Since 2021, the solvency of defined benefit pension plans has been hovering around 100 per cent, giving their sponsors more leeway to build better risk buffers. A recent increase in the value of annuities relative to bonds gives plans even more maneuvering room.
The risks that pension plan sponsors face included those linked to financial markets and retiree longevity. Asset/liability matching and the purchase of group annuities are strategies frequently used to hedge these risks.
The value of annuities relative to corporate bonds has improved by 5 per cent over the past 3.5 years, told Mathieu Tessier, Senior Managing Director, Client Relationships and Innovation, Defined Benefit Solutions, at Sun Life, to Insurance Portal.
Tessier, who is also an actuary, draws this conclusion from a Committee on Pension Financial Reporting educational note issued by the Canadian Institute of Actuaries in March 2021, and its October 2022 update. Published quarterly, the note provides guidance for assumptions for hypothetical wind-up and solvency valuations. It compares annuities with 10-year Canadian bonds.
Best provisioning in 20 years
According to Tessier, the result of improving annuities relative to these bonds “is positive for defined benefit (DB) pension plans.” This has fuelled two recent trends, he adds.
First, plan sponsors are reviewing their fixed-income investment strategy and considering more sophisticated solutions. Second, the funding of many pension plans has improved. Tessier notes that in some cases, funding levels have exceeded 100 per cent. “This reflects the fact that sponsors are using annuities to proactively mitigate risk in a risk management context,” he says.
Mathieu Tessier highlights the good news: “Plans are better funded than they have been in the last two decades.” Mercer's Pension Health Pulse, which measures the median solvency ratio of DB pension plans in Mercer's pension database, increased from 109 per cent as at June 30, 2022, to 108 per cent as of September 30, 2022. In his commentary, F. Hubert Tremblay, senior consultant in Mercer's Wealth practice, noted that the financial health of most plans declined only slightly in the third quarter of 2022, despite significant market volatility.
Plans’ strong financial health provides aggressive plan sponsors with an opportunity to change their approach, Tessier continues, although it is impossible to say how long this situation will last. He expects plan sponsors to take advantage of this opportunity to increase their thinking and actions around risk management. “We fix the roof when the sun shines. It's a good time to take action and do more thinking,” he says.
Annuities a must
Tessier says the situation is even more favourable for annuities than it was last year, “after the distraction of the pandemic in 2020.” Growth in risk transfer transactions (in the form of group annuities or longevity insurance) was spectacular in 2021. “This is the result of the residual demand from 2020 combined with the demand from 2021. We are currently on track for another robust year. It would not be surprising to see these transactions cross the $7 billion mark in 2022,” he adds. In 2021, sales in the Canadian retirement risk transfer market reached $7.7 billion, according to a report by actuarial firm Eckler.
Eckler finds that group annuity pension risk transfers account for almost all of the transaction volume in this market. Longevity swaps are rare in Canada, but more common in Europe. Mathieu Tessier mentions that group annuity transactions have increased in Canada since the boom in 2017. He does not expect the wellspring to dry up soon, because Canada still has a very sizable cohort of large plans.
According to Mathieu Tessier, rising interest rates and vigorous demand from plan sponsors augur continued growth. “We don't seem to have reached a plateau.” He adds that passive bond investment management strategy is no longer as attractive. “Plan sponsors are turning to multi-asset credit strategies or offloading risk to insurers, whose group annuity pricing is currently very attractive,” he says.
Broader quality spectrum
Plan sponsors seem to be willing to take on more risk in their multi-asset strategy, Tessier continues. “They are moving further down the credit (security) quality spectrum, and into private equity,” the DB plan specialist says.
"The multi-asset credit strategy is an opportunistic strategy in the bond market. It is designed to take advantage of investment opportunities in both investment grade and non-investment grade public and private fixed income securities,” Tessier explains. He points out that this strategy provides access to a broad set of public and private bonds across the credit quality spectrum.
Not riskier
Tessier believes that the multi-asset credit strategy offers opportunities for diversification and increased returns that were lacking in recent years. This strategy is not necessarily riskier for pension plans, he adds. “For example, when you take the solvency or accounting valuation basis, there is a lot of credit exposure included. So having credit exposure in the assets allows for a good match between assets and liabilities and potentially reduces the risk associated with credit spread fluctuations,” he says.
Tessier also believes that some flexibility in the financial model of defined benefit pension plans allows for this increased risk-taking in liability management. For example, sponsors can take less risk in equities and “recycle that portion into fixed income securities like bonds,” he says.
