also protects against longevity risk. Under a buy-in, there would be a transfer of some risk to the insurer, but the employer’s plan sponsor can continue to manage the plan with added certainty over pension costs, explained Mr. Steffy. Often, annuities can be bought gradually on a “glide path” to capture gains in interest rates. The remaining assets in the pension plan are treated by the employer as an investment on its books and any deficit may not have to be funded immediately.
In most jurisdictions, a traditional buy-out would see a full and complete transfer that would come off the books almost like a plan windup. In this case, there is an accounting impact.
The group annuity buy-in was recently approved by the Office of the Superintendent of Financial Institutions for federally regulated pensions. Approvals for provincially regulated pensions have not yet been received.
In July 2012, Aon Hewitt released a report on the performance of a plan that used “a few simple de-risking strategies” since the start of 2011. Those strategies included increasing bond investments to 60 per cent from 40 per cent of the portfolio and investing in long bonds to better match liabilities. The result? “The de-risked plan would have experienced a 75 per cent solvency ratio as at June 30, 2012 as opposed to 66 per cent for the median plan,” states Aon Hewitt.
In exchange for taking on the risk, pension plans pay a premium made up of a couple of components, said Mr. Aiken. One is the fee for managing the investments themselves, but like any other annuity, there is also a cost to manage the longevity risk.
While those returns have started to show up on insurance company balance sheets, they’re not yet making a huge impact on the business because it’s so new, he said.
Even though derisking has traditionally been a purview of DB plans, Mr. Steffy said some pension plans that offer defined contribution plans are also considering how to derisk.
Looking to the future, Simmons said he is eagerly awaiting a “jumbo” deal to come to fruition soon. “We’re really optimistic that 2013 will be our tipping point year.”