The Voices of Influence iijournals.com PENSION & LONGEVITY RISK TRANSFER. for INSTITUTIONAL INVESTORS

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1 The Voices of Influence iijournals.com PENSION & LONGEVITY RISK TRANSFER for INSTITUTIONAL INVESTORS FALL 2013

2 Taking Flight: Why Canadian De-Risking Is Poised to Take Off Brent Simmons and Heather Wolfe Brent Simmons is a senior managing director of definedbenefit solutions at Sun Life Financial in Toronto, ON, Canada. brent.simmons@sunlife.com Heather Wolfe is a managing director, client relationships, of defined-benefit solutions at Sun Life Financial in Toronto, ON, Canada. heather.wolfe@sunlife.com Canada is known for a lot of great things maple syrup, talented hockey players, abundant winter sports, and vast wilderness. Canada is not known for being a leader in pension derisking, but that s about to change. Regulatory and market changes in Canada have made defined-benefit (DB) pension plans more challenging to run, and a flock of demand for creative solutions is about to land in Canada. Forward-thinking plan sponsors are taking action, hoping to capitalize on a first-mover advantage. To understand where we re going, it s important to understand where we ve been, which factors are driving change, and which trends are developing. WELCOME ABOARD: A BRIEF HISTORY OF DE-RISKING De-risking is a popular buzzword these days, used to refer to strategies that DB pension plans can use to reduce or remove risk. The options include plan design changes, investment strategies like liability-driven investing, and solutions that transfer the risk away from the plan sponsor s balance sheet, like annuities and longevity insurance. (See Exhibit 1.) Globally, de-risking began to take off in the mid-2000s, when plan sponsors started to feel the pain of their pension plans. The perfect storm of low interest rates and volatile equity markets created pension deficits, earnings per share volatility, and increased cash contributions. In several cases, pension promises surpassed the financial capacity of the plan sponsor. The U.K. was the first market to embrace de-risking and is widely acknowledged as the leader in this area. U.K. pension risk transfer transactions grew from less than 1 billion in 2006 to almost 7 billion in 2012, and almost 50 billion of risk has been transferred off U.K. balance sheets since (See Exhibit 2.) Many factors came together to encourage U.K. plan sponsors to proactively manage their risk, including strict funding regulations, increased accounting transparency, heightened awareness of longevity risk, and a full range of creative solutions to reduce and remove risk. With demand comes innovation, and the U.K. pioneered many of today s most popular de-risking solutions, including annuity buy-ins and longevity insurance. Plan sponsors in North America have been slower to take action because many of the driving factors are just starting to land. Pension risk transfer has been limited to annuity buyouts for plans that are terminating. Until the landmark GM and Verizon transactions in the U.S. in 2012, transaction volumes in both Canada and the U.S. had been steady for many years, at $1 billion to $3 billion per year. The opportunity for Canadian DB pension plans to de-risk is significant, with more Fall 2013 Pension & Longevity Risk Transfer for Institutional Investors

3 E x h i b i t 1 Canadian De-Risking Solutions E x h i b i t 2 Cumulative Risk Transfer Transactions in the U.K., U.S., and Canada since 2007 Source: Lane Clark & Peacock LLP, LIMRA. Taking Flight: Why Canadian De-Risking Is Poised to Take Off fall 2013

4 than $1 trillion in liabilities on their balance sheets. Recent Canadian developments have followed the U.K. path and have created a fertile environment for plan sponsors to take risk off the table. FASTEN YOUR SEAT BELT: U.K. DRIVING FACTORS ARE HAPPENING IN CANADA Many of the same factors that drove U.K. plan sponsors to de-risk their plans are now appearing in Canada, and the market is poised to take off. Increased Accounting Transparency E x h i b i t 3 Canadian Pension De-Risking Timeline U.K. companies have been required to recognize pension deficits on their balance sheets since Similar changes came to Canada in 2011 and 2013, leading to greater transparency of changes in a plan s funded status. (See Exhibit 3.) Canadian companies are now required to immediately recognize pension deficits on their balance sheets and can no longer take credit for future expected equity returns. As a result, earnings per share and capital ratios are more volatile, making pension risks much more visible to investors. Analysts are asking questions, and CFOs are being tasked by their boards with finding a solution to address these headaches to help them get back to what they do best: running their core business. Further support for de-risking comes from 2011 research from Kelvin Wilson at Grant Thornton UK LLP, which found that U.K. companies that have derisked their pension plans benefited from a 10% average increase in share price. Heightened Awareness of Longevity Risk According to Statistics Canada, Canadians are already living about 20 years past age 65, and that number is increasing. It s great news that Canadians are living longer, but it also means that plan sponsors will be paying pensions longer. Canadians continue to outlive our U.K. and U.S. counterparts, but the assumptions used for pension plans haven t kept up. Both the U.S. and the U.K. have recently come out with new mortality tables. These new tables result in longer life expectancies than the assumptions that most Canadian pension plans are using. For the past 20 years, the only real choice that Canadian plan sponsors had was to use Scale AA to project future increases in life expectancy. Scale AA was developed in 1994 by looking at the U.S. experience between 1977 and Scale AA hasn t kept pace with recent experience, which means that Canadian pension plans may be underestimating the life expectancies of their plan members, and consequently their liabilities. The Canadian Institute of Actuaries (CIA) released a proposed new table in July 2013 using more recent Canadian data. If adopted, the new table could result in an increase in going-concern and accounting costs of between 5% and 10%, depending on the plan s characteristics. The increase will cause turbulence for plan sponsors but will increase awareness that longevity risk matters. (See Exhibit 4.) Creative solutions to reduce and remove risk. Canadian plan sponsors now have access to the full range of de-risking solutions that are available across the globe, including liability-driven investing, annuity E x h i b i t 4 Longevity Risk Matters Note: Pension plan with assets and liabilities equal to $100, 50% bonds/50% equities, bonds and liabilities duration of 14 years. Fall 2013 Pension & Longevity Risk Transfer for Institutional Investors

