Protecting against longevity risk is one of the biggest challenges for people with defined contribution pension plans because, if they live longer than their savings last, they’re out of luck. But what if there was a way for defined contribution plans to offer a lifetime income?
A mechanism to protect against longevity risk within defined contribution plans used to exist, but changes brought forward by the federal government in the late 1980s prohibit new plans from offering it.
An example of a plan in practice
Before the changes, the University of British Columbia offered an option, known as the variable payment lifetime annuity, for defined contribution pension plan members that provides a lifetime income. Through grandfathering, the arrangement continues despite the changes.
“It’s similar to an annuity you would buy through an insurance company, only to the extent that it pays a lifetime pension. The main difference is, once a year, the payments from our plan are adjusted,” says Debbie Wilson, the associate director of pensions for the university’s staff and faculty pension plans. The variable annuity guarantees a lifetime payout, with the amount subject to change based on mortality rates and investment performance.
At retirement, members hand over the amount they want to allocate to the fund and no longer have a dollar amount associated with them. Instead, they have a benefit amount, says Wilson.
Once members have enrolled in the variable annuity, they’re locked in. When people retire from the university, they have an option to put some or all of their money into the variable annuity. Wilson says that in the university’s experience, retirees will often put part of their assets towards the variable annuity and another portion into other retirement options as a strategy to spread the risk. In addition, members can transfer to the annuity later in life should they want to start taking a more passive approach.
Barbara Sanders, an assistant professor in the department of statistics and actuarial science at Simon Fraser University, is a strong advocate for the variable annuity as a good example of how minimal pooling can still benefit members. Sanders says she was shocked to learn the arrangement isn’t available for new plans. “As soon as I heard that, I said, ‘But you have to make it available again.’”
The decumulation dilemma
Rosalind Gilbert, associate partner for retirement strategies at Aon Hewitt, says the Canadian defined contribution pension industry is fairly young and only now, as a generation of people retire from their plans, has it become apparent that there needs to be more focus on the decumulation side.
“I think it’s just that the whole industry has shifted focus from accumulation to decumulation, and so plans like the UBC faculty plan have been highlighted as having this awesome internal variable annuity, but nobody else can use it,” says Gilbert, noting plans haven’t been able to introduce the variable payment lifetime annuity option since the rules changed in 1988.
Gilbert says there are benefits to having an annuity option within a defined contribution plan, instead of going to an external provider, because it costs less and the difference in fees would stay with the members.
Still, Wilson emphasizes the importance of proper education about the variable annuity so members go into it with their eyes wide open.
“There’s some volatility to the annual income, so the retiree has to be able to, and willing to, accept some volatility,” says Bill Turnbull, the general manager of the Saskatchewan-based Co-operative Superannuation Society Pension Plan. The plan offers a grandfathered level annuity option to plan members.
“The risk is that members won’t understand what they’re buying,” he adds.
“The challenge always is to make sure that you have transparent and understandable disclosure the laypeople will understand.”
Rules a barrier
So if the variable annuity has been working for the university as a way to protect against longevity risk within a defined contribution pension plan, why don’t the rules allow them?
Regulations under the Income Tax Act require a licensed annuity provider to pay defined contribution lifetime retirement benefits in the form of an annuity. The regulations gave the Canada Revenue Agency the discretion to accept plans that pay annuities directly up to Feb. 27, 2004, but the department chose to accept the arrangements only up to March 27, 1988. The changes didn’t apply to grandfathered plans, such as the university’s pension, that had such arrangements already.
The government later removed the revenue agency’s discretionary authority.
“The reason that self-insured money purchase arrangements are no longer permitted is that, unlike defined benefit pension plans, there is no provision in the Income Tax Act or regulations that permits contributions to fund a shortfall . . . under a money purchase provision,” wrote David Walters, a spokesperson for the Canada Revenue Agency, in an email to Benefits Canada.
Wilson says she understands the clear restrictions against providing level annuities in a defined contribution pension plan but she notes variable annuities are different because they don’t create deficits with the assets set to equal the liabilities every year. “So there’s no risk to the plan,” she says.
Sanders suggests an option like a variable annuity makes sense because there’s no smoothing experience over time. “As soon as you start smoothing and pooling, what you’re saying is, ‘What we’re paying out is not actually how much we have,’” she says. “And that’s the part that should not be allowed in a DC plan.”
In the case of a variable annuity, the gamble is that mortality won’t play out as assumed, says Sanders. However, she says that for a large plan with decent mortality projections, the risk could be very small.
Gilbert would also like to see a reconsideration of the rules. “Some of the issue was related to risk, so with a level annuity, there’s obviously a risk that it wouldn’t be affordable. My personal opinion is that variable annuities should have been exempt from that restriction because they are self-adjusting. There is no additional risk to the plan sponsor.”
The upsides and downsides
Wilson says that even if the variable option becomes available for defined contribution pension plans in the future, some employers may still not choose that route.
“I think people have to go in recognizing that there is a cost to doing this,” she says, noting the model needs an annual actuarial evaluation and a lot of communications so that members understand it. “A smaller DC plan is not going to do this, I don’t think.”
Sanders agrees. “If the plan is too small, then the mortality experience could spin off some significant volatility,” she says.
In addition, Wilson notes employers may stay away from a variable annuity option because many companies don’t want to keep their retirees inside the plan and continue communications with them after they stop working.
“I still think most single-employer DC plans won’t change how they feel about allowing members to stay in the plan after retirement,” says Turnbull. “I think most employers probably don’t want that responsibility or exposure.”
Still, Turnbull thinks it would be useful for the federal government to consider whether or not variable annuities may be an option for defined contribution plans, an issue the Netherlands took action on in June when it passed legislation allowing members to choose them for their pension.
“Right now, you either have to transfer your balance out of the plan to get an annuity or you can stay in the plan and take that variable benefit, which is like a [registered retirement income fund]. I think this would be a good third option, which is kind of in between those two,” says Turnbull, noting that while defined contribution pension plan members are largely on their own when it comes to investment and mortality risk, they’re no longer alone with a variable annuity.
Sanders predicts that as people in defined contribution plans retire, they’ll realize that a handsoff approach isn’t good enough. “Allowing this option of the VPLA would basically be just making smart DC smarter on the decumulation side,” says Sanders.
Yaelle Gang is a former conference editor at Benefits Canada.
Get a PDF of this article.