Re: Towers Watson Submission on Draft FSCO Investment Guidance Note: Buy-In Annuities for Defined Benefit Plans (IGN-001)

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1 175 Bloor Street East South Tower, Suite 1701 Toronto, Ontario M4W 3T6 Canada T towerswatson.com November 7, 2014 Pension Policy Unit Financial Services Commission of Ontario 5160 Yonge Street Toronto ON M2N 6L9 pensionconsultation@fsco.gov.on.ca Re: Towers Watson Submission on Draft FSCO Investment Guidance Note: BuyIn Annuities for Defined Benefit Plans (IGN001) Towers Watson welcomes the opportunity to provide comments on the Financial Services Commission of Ontario s draft Investment Guidance Note IGN001: BuyIn Annuities for Defined Benefit Plans. Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. Towers Watson employs about 14,000 associates worldwide, with approximately 350 engaged in providing services to Canadian pension plans. Our comments are as follows: 2.0 Prudent Investing and Due Diligence The Guidance Note states that an administrator can only invest in a buyin annuity if permitted by the plan and the plan s statement of investment policies and procedures (SIP&P). We assume this means that plan documents need not expressly allow buyin annuities but that buyin annuity purchases are allowed unless it is specifically prohibited in the plan or the SIP&P. We think that the Guidance Note should clearly state this. A buyin annuity is a lower risk plan investment so it would also be helpful if the Guidance Note clarified that this lower risk can be taken into account when determining a plan s overall target asset mix and risk tolerance. 2.2 Pricing and Transaction Costs While we generally support the requirement that administrators should seek quotes from multiple insurers when choosing an insurer to issue the buyin annuity, it would be reasonable to consider an exception if the buyin annuity premium is immaterial to a plan s overall investments. An example of this would be a buyin annuity for a small portion of a plan s benefits placed with an insurer when the plan already has a significant buyin annuity arrangement in place with the same insurer. In a case such as this, the cost of a full due Page 1 of 4

2 November 7, 2014 diligence process to seek current market pricing might exceed the potential cost savings relative to the buyin annuity premium. As well, the Guidance Note focusses on price when determining with which insurer to place the buyin annuity. There may, however, be other important factors to consider besides price and this should be stated in the Guidance Note. Examples of other potentially relevant factors include the financial strength of an insurer, the desire to mitigate counterparty risk and Assuris coverage provided to individual annuitants upon conversion to buyout annuities. 4.0 Actuarial Funding Valuation Reports The Guidance Note states the following: An acceptable method of valuing a buyin annuity to be included in the assets of an actuarial funding valuation report would be to set the asset value equal to the value of the pension benefits covered by the buyin annuity (if the buyin annuity provides an exact hedge to the covered pension benefits), calculated on both a going concern and solvency basis. This could result in the asset value of the buyin annuity being different under the going concern and solvency valuations. Presumably, the above quote from the Guidance Note implies that the going concern discount rate would be based on a blend of the implied yield on the price of the buyin annuity and the longterm expected investment return on the remaining pension plan assets. The buyin annuity asset value would then be set equal to the pension benefits covered by the buyin annuity using the blended discount rate. Our view is that the valuation method should not be overly prescriptive and that as long as the valuation of a buyin annuity assets and liabilities is done in accordance with acceptable actuarial practice, actuaries should have some options (such as those described below) in how to do so. If a blended discount rate as described above is used, the implied yield on the buyin annuity could be based on group annuity pricing conditions on the actuarial valuation date, as opposed to the yield implied in the original purchase price of the annuity. A buyin annuity can be viewed as a type of fixed income investment and reflecting yields prevailing on the actuarial valuation date is consistent with the approach commonly used by actuaries to estimate the longterm expected return on other fixed income investments for purposes of establishing the going concern discount rate (as opposed to using the applicable yield when a fixed income investment was purchased). Also, using the yields prevailing on the valuation date enhances consistency between the treatment of the buyin annuity in the going concern and solvency valuations. An actuary should have the option of valuing the buyin annuity asset using the implied yield on the price of the buyin annuity, even when a blended discount rate is used to value Page 2 of 4