5 E x h i b i t 5 Canadian De-Risking Solutions buyouts, annuity buy-ins, and longevity insurance. (See Exhibit 5.) PREPARE FOR TAKEOFF: EXCITING TRENDS ARE EMERGING IN CANADA Annuities Are Cheap With interest rates at historically low levels, the common mantra that annuities are expensive is rarely questioned. However, as de-risking gains momentum, plan sponsors are realizing that this conventional wisdom is really just a myth. There are many ways to assess the relative expense of any annuity, but no matter which way you look at it, there is compelling evidence that annuities are cheap. Annuities Are Super Bonds is the cost of purchasing the longevity and investment risk protection provided by the annuity. In fact, the opposite is true. For the last six years, the yield on annuities has been consistently higher than the expected yield on a typical bond portfolio. Not only have annuity yields been higher, annuities have also provided longevity and investment risk protection at no additional cost. Exhibit 6 shows the increase in portfolio yields that can be achieved with an annuity purchase for a typical group of retirees over several years. These results are very surprising and counterintuitive, but true. Three main factors are at work: First, insurers are very large institutional investors and have access to better investment opportunities than the typical pension plan. Second, insurers have highly developed risk management and governance functions that allow them to better manage and be more comfortable with investment risk than the typical pension plan. Third, unlike a typical pension plan, insurers are comfortable backing annuities with illiquid investments, which often provide higher yields. Together, these factors allow insurers to construct prudent asset portfolios that more than offset their expenses and risk charges. E x h i b i t 6 Higher Yields + Risk Transfer = Super Bonds One way to determine the relative expense of an annuity is to compare the expected yield that a pension plan would get by purchasing an annuity versus investing in a bond portfolio. Most people would expect that the yield on an annuity would be lower than a bond portfolio and that this lower yield Source: PC Bond, a business unit of TSX Inc., and Sun Life estimates. Taking Flight: Why Canadian De-Risking Is Poised to Take Off fall 2013

6 Plan sponsors who are invested in fixed income can take the opportunity to exchange a portion of their bond portfolio for an annuity super bond to transfer risk while getting a yield increase. E x h i b i t 7 Annuity Buy-In Annuity Prices Are at Their Lowest Level in More Than a Year Although interest rates are still at very low levels, they have come up significantly in the last year. Since the beginning of 2013, Government of Canada long bond yields have risen by approximately 60 basis points, 1 resulting in a decrease in annuity prices of around 6%. 2 In fact, August 2013 annuity prices are at their lowest level since March Although Canadian equities have been flat over the period from March 2012 to August 2013, foreign equities have performed well, with the S&P500 gaining over 20%. Solvency funding levels have risen for many plans; now is the best time in recent memory to lock in gains and take risk off the table, particularly for plans with material equity investments. Canadian Plan Sponsors Are Getting a Bargain Since most pension plan sponsors and pension actuaries don t purchase annuities regularly, they don t have a good sense of their cost at any point in time. To assist them, the CIA publishes guidance on the estimated cost of purchasing annuities each quarter. Pension actuaries can then use this guidance to calculate the solvency liabilities for members who are expected to receive annuities. This annuity proxy rate is currently equal to Government of Canada long bond yields plus 70 basis points. We hear anecdotally that U.K. annuities are typically priced using a yield around Government of England long bond yields +0 to 30 basis points. This difference can equate to a significant annuity price difference (maybe 5% for a typical retiree group with a duration of 10) and should have Canadian plan sponsors rushing to buy annuities. New Risk Transfer Solutions Are Gaining Momentum Annuity buy-ins. In the wake of the OSFI advisory supporting annuity buy-ins, plans are embracing this new and flexible solution to right-size their DB plans. Since 2012, at least six plan sponsors purchased annuity buy-ins to make their DB plan sustainable for the long term, or to prepare for a future plan windup. The annuity buy-in is an insurance contract held as an investment of the pension plan. As a result, no top-up contribution is required for an underfunded plan, and our research indicates that no accounting settlement is triggered. This makes annuity buy-ins particularly attractive for underfunded plans. An annuity buy-in transfers the risks for a group of members from the plan sponsor s balance sheet to an insurer s balance sheet. All the risks associated with these liabilities (investment, longevity, operational) are transferred to the insurer, isolating the plan sponsor from these risks and their volatility. This reduces the size of the remaining pension plan, which reduces contribution volatility and the impact of the pension plan on earnings per share and capital positions. (See Exhibit 7.) Fall 2013 Pension & Longevity Risk Transfer for Institutional Investors

