No free lunch: annuity buy-ins or in-house pension management?
Annuity buy-ins are gaining popularity for defined benefit (DB) pension plans in Canada. But are they the best solution or simply a way for employers to gain some peace of mind? We explore a range of solutions that could help you meet your obligations to beneficiaries at a low cost and for every risk tolerance level.
For DB pension plans, an annuity buy-in consists of paying a single lump sum (in the form of assets and, if necessary, an additional cash amount) to an insurer in return for a guaranteed payment that covers the retirement benefits of policy members until their death.
Historically, the annuity buy-in market has been slow to gain popularity, since in general, the plan assets haven’t been sufficient to cover the required up-front payment to the insurer, forcing the plan sponsor to hand over a significant cash outlay (in addition to the pension plan’s assets). However, with recent interest-rate increases, pension plans are in healthier shape, and any additional cash outlays are generally lower than they were a few years ago.
DB pension plans are much healthier
Funded status of the average defined benefit pension plan in Canada
Source: PFaroe Moody’s Analytics 2023, as of June 30, 2023.
The main goal of an annuity buy-in is to transfer investment and longevity risks from the employer to the insurer. However, it’s important to keep in mind that in finance—like in other domains—there’s no such thing as a free lunch. In fact, despite the enviable position in which pension plans find themselves, we believe that, on average and over the long term, annuity buy-ins are still a more expensive option than the other available investment solutions. While in some cases an annuity buy-in may be preferable, we believe that for certain plan sponsors, it could be financially more advantageous to implement an investment solution that’s tailored to their own risk tolerance.
Range of solutions available
Investment risk is divided into two categories: compensated and uncompensated risks. Unlike with an annuity buy-in, no investment solution can eliminate these risks completely. However, by minimizing uncompensated risks and optimizing compensated risks, pension plans can transform investment risks into investment opportunities.
For illustrative purposes only.
To achieve this, we first establish a cash flow matching portfolio. This portfolio is entirely made up of government and corporate bonds and constructed such that the impact of interest rates, inflation, and currency fluctuations is the same for assets and liabilities, leaving little to no effect on the plan’s financial health—in other words, immunizing the portfolios from those factors.
Then we introduce a growth portfolio. This portfolio is made up of all other types of assets (other than traditional bonds) and offers the possibility of a higher absolute return in the long term. For example, real assets (e.g., real estate, infrastructure, timberland, and farmland) are potential investment options in this situation as they can provide stable, predictable cash flow (like bonds) while offering the potential for capital growth.
Lastly, we combine the matching portfolio and the growth portfolio to benefit from a wide range of solutions that are suited for each pension plan. The optimal allocation between the matching and growth portfolios depends on the plan sponsor’s risk tolerance and the risk/reward trade-off.
While the total cost of a pension plan may not be fully known until the death of the last plan member (for a plan that’s closed to new members), we can still estimate that a solution fully invested in the matching portfolio will likely cost 10% less than an annuity buy-in given the investment risk. In addition, by introducing the growth portfolio and taking on a higher level of risk, the potential savings are significantly higher.
Reduction in the cost of a pension plan (%)
Using proportional matching
Allocation to the growth portfolio (%) |
Average cost reduction relative to an annuity purchase | Probability of a higher cost than the annuity purchase rate |
0% |
10% |
<1% |
20% |
20% |
<1% |
40% |
27% |
3% |
60% |
32% |
7% |
80% |
36% |
10% |
How much are you willing to pay for peace of mind? More than 10%? How much risk are you willing to take on? These are a few of the questions you should ask yourself before choosing between an annuity buy-in and managing a plan.
Other considerations
The above cost-savings figures only take into account investment risk and represent the reality of DB pension plans. They don’t consider longevity risk (the longer beneficiaries live, the higher the cost of the plan) and aren’t applicable to indexed plans.
Indexation
An annuity buy-in is a contract by mutual agreement, so nearly any condition can be added to the contract, including inflation indexation; however, these conditions have a price, and you must be able to find a counterparty. In addition, the annuity buy-in market remains fairly small, and the more bespoke the contract becomes, the shallower the market gets, giving the insurer more pricing power. This means that for a plan seeking an annuity to cover its inflation-indexed benefits, particularly with inflation as high as it is right now, it would be harder to find an attractive price.
On the other hand, active and disciplined management of a pension plan will enable it to adapt to all types of environments and conditions, such as indexing during high inflation. Each asset class has its own attributes, reacts differently to market events, and can be used to achieve different objectives. For example, infrastructure can be useful for an indexed benefit plan, as operators can set their own prices, which can grow as with inflation, making it easier to match the pension plan’s outgoing cash flows, which fluctuate with inflation.
Longevity risk
It’s important to note that longevity risk is generally marginal compared to investment risk. For example, if retirees in a given pension plan live 3% longer than first expected (which is a very large and unlikely longevity change), the cost of the pension plan would increase by about 6%—still well below the average savings against an annuity purchase as seen above. Moreover, after a significant increase in life expectancy in recent decades, which made longevity risk trickier, its growth has been fairly limited in recent years—the impact of the COVID-19 pandemic even caused a major setback in 2020. Actuarial tables are also increasingly accurate in estimating longevity, somewhat simplifying the task of managing longevity risk.
Life expectancy growth has slowed significantly in recent years
Growth in life expectancy at birth in Canada
Source: Manulife Investment Management, Bloomberg, with latest available data as of April 2023.
When managing a plan, longevity risk will always be a factor. However, we believe that you shouldn’t be deterred by longevity risk and that when all the costs, risks, and benefits are weighed, the best solution for most pension plans is found within the range of available solutions rather than in an annuity buy-in.
Peace of mind for less
Ultimately, annuity buy-ins allow employers to purchase peace of mind by transferring investment and longevity risks; however, we don’t believe that they’re the best solution for all pension plans, even if pension plans are now healthier.
Another potential way to achieve peace of mind is by employing an outsourced chief investment officer, whether for a specific project or to fully manage the pension plan (e.g., advisory services, management and development of matching and growth portfolios, and administration). Although management fees apply, they are far lower than the cost of an annuity buy-in, and this option comes with a number of advantages, such as a vast platform of real assets and daily follow-up of investments and objectives.
In the end, although there’s no free lunch in the world of finance, it’s critical to get the best value for your—and your plan members’—money.
Important disclosures
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