3 November 7, 2014 the plan liabilities. The reason why an actuary should have this option is demonstrated in the illustrations summarized in the Attachment to this submission. For purposes of the illustrations, we have assumed that a buyin annuity is purchased for the plan s retirees. The plan s bond portfolio is used to pay the annuity premium and the amount of the premium is exactly equal to the value of the bond portfolio at the time of the purchase (i.e., ). Approach I in the Attachment is based on valuing the buyin annuity asset using a blended discount rate, consistent with the approach suggested by the Guidance Note. Under Approach I, the going concern funded position of the plan deteriorates by 86,777 due to valuing the buyin annuity asset using a blended discount rate, even though all that has occurred by purchasing the buyin annuity is that one type of fixed income instrument (conventional bonds) valued at has been exchanged for another type of fixed income instrument (a buyin annuity) valued at. This apparent discrepancy is avoided by valuing the buyin annuity asset using the implied yield on the price of the buyin annuity, as illustrated in the Attachment under Approach II. Where the buyin annuity provides an exact hedge to the covered pension benefits, an actuary should also have the option of valuing both the buyin annuity going concern asset and liabilities using the implied yield on the price of the buyin annuity. The going concern discount rate used to value the pension benefits not covered by the buyin annuity would then be based on the longterm expected investment return on the remaining plan assets. This approach, illustrated in the Attachment under Approach III, likely best reflects the risk management strategy of the plan sponsor (i.e., the immunization of the benefits covered by the buyin annuity) and enhances consistency of the treatment of the buyin annuity in the going concern and solvency valuations. It would also be useful to explicitly state that the buyin annuity assets and liabilities are included in the transfer ratio and, if applicable, the calculation of the maximum letter of credit face value. 6.0 Pension Benefits Guarantee Fund Though implied, this section should explicitly state that only Ontario members need to be included in the PBGF assessment base. 7.0 Foreign Insurance Companies Since footnote 4 is not about foreign insurance companies, it should be moved to another section (for example, section 1.0 or 2.0). It could also be moved to the body of the Guidance Note to give it greater prominence. * * * Page 3 of 4

4 November 7, 2014 We greatly appreciate the opportunity to comment on the draft Guidance Note. We would welcome the opportunity to address any questions you may have regarding our comments. Sincerely, Gavin Benjamin Senior Consultant Towers Watson Canada Inc Karen Figueiredo Director, Canadian Investment Leader Towers Watson Canada Inc Rohan Kumar Senior Consultant Towers Watson Canada Inc. rohan.kumar@towerswatson.com Attachment: Page 4 of 4

5 ATTACHMENT Treatment of BuyIn Annuity in Going Concern Funding Valuations Illustrations for BuyIn Covering Plan Retirees BuyIn Purchased with Available Bonds Plan Characteristics Expected longterm return on equity portfolio: 8.0% Expected longterm return on bond portfolio: 4.0% Yield implicit in buyin annuity price: 4.0% Duration of active going concern liabilities: 20.0 Duration of retiree going concern liabilities: 10.0 Duration of normal actuarial cost: 20.0 Plan Assets equities bonds buyin annuity total plan assets Approach I: Value BuyIn Asset Using Blended Going Concern Rate Prior to BuyIn Transaction Effect of BuyIn After BuyIn Transaction Balance Sheet Rate Balance Sheet Balance Sheet () 413,223 (86,777) Rate Going Concern Liabilities actives (586,777) 6.0% (586,777) 6.0% retirees (413,223) 6.0% (413,223) 6.0% total liabilities () () 413, ,223 Surplus / (deficit) (86,777) (86,777) Normal actuarial cost 200, % 200, % Notes: 1. It is assumed that no asset smoothing is used for purposes of the valuation. 2. Where a blended discount rate is used, the rate is determined as the weighted average of the longterm expected returns on the equity and bond portfolios and the implicit yield on the buyin annuity. For simplification purposes, other adjustments to the discount rate due to factors such as expenses, diversification and rebalancing, and a margin for adverse deviations have been ignored. Page 1 of 2

6 ATTACHMENT Treatment of BuyIn Annuity in Going Concern Funding Valuations Illustrations for BuyIn Covering Plan Retirees BuyIn Purchased with Available Bonds Plan Assets equities bonds buyin annuity total plan assets Approach II: Value BuyIn Asset Using Yield Implicit in Annuity Pricing Prior to BuyIn Transaction Effect of BuyIn After BuyIn Transaction Balance Sheet Rate Balance Sheet Balance Sheet Rate () Going Concern Liabilities actives (586,777) 6.0% (586,777) 6.0% retirees (413,223) 6.0% (413,223) 6.0% total liabilities () () Surplus / (deficit) Normal actuarial cost 200, % 200, % Approach III: CarveOut Valuation of BuyIn from Remaining Plan Assets and Liabilities Prior to BuyIn Transaction Effect of BuyIn After BuyIn Transaction Balance Sheet Rate Balance Sheet Balance Sheet Rate Plan Assets equities bonds buyin annuity total plan assets () Going Concern Liabilities actives (586,777) 6.0% 179,293 (407,484) 8.0% retirees (413,223) 6.0% (86,777) () 4.0% total liabilities () 92,516 (907,484) Surplus / (deficit) 92,516 92,516 Normal actuarial cost 200, % (61,111) 138, % Page 2 of 2