Plan for Success: Navigating Pension De-Risking

Nathan Kanter: Hi, I'm Nathan Kanter and welcome to this episode of the Blakes Sound Business podcast. Today, we're exploring an increasingly important topic for pension plan administrators — de-risking registered pension plans. 

Joining me are Blakes Partners Bonny Murray from our Financial Services group and Jeff Sommers from our Pensions, Benefits & Executive Compensation group. They'll share their insights on key strategies for de-risking a pension plan, including buy-in and buy-out annuity contracts and longevity risk transfers, and highlight what plan administrators need to know about the Canadian regulatory landscape.

Let's get started.

[music]

Nathan: We often hear the term de-risking in the context of registered pension plans, but what does that actually mean, and what are the most common strategies for de-risking a pension plan?

Jeff Sommers: Sure, well, let’s start with what we mean by de-risking. Pension plans face various types of risks, some of which can be mitigated or minimized by various de-risking strategies. For purposes of this podcast, we're focusing on defined benefit pension plans. And the primary risks that we're talking about addressing include longevity risk, which is the risk that plan members will live longer than the actuaries have estimated they will live, investment risk, which is essentially that the rate of return on the plan's assets won't be as high as expected, and interest rate risk, which is essentially that long-term interest rates won't behave as projected. The de-risking methods that we're going to discuss today help reduce or minimize one or more of those risks, depending on the particular method.

Bonny Murray: The most common methods of achieving this pension de-risking are really by far utilizing buy-in and buy-out annuity contracts. These are insurance products provided by life insurance companies to the pension plan, or, less commonly, longevity risk transfers. Those are also typically insurance contracts issued by a life insurance company, but they can also be structured as bank swaps or a swap with a non-insurance provider. And we'll discuss all of these approaches on the podcast. 

Understanding and negotiating these products requires both insurance and pension regulatory expertise, and Blakes is a market leader in both of these areas. And so, that's why Jeff and I are teaming up on the podcast today as we regularly work together to assist pension and insurance clients with these kinds of products.

Nathan: Can you walk us through the difference between buy-in and buy-out annuity contracts and why that distinction is important?

Jeff: Sure, well, let me start with buy-in annuities. In a nutshell, what happens in the case of a buy-in annuity is that the funding agent for the plan, which is typically the trustee if the plan is funded through a trust, on the direction from the plan administrator, will enter into a contract with an insurance company under which the plan makes a single premium payment to the insurer. And in return, the insurer becomes responsible for paying to the pension plan the amount of the monthly pension payments that become due to a defined pool of retirees who are covered by the policy. And from a pension regulatory perspective, a buy-in annuity is essentially an investment of the pension plan, and it should be subject to all the same levels of scrutiny as any other pension plan investment. 

From the member's perspective, it's essentially invisible. The insurer is making the payment into the pension fund, and the pension fund just continues to make the pension payments to the member out of the plan. So, from a member's perspective, nothing changes. They still get their pension every month from the pension plan, it is completely invisible to them. 

In terms of statutory discharges, which I'll get into more when we talk about buy-out annuities, but the key thing from a buy-in perspective is that there is no statutory discharge available under pension legislation, so that is a notable difference. Essentially, doing a buy-in annuity helps mitigate, as I mentioned, longevity risk, investment risk and interest rate risk, at least with respect to the particular pool of retirees who are covered by the policy.

Bonny: And I'll add that, from an insurance regulatory perspective, the buy-in annuity, it's a single bulk annuity policy, again, issued by a life insurance company to the pension plan. And there are limited compliance elements that apply, so limited statutory requirements that we need to see in the policy from an insurance perspective. But we do review these for clients to make sure we have all of those requirements. And we do see a fairly significant difference in the form of bulk annuity policies that Canadian insurers will offer to pension plans for this purpose. And so, Jeff and I regularly review these for pension plan clients to help them figure out the benefits of the different forms of policies and what will be most suitable for them. 

Jeff: Great, now let's turn to buy-out annuities. So, what happens in the case of a buy-out annuity is very similar to the structure of a buy-in annuity, except in this case, it’s the plan administrator that enters into a contract with a life insurance company, rather than the trustee or other funding agent of the pension plan. And under that policy, a single premium is paid by the plan to the insurer. And in exchange for that, the insurer actually becomes responsible for paying the monthly pensions as they come due directly to the pensioners who are covered by the policy. So, the big difference here is that the insurer is actually making the payments directly to the retirees and not to the pension plan, as in the case of a buy-in annuity. 

And so, what happens here from a legal perspective is that the buy-out annuity is essentially settling the benefits under the plan. The insurer becomes responsible for directly making those payments to the pensioners. This does involve a member communication issue, obviously, because from the member's perspective, it is changing. They're no longer going to get their pension from their employer's pension plan. They're going to be receiving their pension from the insurance company. So, there's a communication aspect to this. 

