Recent mortality research in Canada has considerably extended the time at which virtually all closed-to-new-entrants DB pension plans are projected to end up with their “last man standing.” That has given a sudden boost to pension liabilities and normal costs, depending on which of several mortality tables is chosen (most notably, tables that differentiate between private and public sector workforces). It is readily apparent that more judgment is required in that choice than under the previous commonly used table. Never before have Canadian DB plan sponsors given so much attention to the life expectancy of their plan members.

There’s been an increase in a 65-year-old DB member’s life expectancy, based on the mortality study recently concluded by the Canadian Institute of Actuaries (CIA), relative to the mortality assumption typically used for DB plans prior to the study’s release (see Figure 1 below).

With a one-year increase in life expectancy—resulting in, perhaps, a 3% increase in liabilities for a typical non-indexed private sector DB plan— the new mortality table might translate into a low- to mid-single-digit percentage increase in the pension obligations that a plan sponsor would fund in cash on a going-concern basis or record in its financial statements. In fact, mortality sensitivity is now an emerging financial statement note disclosure item for companies reporting under International Financial Reporting Standards. According to Manulife’s 2013 annual report, for example, a 0.7-year increase in life expectancy at age 65 would have the same impact as a 21-basis-point decrease in the discount rate. One key distinction here is that discount rates tend to fluctuate over time, whereas mortality assumption changes have generally meant only bad news.

A Better Life
Life expectancy has risen rapidly in recent decades, outstripping most expectations each time a new table is published. The decrease in overall mortality within the Canadian population in recent decades is largely due to the drop in mortality from diseases of the heart. Assumptions regarding future mortality improvements inherently involve some degree of speculation and debate. Judgment is required on the impact of factors such as medical improvements, lifestyle (including wellness and obesity trends) and the environment (such as pollution).

There is ongoing debate in pension and insurance circles about appropriate assumptions for future mortality improvements. For better or worse, the recent CIA study assumed that the short-term future would see improvements similar to those experienced by Canada/Quebec Pension Plan (C/QPP) recipients in the recent past (approximately 1.5% to 3.0% per year for those aged 55 to 75) but that longer-term improvements would be at lower levels (0.8% per year at most ages).

Risk Ahead
The financing mechanism for traditional DB plans is based on the pooling of mortality risk among plan members. The deficits caused by members living longer than anticipated are absorbed by the surpluses caused by those dying early. But there has been no cost protection against longevity risk (the risk of members as a whole living longer than expected), although DB plans do make the longevity risk somewhat apparent to stakeholders as and when the regular actuarial valuations reveal overall mortality losses.

Compare that to DC pension plans, which absorb neither mortality nor longevity risk. They typically pass these (as well as economic and other demographic risks) on to plan members. Yet, historically, the mortality/longevity risks borne by DC members as they approach the payout phase have not been made transparent to them by their employers.

The Canadian Association of Pension Supervisory Authorities’ DC Guideline No. 8 might help. It encourages plan administrators to periodically provide members with “an estimate or example of the benefit that may result from the accumulated value.” Many older Canadians are at least aware of the recent changes to the retirement age provisions under old age security and the C/QPP, which have been partially inspired by longer life expectancies. With the current degree of media attention devoted to extended life, perhaps life annuities will gain more appeal among DC members to mitigate the mortality and investment risks they face during the payout phase.

Maximum Security
How might DB plan sponsors manage and mitigate the challenges imposed by longevity risk? There are several potential strategies to consider.

Ongoing monitoring and reserves for adverse experience – The CIA mortality study was the first study devoted to Canadian pension plans and was a long time coming. It is anticipated that updates will be performed more regularly in the future. However, DB plans—especially the larger ones—can and should regularly monitor their mortality experience and assess the need to update their assumptions, even in the absence of a future Canadian study by the CIA. Plan sponsors can also consider the merits of a mortality assumption that is more conservative than the best estimates of future mortality experience as a reserve for adverse future experience.

Lump-sum settlements –
Terminating DB plan members who are not yet eligible for early retirement, must, by law, be offered lump-sum settlement options, which transfer the mortality and investment risks to the members. These options could be re-extended to deferred vested members who initially opted not to receive a lump sum—in fact, such re-extensions are actually required in Quebec. The mortality and discount rate bases underlying these lump-sum commuted values (CVs) are prescribed and are not updated very regularly. It is expected that an update to CV standards to reflect the results of the recent CIA mortality study will become effective in early to mid-2015. Depending on the new mortality basis prescribed, the impact on lump-sum CVs could potentially be an increase in the 5% to 7% range, and re-extensions of CVs that are offered and elected by members before that change would not accommodate that increase.

