Many defined benefit plans’ funded statuses are in relatively good territory, but with an uncertain investment atmosphere on the horizon, is now a good time for plans to consider taking risk off the table by purchasing an annuity?

And for plans looking to de-risk in the future, what considerations are there from an investment perspective?

“Most pension funds have been underfunded on a solvency or windup basis for most of the last two decades, but over the last few years we’ve seen that funded positions have improved to the point where at the end of September of last year, more than half the plans were fully funded,” says Manuel Monteiro, leader of Mercer Canada’s financial strategy group. “Once you’re fully funded on a solvency or windup basis, that essentially means you can buy an annuity without having to make any cash contributions.”

Read: Buy-ins and boomerangs: A look at the trends in Canada’s annuity market 

Many closed or frozen plans wanted to get out of the defined benefit game, he notes, adding that with investment risks on the horizon, now may be an opportune time to reduce risk.

To prepare investments for purchasing an annuity, the key for plan sponsors is to have a strategy to get out of the defined benefit space, says Monteiro, noting he’s seen closed or frozen plans continue to carry a lot of risk through equities. “Even though plans have been closed or frozen, they might still have very high equity contents. Then they get to a fully funded state, and at that point, in many ways, human psychology is saying, ‘Why would I cash out now when it looks like things are pretty good?’ and then you end up going in a circle.”

To avoid a scenario where a plan becomes fully funded, the equity markets crash and then it goes back to square one, plan sponsors should determine their timeframe and develop a systemic plan to reduce risk over time to reach an end goal, says Monteiro. “I think the answer in terms of strategy is quite different for someone who has a five-year time horizon versus a 20-year time horizon. But I think the key is to have a plan upfront.”

John Poos, group head of pensions and benefits at George Weston Ltd., oversees plans for both George Weston and Loblaw Companies Ltd. Among these plans, he’s entered into seven buyout annuity agreements totalling more than $1 billion.

Read: Loblaw buys $350M in annuities for inflation-linked DB obligations

The journey to de-risk started about seven years ago when the plans changed their approach from a focus on returns to a liability-focused strategy while simultaneously increasing contributions, says Poos.

Then, in 2012, the plans developed a glide path with the goal of raising their funding statuses north of 90 per cent, he says. “At the time, we had about 17 different pension plans and they all had different demographics — some were open, some were closed, some had been closed for a long time, so they were fairly mature, and each of them had different funding levels. So we created a glide path that set the asset mix for each of the individual plans depending on whether or not they were open or closed, and it created an asset mix driven by the funded status of the plan and its demographics.”

As the plans approached a fully funded position, the plan sponsor wanted to eliminate the potential of falling below 100 per cent, says Poos. “We didn’t want to see ourselves with a big unfunded position again. Once we’d gotten ourselves above a certain number, we wanted to eliminate, or reduce as much as possible, that potential downside risk. So we were more about downside risk than we were necessarily about getting to 100 or getting to 105 or getting to 110.”

At the same time, Poos says the plans started to look at opportunities to further limit downside exposure, ultimately choosing annuities to achieve that.

“My objective has always been, once the pension promise is available, to lock it in and to make sure the beneficiaries receive the pension,” he says.

As a first step, Poos says the company had to convince the board an annuity was the right choice, despite potential boomerang risk — the risk an insurer providing the annuity ends up in trouble, returning the responsibility for the pension to the plan sponsor.

Read: Ontario annuity discharge changes coming July 1

“Once we got the board comfortable with the risk that might be still within the company, we had to decide when the time was appropriate to go to market,” he says. Major challenges included governance and ensuring internal processes were in place to quickly approve the transactions.

After going through this process, Poos advises plan sponsors looking to purchase an annuity to have a goal in mind and governance in place. Particularly, knowing how much a plan is willing to pay to settle obligations itself if it isn’t in a fully funded position. “Are you ready at 95 per cent? If you have to pay the additional five per cent, are you prepared to pay that? And if not, then you’re not in a position to do so.”