And from a pension legislation perspective, in some jurisdictions, there's a statutory discharge, which I mentioned before, available to the plan administrator. And what that essentially means is that the pensions that are settled by the buy-out annuity are no longer obligations of the plan and no longer need to be reflected on future actuarial valuations and whatnot for the plan. So those statutory discharges are very important to the plan administrator. And from the administrator's perspective, you should ensure that you satisfy the requirements in the particular legislation to qualify for those discharges. And the discharge requirements differ by jurisdiction, and it depends on the jurisdiction in which the retiree was last employed, in respect of their pension, and each jurisdiction that has discharge provisions has different requirements, and so there is a fairly significant legal exercise to go through to make sure that you satisfy all of those requirements. So, it is highly recommended that you obtain legal advice, and we've done this for many, many clients in ensuring that that discharge is available and that you qualify for it.

Bonny: And from an insurance regulatory perspective, whereas the buy-in was a single bulk annuity policy issued by the insurer, as Jeff said, the buy-out results in individual annuities issued by the life insurance company to each plan member. So, the members are now customers of the insurance company. Again, when we're reviewing these for clients, we might look at those annuity policies just to ensure that they meet the limited statutory requirements.

Nathan: For plan administrators considering a buy-in or buy-out annuity, what does the purchase process typically involve?

Jeff: So, at a high level, the plan administrator works with its actuaries, its consultants and its legal counsel, all as part of deciding and executing the purchase of a buy-in or a buy-out annuity. The first step is typically for the plan administrator to analyze with its actuaries and its consultants whether the purchase of a buy-in or buy-out makes sense in the context of the particular plan, which also includes consideration of any counting impact on the plan sponsor. But once you've decided that it's the right thing to do for your particular plan, the next step is typically to ensure that your plan data is up to date. And after that, you work with your consultants, typically, to help prepare a request for a quotation document. Your consultants help you identify the insurers that might be interested in participating in the bidding process. Essentially, you're looking for initial, sort of, expressions of interest from insurers. 

Legal counsel sometimes retain to assist with the RFQ document. It really does depend on the plan administrator. We recommend that you do it, not that we draft that document, but that we at least review it from a legal perspective. 

The next step is typically that the insurers who are interested in potentially bidding would provide the plan administrator with their standard form contracts, either buy-in or buy-out, depending on the situation. And that's another place where legal counsel, I think, should get involved because what we do is we review those template agreements at a very high level to do what we call a red flag review to see if there's any key legal provisions that are either missing or not worded the way you would like them worded. And we have found that it's actually possible to negotiate with insurers, even before the bids come in, that they'll agree to make certain tweaks to their standard form contracts, so that as the administrator, you get the comfort that the legal provisions that you're going to be looking for will be agreed to by the insurer. 

Typically, then, the bidding process occurs so that the interested insurance companies provide their bids. Bids are open for a very short period of time, usually just a few hours. So, the plan administrator needs to have its team in a war room somewhere, ready to review and decide on various bids that come in. Legal counsel is sometimes involved in that, but certainly your actuaries and your consultants will be involved. And once you've decided who the winning bidder is, you typically confirm that either through the signing of an application with the insurer or sometimes it's as informal as just sending an email confirmation.

The next step then is again cleaning the data and making sure that the data that has been provided to the insurance company is correct and actually negotiating the final contract with the winning bidder. And that's where it's really important to have legal counsel involved, as well as your actuaries and your consultants, in negotiating the terms of that contract. And if it's a buy-out policy, ensuring that all of the requirements for a discharge under the applicable pension legislation have been satisfied.

Nathan: Let's turn to another strategy that's generating interest — longevity transfers. What exactly are they, and how do they help pension plans manage risk? 

Bonny: Well, longevity risk, as Jeff said at the top, is the risk of members living longer than the plan had anticipated. And this is a big risk that pension plans face, and pension plan sponsors typically aren't in the business of estimating mortality. And so, a longevity transfer essentially helps the pension plan manage that longevity risk while still retaining control of the plan's investments. The transfer mitigates against errors or volatility in the plan’s current estimations of life expectancy, as well as against future improvements in life expectancy. And the transfer shifts the longevity risk and this aspect of pension plan management from the sponsor to a life insurer, which is in the business of estimating mortality, and so, therefore better suited to take on that longevity risk and manage it. 

As I said, these are typically structured as insurance products and offered by life insurers. They did originally emerge as bank swaps where the bank was the counterparty, but these are very long-term contracts. The contract essentially matches the lives of the people covered under the contract. And so that ultimately made them less attractive to banks from a capital perspective, and now they've shifted and they're really primarily available as insurance products. 

