Most regulators do not view a buyout group annuity purchase from an ongoing pension plan as a complete settlement of the obligations covered by the annuity. Some DB plan sponsors with a desire to reduce pension risk face this barrier.
This position does not align with the reasonable safeguards in place to protect member benefits covered by a buyout annuity and may not ultimately serve the public policy goals of expanding pension coverage and facilitating sustainable DB plans. Pension legislation should be amended to clarify that a buyout represents a full settlement of obligations.
Rightsizing the plan
As DB plans have matured over the years, the size of plan assets and obligations have grown significantly. If a pension plan sponsor’s business is mature or in decline, the size of the pension plans may have become large relative to the size of the business. This is the case today for many companies that sponsor DB pension plans.
For these sponsors, a significant deterioration in the funded position of their plans could have painful cash and profit and loss implications and, in some cases, may even jeopardize the viability of their core business. Therefore, plan sponsors should ideally have the ability over time to reduce the size of their plans (i.e., rightsize their plans), so that the size of pension risk remains within the risk tolerance of their business.
Buyout annuities
One potential approach for rightsizing an ongoing pension plan is to settle a portion of the plan’s obligations by entering into a buyout group annuity contract with an insurance company in respect of some or all of the plan’s retired and deferred vested members (inactive members).
Under a buyout annuity, a premium is paid from pension plan assets to the insurance company in exchange for transferring to the insurance company the obligation to pay pension benefits due under the plan. Thus, the insurance company assumes all risks associated with providing the pension benefits covered by the annuity contract, including the investment, interest rate, longevity and administration risks.
Boomerang risk
With the improvement in the financial health of DB plans during 2013, many plan sponsors are reviewing and implementing approaches to adjust the level of risk in their plans. This includes rightsizing their plans through a buyout group annuity for the plans’ inactive members.
However, a barrier faced by a sponsor considering a buyout annuity is that, while pension regulators consider a buyout from a plan that is being wound up as a settlement of obligations, most regulators do not view a buyout from an ongoing plan as a complete settlement of benefit obligations. This view of a buyout from an ongoing plan has a number of implications.
- In the unlikely event that the obligations under the buyout contract cannot be fulfilled due to the bankruptcy of the insurance company, it is currently the view of most regulators that the pension plan remains ultimately responsible for keeping the former members covered by the contract whole. (This is sometimes referred to by plan sponsors as boomerang risk.) Some may argue that the boomerang risk is extremely low, particularly in light of the protection provided by Assuris in the case of insurer bankruptcy. However, this potential risk is often a concern for plan sponsors that want regulatory certainty with respect to the settlement of the obligations covered by the buyout annuity.
- With the elimination of partial windups in many jurisdictions, the only way a plan sponsor may be able to fully settle benefit obligations for inactive members is through a full plan windup. This potential restriction on fully settling obligations may act as a significant impediment to a plan sponsor’s ability to manage the financial risk of their plans and could encourage full windups.
- Individuals whose benefit obligations are included in a buyout would likely still be considered by the regulator as plan members. In the case of a full windup of an underfunded plan due to the bankruptcy of the plan sponsor where a buyout occurred in the past, a portion of the annuity purchase premium may need to be returned to the plan by the insurer. The return of premium may be required in order that all plan members (i.e., both those excluded from and included in the previous buyout) are treated consistently in the case where accrued benefits need to be reduced. The potential need to return a portion of an annuity purchase premium in the future may have adverse effects on annuity pricing.
- In the case of a full plan windup, some jurisdictions (e.g., Ontario) require that all plan members not yet in receipt of a pension be offered portability (i.e., the option of receiving their accrued pension in the form of a lump sum commuted value transfer). As a result, insurers may be required to offer portability in respect of certain deferred vested pensions included in a buyout from an ongoing plan if the plan winds up in the future. The potential need to offer a portability option in the future may have adverse effects on buyout annuity pricing for deferred vested pensions.
- The obligations in respect of inactive members included in a buyout may need to be reflected in the balance sheet for the plan’s future funding valuations, as the regulator considers these obligations as liabilities of the plan. Additional effort and expense will be required to collect the data that are needed to value these obligations.
The need for settlement treatment
In order to enhance the sustainability of DB plans in Canada, it is in the public policy interest for a plan sponsor to be able to manage pension risk by settling a portion of the plan’s benefit obligations through a buyout annuity with a properly licensed insurer.
Due to the importance of protecting the benefits accrued by plan members, a reasonable condition for allowing full settlement through a buyout annuity is to provide that the insurance company taking on these obligations is financially strong and there is a very high probability that the obligations will be met.
This can be achieved by a combination of the regulatory oversight of Canadian insurance companies currently in place, the protection in the case of insurer bankruptcy provided by Assuris and a reasonable level of due diligence conducted by the plan sponsor prior to placing a group annuity with an insurance company. Under these conditions, a buyout may provide additional security above that afforded by the original pension plan.
Moving forward
If DB plans are to remain viable over the long term, plan sponsors need the ability to adjust the financial risk profile of their plans to be within the risk tolerance of their business. In some situations, this can be achieved by settling obligations through a buyout annuity. The desire and need of sponsors to rightsize their plans through buyouts will likely increase over the coming years as DB plans continue to mature.
While pension standards legislation is ultimately intended to protect members’ benefits, the provincial and federal governments should consider the potential implications on pension coverage should a plan windup be the only situation in which there is some regulatory certainty regarding an employer’s discharge upon purchasing a buyout annuity.
To the extent that plan sponsors are able to clearly settle some liabilities by purchasing annuities when conditions are favourable and thereby strengthen the organization’s future by reducing pension risk, employees benefit through greater security of both their future retirement income and, potentially, their jobs. Alberta and B.C. are already moving in this direction by amending their new minimum standards legislation to provide a discharge for buyout annuities in respect of inactive members. Other jurisdictions should follow.