Today, most plan sponsors’ contributions to their DB plans are being driven by the results of their pension plans’ solvency valuations.
Unfortunately, the one-size-fits-all guidance used by most plan sponsors to calculate their solvency liabilities means that they could be contributing too little (or too much!) to their plans. In fact, we’ve run into examples of plans whose solvency liabilities were off by 5% to 10%. This could mean that some plans are underfunded (or overfunded) by millions or even tens of millions of dollars.
This is troubling for plan sponsors that are worried about the benefit security of their plan members, and for plan sponsors that want to spend their limited cash wisely. A plan sponsor winding up what it thought was a fully funded pension plan can face unpleasant surprises: either underfunded benefits or trapped surplus.
How are solvency liabilities determined?
Solvency liabilities are based on an estimate of the cost of settling the pension plan’s obligations at the valuation date. This means that the liability for a member who is expected to receive a commuted value is based on the expected cost of paying that member a commuted value. The liability for a member who is expected to receive an annuity is based on the expected cost of purchasing an annuity for that member.
Since most pension plan sponsors and pension actuaries don’t purchase annuities regularly, they don’t have a good sense of their cost at any point in time. To assist them with this problem, the Canadian Institute of Actuaries (CIA) publishes guidance on the estimated cost of purchasing annuities each quarter. Pension actuaries can then use this guidance to calculate the solvency liabilities for members who are expected to receive annuities.
What goes into annuity prices?
The pricing of an annuity is based on three broad factors:
- the returns available on the assets that the insurance company uses to back the annuities;
- the characteristics of the members included in the annuity purchase; and
- the supply and demand in the market.
To estimate the cost of purchasing annuities, the CIA asks a number of Canadian life insurance companies to prepare illustrative quotes each quarter. The CIA then looks at these illustrative quotes (along with recent actual annuity purchases) and comes up with their guidance.
Currently, this guidance is one size fits all for all pension plans. It captures the returns available on life insurance companies’ assets but doesn’t capture the characteristics of the members included in the annuity purchase. That is, it doesn’t distinguish between different plan characteristics that could cause annuities to be more or less expensive.
The current guidance captures a portion of the impact of supply and demand, but because it’s released quarterly it doesn’t capture minor week-to-week pricing differences caused by changes in supply and demand.
How does a plan’s membership influence annuity prices?
There are many different characteristics that can influence the cost of purchasing annuities for a group of pension plan members. Two of the most important factors are the average age of the members and the relative life expectancy of the members.
The average age of members impacts the price of annuities by determining the types of assets that the insurer can use to back the annuities. If members are older, then the insurer can only buy shorter-term assets, which generally have lower yields. If members are younger, then the insurer needs to buy very long-term assets (such as provincial bonds), which generally have lower yields. Recall that the lower the yield, the higher the annuity price. In fact, there’s a sweet spot for an annuity purchase with an average age of about 60. An average age either higher or lower than about 60 generally results in higher annuity prices.
The relative life expectancy of the members impacts the price of annuities by determining how long pensions are expected to be paid. Annuities for plans with blue-collar members are generally less expensive than annuities for plans with white-collar members, as blue-collar members are not expected to live as long as white-collar members.
The illustrative data that the CIA sends to the Canadian life insurers assumes an even blend of white-collar and blue-collar members and a mix of immediate pensioners and deferred vested pensioners. By chance, the average age of the combined group happens to be about 60. Recall that age 60 is the sweet spot that will generally result in the highest insurer yield (and lowest annuity prices).
One size does not fit all
Here’s a table of how the cost of non-indexed annuity purchases might change compared to the guidance provided by the CIA:
Annuity purchase members’ average age
0.5 years longer than average
0.5 years shorter than average
Source: Sun Life Financial estimates for a typical sample plan. The actual impact for a plan will depend on that plan’s actual characteristics and each insurance company’s actual pricing.
This means that the true cost of purchasing non-indexed annuities for a group of members with an average age of 75 who are expected to live longer than average is 12% higher than the cost suggested by the CIA estimate (based on the sample plan considered above).
Recently, we encountered an example of how relying on the CIA guidance can create an unwelcome surprise. A pension plan budgeted for a non-indexed annuity purchase by estimating the cost of purchasing annuities using the CIA guidance. Unfortunately, the average age of the members for whom the annuities were to be purchased was much higher than that assumed in the guidance. As a result, the cost of purchasing annuities was higher than the plan expected, leading to the plan cancelling its annuity purchase and having to seek additional cash from its sponsor.
Change is coming
The good news is that the CIA is planning to update its estimated cost of purchasing non-indexed annuities later this year. We understand that the new guidance will make allowances for different average ages to give plan sponsors a better idea of the cost of purchasing annuities.
This is great news for plans that are thinking of purchasing non-indexed annuities and want a more realistic idea of the cost. It’s also great news for plan sponsors that are worried about benefit security and want to ensure that their solvency liabilities more accurately reflect the true cost of settling their obligations.
The new guidance won’t capture life expectancy views (which can differ by life insurance company) or minor shifting supply and demand differences (which can change weekly). Thus, plan sponsors and their consultants will still need to use judgment and common sense when determining their liabilities.
Brent Simmons is the senior managing director of defined benefit solutions at Sun Life Financial. These are the views of the author and not necessarily that of Benefits Canada.