Nathan: And how does a longevity transfer work in practice? Can you explain the mechanics and how risk is transferred?

Bonny: Yes, so the insurance product itself, it's a contract between the life insurance company and the plan sponsor, and it's structured as a swap — a swap of a fixed payment leg and a floating payment leg. So, the pension plan will identify the pool of members that it wants covered, just like with a buy-in or buy-out. The insurer then assesses the longevity risk of that pool, and they'll offer the pension plan a price to take on the longevity risk. So that is a fixed price that the pension plan will then pay to the insurer for the duration of that longevity contract. So, it will be a premium payable at a certain frequency. And like I said, the duration of the contract aligns with the lives of the pool that have been identified. So, over the course of the contract, the insurance company, in turn, will pay the pension plan a floating amount that matches the actual pension benefits payable to the covered members. So, pension plan pays fixed amount to the insurance company, insurance company pays a floating amount back to the pension plan, and then the pension plan continues to pay out the benefits to members.

The fixed and floating legs are set so that the insurer is in the money, is making a profit margin to start. And then the pension plan is willing to pay that premium to have that certainty of paying the fixed amount for the duration of the contract rather than being exposed to the longevity, which provides uncertainty into the future.

The long-term nature of the longevity contract does introduce some complexity, and this all has to be accounted for in the contract. So, for example, the accuracy of the member data is, of course, critical to the insurer, and the contract will typically have very detailed provisions relating to the initial and ongoing data reviews and corrections. And depending on the materiality of corrections that are made, this may impact pricing going forward. There may be a pricing adjustment within the contract. The parties will also typically have rights to conduct additional mortality basis reviews at certain frequencies throughout the contract. Or upon the happening of certain events or thresholds, and that may alter the assessment of the longevity risk and may also result in a pricing adjustment during the term of the contract.

The parties may implement a collateral structure that would secure the divergence between the fixed and floating legs. And that divergence, it may vary back and forth during the contract, and it may become more material over time. And if the divergence, again, crosses a certain degree threshold, it will often result in a reset of the fixed-and-floating legs if that divergence becomes too large. These collateral structures, I'll just say in particular, can be tricky given, again, the parties we're dealing with are pension plan insurance companies, they are subject to regulations and those regulations do tend to impose some limitation on granting collateral.

Jeff: I would just note that from a pension regulatory perspective, longevity swaps are somewhat similar to buy-in annuities. There is no statutory discharge available to the plan administrator, and essentially that insurance contract or swap contract is treated like an investment of the plan. As I mentioned, with buy-in annuities, they should be subject to the same level of scrutiny that other pension plan investments would also involve.

Nathan: How common are longevity transfers in the Canadian market today?

Bonny: Longevity transfers aren't overly common in the Canadian market. You know, compared to the U.K., there's been a very active market in the U.K. for, you know, going back 20 years. There's also been a market developing in the U.S. There have been some significant longevity transfers in Canada, but the market has not developed certainly to the same extent as in the U.K. That's probably due to a combination of factors like limitations in pension and insurance regulations, the size and the nature of the pension plan market in Canada. There's a tendency for Canadian pension plans to divide their members into tranches and split that up among different insurers. And of course, interest rates and other market factors at times can make longevity pricing less attractive. They certainly can also be daunting from a legal perspective due to the potential complexity of the contract. That means higher legal fees to get these set up and they are often perceived as much more complex compared to buy-ins and buy-outs which have become much more routine. 

However, general market expectation is that pension risk transfer activity in Canada will continue to be high over the next few years, and so longevity transfers may be appropriate for certain pension funds or certain parts of the plan. And while the legal aspects can be complicated, Blakes has had the opportunity to advise on most of the significant longevity transfers that have taken place in Canada, so we're very well placed to help our pension plan and insurance clients navigate these issues and use these products when they're appropriate.

Nathan: If our listeners want to learn more about these de-risking products, who should they reach out to? 

Jeff: Well, they can reach out to any member of the Blakes Pension, Benefits & Executive Compensation group or our Insurance Regulatory group. Those groups work very closely in advising clients, and we have extensive experience in advising clients on all of the products we talked about today. We've certainly negotiated or helped clients negotiate buy-in and buy-out annuity contracts opposite all of the major insurance companies that operate in this space. So, we do have extensive experience, and we'd be happy to assist anyone listening with navigating the pension de-risking process and addressing the issues that we've talked about today.

[music]

Nathan: Bonnie, Jeff, thank you for sharing your insights today on pension plan de-risking. 

Listeners, for more information on this topic and to explore other episodes of the Blakes Sound Business podcast, please visit blakes.com. 

Until next time, take care.

[music]