The recent announcement that General Motors of Canada Co. purchased $1.8 billion of annuities for its salaried pension plan is creating a lot of excitement. GM Canada joins a growing list of plan sponsors who’ve purchased sizeable annuities in the last few years: Stelco Inc. ($885 million), Alcoa Corp. ($750 million), Rio Tinto Group ($560 million) and Domtar Corp. ($360 million).
The dollar amounts are large and so are the number of plan members involved. Sun Life estimated that Canadian pension plans have purchased over $14 billion of annuities for about 60,000 plan members since 2018. And the market is just getting started — there’s likely many more jumbo deals on the horizon.
Why are these deals happening?
One common misconception is that annuity purchases are the result of plan wind-ups. Yet, according to Willis Towers Watson’s first quarter of 2021 group annuity market report, only about 13 per cent of the annuity volume in the last three years was the result of plan wind-ups. This means that 87 per cent (or about $12 billion) of the annuities purchased were for ongoing pension plans.
So why are ongoing pension plans purchasing annuities? It’s important to remember that every plan sponsor is different and has different goals. However, two common themes are emerging — better risk management and enhanced benefit security.
Purchasing annuities reduces a plan sponsor’s risk. The insurer, not the plan sponsor, bears the risk of underperforming investments and covered members living longer than expected. In addition, the annuity purchase reduces the effective size of the pension plan. A smaller pension plan means smaller future cash or accounting surprises, making it easier for the plan sponsor to focus on its core business.
Purchasing annuities might also enhance benefit security as the plan members included in the annuity purchase now have their pensions paid by a highly regulated insurance company.
How do these deals get done?
Annuity transactions require partnership and collaboration between the plan sponsor, consultant and insurer. Here are a few of the more important considerations to work through for larger transactions:
- Governance. An annuity purchase is a form of corporate divestiture and has many of the same complexities. A robust project plan and strong project manager are critical. So is identifying and educating key decision makers in advance of the transaction and agreeing on go/no go decision criteria. Transactions have failed because the decision makers and decision criteria weren’t clearly defined.
- Structuring. Each jumbo transaction is highly customized. It’s helpful to approach insurers many months in advance of the intended transaction date. This gives enough time for feedback on the unique aspects of the transaction as well as the transaction tranching and timing. After all, no one wants two jumbo transaction happening in the same week. The goal is to structure the transaction so that insurers find it attractive and have time to gather great assets to provide excellent pricing.
- Longevity study. The estimated life expectancy of the plan members included in the annuity purchase can impact an insurer’s price by several percent. For smaller transactions insurers rely on their internal underwriting models, but for jumbo transactions they’ll typically want to do a longevity study. Allowing insurers the time to perform a longevity study will usually result in better pricing. Insurers will have more conviction about the life expectancy of the group and hold lower risk margins.
- De-risked asset mix. Once a plan sponsor decides to purchase annuities, it’s important to review the pension plan assets supporting the annuity purchase. In most cases, it will make sense to shift return-seeking assets (like equities) into matching assets (like bonds). Otherwise, a sudden drop in equity markets could derail the transaction.
- In-kind asset transfer. When hundreds of millions or even billions of dollars are changing hands, it’s helpful if it’s not all in cash. Transferring a large portion of the purchase price as a high quality bond portfolio keeps the money invested. This protects both the plan sponsor and the insurer from market movements and can lead to improved pricing. In addition, an in-kind transfer can reduce trading costs, which further improves pricing.
Many aspects of these considerations also apply to smaller transactions.
Plan sponsors of all sizes are using annuity purchases to reduce their pension risk and enhance their plan members’ benefit security. These transactions require careful planning and lots of collaboration. Pension consultants can help you look under the hood and determine whether an annuity purchase is right for you.
Brent Simmons is head of defined benefit solutions at Sun Life. These views are those of the author and not necessarily those of the Canadian Investment Review.