Many employers that sponsor DB pension plans are considering reducing the risk in their plans. An approach to reduce risk that is gaining popularity is to purchase a group annuity in respect of all or a portion of a pension plan’s retiree (and, in some cases, deferred vested) obligations.
In response to the increased interest from employers in buy-in annuities, in February 2015 the Financial Services Commission of Ontario (FSCO) released an Investment Guidance Note: Buy-In Annuities for Defined Benefit Plans. The document sets out the expectations of FSCO when an Ontario registered pension plan (RPP) purchases a buy-in annuity. It also emphasizes that a buy-in annuity is considered an investment of the pension fund.
Buyout versus buy-in annuities
Under a group annuity purchase, a one-time premium is paid from pension plan assets to a life insurance company. In exchange for this premium, the insurer becomes responsible for future pension benefits payable in respect of the former plan members covered by the annuity contract. By purchasing a group annuity, investment, interest rate and longevity risk is transferred from the pension plan to the insurer.
A group annuity typically falls into one of two types of contractual arrangements. In both cases, the insurer takes on the investment, interest rate and longevity risk. The main difference is who handles administration and deals directly with the members covered by the annuity.
Buyout: Upon payment by a pension plan of a buyout annuity premium, the insurer:
- issues individual certificates to the former plan members covered by the annuity contract informing them of the annuity purchase;
- is responsible for administering the pension benefits covered by the contract; and
- pays pension benefits directly to the former members covered by the contract.
Buy-in: Buy-in annuities are structured as an investment of the pension fund. Upon payment by a pension plan of a buy-in annuity premium:
- the plan retains responsibility for administering the pension benefits covered by the annuity contract;
- the plan continues to pay the pension benefits to the former members covered by the contract; and
- on a monthly basis, the insurer reimburses the plan for the pension benefits paid by the plan during the month to the former members covered by the contract.
Depending on the circumstances of a particular pension plan, the purchase of a buyout annuity could result in the need for a special employer contribution to the pension plan and could also result in a one-time settlement charge in the employer’s profit and loss statement.
Buy-in annuities mitigate or defer these one-time cash and accounting effects, which likely explains their increase in popularity during the past couple of years. While historically almost all group annuities were structured as buyouts, $800 million of the total 2013 Canadian group annuity market sales of $2.2 billion was for buy-in annuities. In 2014, this trend of an increase in buy-in transactions continued, with $700 million of total group annuity sales of $2.4 billion for buy-in annuities.
An employer that is considering purchasing or has already purchased a buy-in annuity for an Ontario RPP should carefully consider the contents of the Guidance Note. The document sets out the expectations of FSCO when an Ontario RPP purchases a buy-in annuity:
(i) The Ontario Superintendent of Financial Services does not have to approve a buy-in annuity purchase since the transfer deficiency rules with the possible need to top up the fund will not apply. Such rules, however, would apply to a conversion of a buy-in annuity to a buyout annuity.
(ii) Considerable flexibility is available in structuring a buy-in annuity contract. For example, the buy-in contract could cover active, deferred vested or retired members, or a specific class or subgroup of such members. Also, specific components of a pension benefit, such as indexing, can be excluded from the buy-in contract.
(iii) The plan administrator remains responsible for ensuring all benefits covered by the buy-in annuity are paid, even if the insurer cannot make the required annuity payments.
(iv) A buy-in annuity contract should allow for its termination or modification and permit the plan administrator to administer benefits covered by the contract in accordance with the plan provisions and in compliance with statutory requirements such as:
- early retirement provisions;
- pre-retirement death benefits;
- optional forms of payment; and
- pension division or lump sum transfer on spousal relationship breakdown.
(v) The buy-in annuity must be a permitted investment under the terms of the pension plan, the statement of investment policies and procedures established for the plan, and under applicable statutory requirements, including investment regulations.
(vi) The pension plan administrator should do the following:
- negotiate a reasonable price for the annuity;
- consider the pricing of buy-in annuities compared to similar investment options;
- in most cases, retain independent expert advice;
- consider counterparty risk; and
- determine the extent of Assuris coverage if the insurer becomes insolvent, the adequacy of such coverage, and the contract terms relating to changes in Assuris coverage. (Assuris is an organization that protects annuity payments, up to certain levels, in the event that the insurance company fails.)
(vii) Appropriate asset and liability values should be attributed to a buy-in annuity and the related pension obligations for purposes of future going concern and solvency funding valuations of the plan. Also, for the purpose of preparing financial statements for the pension fund, the technique to value the buy-in annuity must comply with generally accepted accounting principles.
(viii) Members covered by a buy-in annuity contract who were employed in Ontario must be included in the calculation of the plan’s annual Pension Benefits Guarantee Fund assessment, for those plans covered by the Pension Benefits Guarantee Fund.
(ix) The Guidance Note also addresses the scenario in which the pension plan winds up at some point after purchasing a buy-in annuity and benefits are reduced due to the existence of both a deficit in the plan and employer bankruptcy at the time of the windup. In this case, FSCO would not want members covered by the buy-in annuity to be provided with greater benefit security than other plan members. In order to provide for equitable treatment among plan members, the benefits covered by the buy-in annuity would have to be reduced in the same proportion as for other members of the plan and the contract could then be converted to a buyout annuity paying the reduced amounts. FSCO would expect that the difference between the full value of the buy-in annuity and the value of the reduced buyout annuity would be made available to the plan to provide for the benefit entitlements of plan members not covered by the buy-in annuity.
(x) The Guidance Note also addresses additional considerations in the event that the buy-in annuity is issued by a foreign insurance company. For example, the 10% investment concentration limit would likely apply, which could limit the ability of foreign insurers to market to Canadian pension plans.
FSCO’s Guidance Note is similar in a number of respects to the Office of the Superintendent of Financial Institutions (OSFI) September 2012 guidance document for federally registered pension plans entitled “Buy-in Annuity Products.” The focus by regulators on buy-ins is yet another indication of the increasing importance of group annuities as a tool for managing the risks of ongoing pension plans. An employer that is considering purchasing or has already purchased a buy-in annuity for an Ontario RPP should carefully consider the items addressed in the Guidance Note.