7 E x h i b i t 8 Longevity Insurance E x h i b i t 9 Canadian Wheat Board Transaction Longevity insurance. Longevity insurance is the newest solution to land in Canada, and several plan sponsors are investigating this option. Longevity insurance is particularly appealing to plan sponsors who are comfortable with their investment risk and are looking to sustain their DB plans. Combining longevity insurance with a liabilitydriven investment strategy can be a powerful and flexible risk mitigation tool (called a synthetic annuity buy-in in the U.K.). Longevity insurance transfers the longevity risk for a group of members from the plan sponsor s balance sheet to an insurer s balance sheet. If plan members live longer than expected, the insurer covers the cost of the additional pension payments. (See Exhibit 8.) The Market Is Innovating to Meet Demand A few years ago, the only way to de-risk your pension plan was to invest in more bonds or purchase an annuity buyout. Now, Canadian plan sponsors have access to the full range of de-risking solutions offered around the globe, and demand is driving innovation: Sophisticated liability-driven investment strategies are becoming more common, and many plan sponsors are investing in custom portfolios that match their assets to their liabilities. Liability-driven investment solutions are being bundled with annuities to transition risk off the sponsor s balance sheet in a planned and cost-effective way. In-kind asset transfers are being used to facilitate larger deals. U.K. solutions are being imported to provide choice and f lexibility for Canadian plan sponsors. Global reinsurers are exploring Canadian opportunities and preparing to provide additional capacity to meet growing demand. Larger deals are becoming more digestible for Canadian insurers, and the first jumbo transaction ($1+ billon) may be just around the corner. Capacity and cost-effective solutions are being built for fully indexed pensions. Plan Sponsors are Taking Action The news about the Canadian Wheat Board (CWB) transaction in June 2013 was ground-breaking for Canada and a great example of demand driving market innovation. CWB, a AAA government entity, wanted a simple way to reduce its pension risk and ensure the security Taking Flight: Why Canadian De-Risking Is Poised to Take Off fall 2013

8 of members pensions. Like many plan sponsors, it was working within a tight budget, and to add to the challenges, CWB s pensions are fully indexed (they increase with Canadian inflation). CWB had been told that a large annuity purchase for indexed pensions could not be done in Canada. CWB transacted the largest fully indexed annuity deal in Canadian history, using the flexible annuity buy-in solution described earlier. To stay within its budget, CWB worked with the insurer to transition its assets to an ideal annuity portfolio so it could purchase the annuity at an opportune time by transferring its assets in kind. The powerful combination of liability-driven investing and annuity purchase allowed CWB to transfer its pension risk within its budget. (See Exhibit 9.) File a flight plan Contact an insurer to get a free illustrative quote to help understand the cost of risk transfer. This will serve as an important benchmark when evaluating the relative merits of asset-only derisking strategies. Monitor pricing and be ready to take advantage of sometimes temporary market opportunities. ENDNOTES 1 From January 2, 2013, to July 31, Provincial and corporate bond spreads have been fairly constant over this period. 2 Estimate for a typical retiree group with a duration of 10. PREPARE FOR LANDING: POSITION THE PLAN FOR SUCCESS To order reprints of this article, please contact Dewey Palmieri at dpalmieri@ iijournals.com or CWB is one of the first Canadian plan sponsors to announce a landmark de-risking transaction, but it won t be the last. Many forward-thinking Canadian plan sponsors are actively investigating de-risking solutions, hoping to capitalize on a first-mover advantage in the f ledgling Canadian de-risking market. Get ahead of the impending wave of demand by taking action to ensure a successful journey: Do a pre-f light check Contact an investment banker, pension consultant, and/or investment consultant to evaluate the pension plan s risk profile and the de-risking solutions that are available. Get off the ground Educate key stakeholders and decision makers about de-risking trends and solutions. Align the asset portfolio to support de-risking objectives. Fall 2013 Pension & Longevity Risk Transfer for Institutional Investors