Longevity insurance aims to shore up defined benefit pension plans

By Susan Yellin | July 13 2015 01:52PM

A strategy recently introduced into Canada may help dispel the dilemma that Canada’s all-time high proportion of seniors, coupled with medical breakthroughs, will be the bane of defined benefit pension plans and a drain on our economy.
According to Statistics Canada, between 1981 and 2011, the number of Canadians increased significantly among those 65 and over with seniors projected to make up nearly one quarter of the Canadian population by 2041, compared with 14.8% today. Those aged 85 and over are expected to nearly triple to 5.8% of the total population by 2041.

Canada’s chief actuary Jean-Claude Ménard has warned that as lifespans increase, so will pension costs.

“Half of Canadian retirees are expected to live past age 90,” Ménard told a recent meeting of the American Society of Actuaries. “This will result in increased costs for pension plans as beneficiaries are expected to receive their benefit for a longer period.”

Recent research by Ménard’s office has suggested that a life expectancy of 100 could be attained by 2094 for men and by 2121 for women.

Unfortunately, says Lars Stentoft, associate professor and Canada research chair in financial econometrics at Western University in London, Ontario, forecasting mortality has traditionally been off by 18 months per decade.

“When we consistently underestimate these things, we run the risk that we set aside too few resources,” Stentoft told an April pension conference put on by the Conference Board of Canada.

Transferring risk

One of the antidotes to this problem may be the introduction to North America of longevity insurance for defined benefit (DB) pension plans. Earlier this year, Sun Life Financial announced an agreement with BCE Inc. to help it de-risk its DB pension plan by transferring longevity risk for $5 billion of pension plan liability to the insurance company.

Under the plan, Sun Life will monitor the longevity experience of BCE employees and if those in the group tend to live longer than what was originally agreed or assumed, the insurance company will make up the difference to BCE’s pension plan, Brent Simmons, a senior managing director in Sun Life’s DB Solutions Group explained in an interview.

Pricing is complicated because there are so many variables, says Simmons. But currently, for example, one year of additional life expectancy for a 65-year-old is worth 3%-4% of liabilities. So, let’s say a pension plan puts aside $100 for Mr. Smith when he retires; if suddenly there is a major cure for an illness or a major development in prolonging life, the pension plan now has to put aside $103-$104 for Mr. Smith. Multiply that by the number of members in a plan and that extra 3%-4% can be fairly material, says Simmons.

With the tech meltdown and the recent financial crisis, a number of pension plans are looking to de-risk, or transfer risk, out of their pension plans. There is a wide continuum of choice in how an insurer can help a pension plan de-risk with each company determining the risks for its pension plan and the best solutions.

For example, larger pension plans may be comfortable with the way they are managing investment risk, but they might be looking for a safer strategy for longevity risk only. Smaller companies may look at winding up their pension plans plan altogether and buy an annuity, therefore transferring all the responsibility to an insurer. “No one size fits all,” says Simmons.

Growth market

The total market for group annuities in Canada stood at about $1 billion prior to last year, when the market jumped to $2.5 billion in liabilities moving to insurance companies via annuities. Sun Life’s share, says Simmons, is about 40% of that, holding the top position in the country. “We see Canada as a growth market,” he says, noting that the country has about $1.4 trillion in defined benefit pension plan liabilities.

The top three trends in de-risking strategies are annuities, longevity insurance as well as investment risk, says Simmons. When it comes to investment risk, companies are recognizing that having equities in their pension plans creates a lot of risk so they are increasing the amount of more stable bond holdings. The problem with that is that the expected rate of return from bonds is low. Some pension plans are now turning to alternative asset classes like private fixed income, real estate and commercial mortgages to make those fixed-income assets work harder and make up some of the returns they are experiencing.

Simmons says the longevity insurance de-risking strategy with BCE, while big in England, is a first in North America, and he doubts it will be the last.

“Our phones have been ringing off the hook with people being really interested in what it was that BCE did and what other types of resolutions there are.”

RBC Insurance recently launched its own pension derisking solution for DB pension plans (See The Insurance and Investment Journal, May 2015).

Meanwhile, Stentoft says different kinds of risk affects the profit of many companies, weakening their balance sheets; individuals are affected by the anxiety that they may run out of money before they die, and society suffers from different risks which could potentially put a strain on the entire retirement system.

To compensate for longevity risk, Stentoft says companies would have to raise their pension fund provisions by about five per cent – a total of $90 billion in Canada.

He outlined a number of potential ways funds could use the stock market and so-called longevity derivative products to ensure longevity risk is taken into account when operating a pension plan. Should an index be created to offset longevity risk, Stentoft says it would have to measure the overall improvement in mortality, be interpretable so people know what it is they trade, allow people to invest easily and not be constantly revised with new information.

Stentoft says longevity risk is important and considering its size it is reasonable to argue that capital market solutions are required.

But in spite of the clear benefits of creating indices on which contracts can be structured, he says there is no consensus about which index to use.

More importantly, he notes, even if people could agree on a longevity risk index, it may be impossible for a market to develop.

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