If plan sponsors know their target and their governance, it’s really just about looking at the market, he says, and when they think it’s the appropriate time, to ensure the pricing is right. “There’s really no magic to it.”

It’s also important to consider what kind of de-risking option a plan wants to pursue, such as a buy-in or buyout, longevity transfers or a combination of these options.

A buy-in annuity is when an insurer makes payments to the pension fund and the plan sponsor pays the members. In this case, the plan is still the administrator and the contract is between it and the insurance company, says Neil Duffy, vice-president of group retirement solutions, pricing and pension risk transfer, group customer at Great-West Life Assurance Co. “The pension plan can remain open and can use an annuity as a different type of asset.”

On the other hand, in a buyout, a plan purchases an annuity and the insurer takes on the administration of the plan, he says.

Read: Pension stakeholders call on feds to remove barriers to longevity risk pooling

In a longevity insurance transaction, the plan still wants to invest its own assets, but pays premiums to insure its longevity risk. “For a plan that feels comfortable . . . with the asset risks they’re taking and the asset managers they deal with, they may not want to transfer that risk,” says Duffy. “But they really don’t have any control of the longevity risk and that’s where the insurers would come into play.”

He calls this a step towards de-risking and is a do-it-yourself option where plans can maintain the asset strategy, but can’t manage the longevity risk.

In addition to considering the time horizon, a plan can decide if it’s ready to de-risk by looking at numerous factors, including how much of its liabilities are tied to retired members, says Duffy.

“If we see a plan that’s recently closed with younger members in it, we would say to them it probably makes sense to run the plan as it is, as a defined benefit plan with the plan sponsor still administering the plan,” he says, noting as the plan matures and the pensioners and active employees get a bit older, it becomes a little more ripe for a pension risk transfer.

“When we talk to pension plans, we say that as they get closer to being able to transfer the risk, they have to decide whether they want to do that or not,” says Duffy. “They can choose to keep the risk themselves and administer the plan until their last member has been paid their last payment. Or at some point along that spectrum, they can also choose to send plans to market for an annuity.”

Although there isn’t a magic number, Duffy says Great-West Life typically prefers 70 per cent or more of a closed plan to be populated by retired members.

Read: Take advantage of current plan health by de-risking now, sponsors urged

For plans approaching a demographic position that’s ready to de-risk, he recommends looking at the current investment structure and risk tolerance.

“We invest in fixed income, so if the plan has invested in equities we would tell them what risk they have while continuing to stay invested in equities,” he says. “So if they were five years away from being eligible for a pension risk transfer and they continued to have some portion of their assets invested in equities, we would advise them on how much risk that can pose to the plan.”

Plan sponsors also need to understand their risk exposure if they’re ultimately looking to de-risk and buy annuities, says Duffy, noting they can do this by considering an investment strategy that helps preserve the funded position of the plan like those used by an insurance company. As examples, he points to moving assets into fixed income to reduce or eliminate the equity risk exposure and looking to align the duration of assets to the duration of liabilities to reduce interest rate risk exposure.

For some plans, adds Duffy, moving into fixed income may not be the right choice, so it’s important they understand the risks they’re taking on. Furthermore, it’s key to consider liquidity because plans need to have enough cash on hand to purchase an annuity, he says.

“If they’re in very illiquid assets that are difficult to liquidate and turn into cash, those are the wrong assets to have just prior to an annuity purchase . . . If they’ve copied a fixed income strategy that insurers would have, those are very liquid assets and they could be turned into cash fairly easily.”

Read: Canadian pensions have healthy liquidity despite alternative investments: report

Although not prevalent, the insurance industry does allow transfers in kind instead of only accepting cash, says Duffy. “So when they do get to the point of transacting on an annuity, if they have assets the insurer would deem suitable for their investments, instead of paying cash they could pay us in kind with the assets they have.”

Duffy highlights that, although plans are more likely to speak about de-risking when preparing for an annuity, risk management should be an active discussion throughout a pension plan’s lifetime.

This article was originally published on Benefits Canada‘s companion site, the Canadian Investment Review.

Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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