Buying annuities – Consider buyout or buy-in annuities as a way to transfer the mortality and investment risks to an insurance company. There has been a dramatic increase in plan sponsor interest these days in creating glide paths to achieve such forms of de-risking under the right economic conditions. Indeed, a recent Towers Watson survey of pension risk revealed that 38% of participating private sector sponsors are likely to consider annuity purchases in the next one to three years.

Longevity hedging –
While not yet the norm in the U.K., this has become more prevalent there in recent years. However, the North American market is still in its infancy. Essentially, a longevity swap allows a DB plan to retain the investment and interest rate risks while off-loading some of the longevity risk to a counterparty such as a bank or insurance/reinsurance company. The hedge may be less than perfect, as the term of the swap may be limited (rather than covering whole of life), and the counterparty may make payments to the pension plan based on a broad mortality index (such as general population mortality) rather than the plan-specific mortality. The recent Towers Watson survey of pension risk showed that over 10% of survey participants are likely to consider such swaps in the next one to three years.

Shared-risk plan designs –
There are DB plan designs that can pass some or all of their risks—not just longevity but also other plan experience—on to plan members while retaining their DB nature. These can provide useful relief valves for employers. Example of such designs are target benefit plans, jointly sponsored pension plans and benefit provisions that replace guaranteed indexing by conditional or ad hoc inflation protection.

There and Back Again
Not only has media attention been drawn to longer life expectancy, but there is a related coping mechanism by workers that has also gained attention. Those who are in good health as they approach retirement may elect to keep working for longer. Many are able to imagine the financial risks that can arise, for both themselves and their spouse, given the potential for an extended period of retirement as they live into their 90s— and they are aware that they may not have saved enough to counterbalance their own increased longevity risk.

Apart from the much-publicized pattern of lower retirement ages in the public sector compared with the private sector, there is a trend of increasing retirement ages in both sectors over the last 15 or so years (see Figure 2 below).

From the perspective of the funding and accounting of a DB plan, deferred retirement serves to create actuarial surpluses if the actuarial retirement assumption has not allowed for its effect, and these can act as an offset against evolving mortality losses. But deferred retirement also has important employer implications for attraction, retention and total rewards strategies.

Employers are increasingly facing labour shortages in some markets and with respect to certain job categories as baby boomers retire. Many are instituting or considering strategies such as creating phased retirement packages for certain individuals (including both financial elements and changes to the nature of their jobs); offering tenure-based DC contributions; and reviewing the subsidies inherent in early retirement pension provisions.

Actuaries may well say they’ve been dying for mortality to move into mainstream thinking. Certainly, it has become top of mind for many employers in the past year or so—even though its risks remain far smaller than the investment and interest rate risks that create significant volatility in pension costs for the vast majority of DB plan sponsors. And Canadians are generally considering the financial risks of living longer: even the ones lucky enough to have DB pensions will have some element of DC in their lives, whether via their RRSPs or via their spouse’s retirement plan.

Given that this topic has only moved to the forefront in recent years, employers have an important role to play in sensitizing their employees to the trend of mortality improvements and the implications. While many Canadians would aspire to the words of Woody Allen—“I don’t want to achieve immortality through my work. I want to achieve it through not dying”—there is a price to be paid for living longer.

Geoffrey Melbourne is senior consulting actuary, and Ian Markham is senior consulting actuary, Canadian retirement innovation leader, with Towers Watson.

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Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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Charles Spina:

I’m not sure why this particular risk factor is being isolated from others in the pension risk factor mix. It simply re-states what, for most informed people, is the perfectly obvious: life expectancies have been increasing; the mortality gains can be quantified with low margins of error; the changes are gender and age specific; all other things being equal, the dependent/independent variables as they pertain to liabilities and contribution rates, are well understood.

I think that the less time we spend on randomized, out-of-context analyses, and the more time on valuation quality and investment performance, the more will be the time recovered by plan sponsors to focus on managing the true value drivers of their businesses.

Thursday, October 30 at 2:31 pm | Reply

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