The Mercer Canada Pension Buyout Index (“the Index”) tracks the relationship between the estimated cost of settling non-indexed pensioner obligations through purchase of annuities and the accounting liability shown in corporate financial statements for a hypothetical defined benefit plan. Similar indices are also being published by Mercer in the US, UK and Ireland. Mercer also publishes a monthly Mercer Global Pension Buyout Index which compares the cost of insuring DB retiree pension obligations in the US, UK, Ireland and Canada.
This information is intended to help inform decisions with regards to the appropriate time, if any, to consider purchasing annuities. Of course, there are many different ways to manage risk of defined benefit pension plans, ranging from diversifying the growth portfolio, through increases in allocation to liability hedging assets, dynamic de-risking, and settling plan obligations through purchase of annuities. Mercer consultants are available to assist pension plan sponsors, trustees, and administrators with a thorough analysis of the various de-risking opportunities as they apply to their specific plans and helping them decide which approach is the most appropriate for their organization.
The chart below illustrates the estimated cost of annuities for a sample group of retirees expressed as percentage of the corresponding accounting liability that would be disclosed in a plan sponsor’s corporate financial statements. As of December 31, 2014 the estimated cost of annuities for a typical group of pensioners was about 108.6% of the accounting liability. This means that the estimated cost of settling obligations through the purchase of annuities was approximately 8.6% higher than the liabilities shown in corporate financial statements.
The cost of purchasing annuities for retirees relative to the corresponding accounting liability increased approximately 4% in 2014, reversing more than half of the decrease observed in 2013. The index at December 31, 2014 is still considerably lower than its high points in December 2009 and December 2011.
We note that the accounting liability shown in corporate financial statements does not represent the full long-term economic cost of the pension plan. The full economic cost also includes factors such as provisions for asset defaults and longevity risk, future administration costs, investment management fees, as well as Pension Benefits Guarantee Fund premiums (for pension plans with Ontario members). These additional costs, which will vary depending on the specific circumstances of each plan and market conditions, can be significant and should be taken into account, along with other relevant factors, when considering any de-risking or risk transfer strategy.
In addition to the relative cost measure described above, it is important to consider the absolute cost of settling plan obligations. The chart below illustrates changes in the estimated cost of purchasing annuities and accounting liabilities over time. For the purpose of this chart, the Annuity Cost Index was arbitrarily started at 100% at December 31, 2009. The absolute cost of purchasing annuities for retirees increased approximately 15% between December 2013 and December 2014. This increase was driven both by a decline in long-term interest rates as well as more conservative pricing from some insurance companies.
On the other hand, accounting liabilities for the sample group of retirees increased approximately 10% over 2014 as a result of declining long term corporate AA bond yields.
Whether one looks at the relative or the absolute cost of settling the plan obligations, market conditions can change quickly. As a result, we believe that anyone that wishes to incorporate annuities into their de-risking strategy needs to be prepared and should evaluate in advance the steps required to facilitate such a strategy as well as gauge the financial and investment strategy impact.
Despite the headwind of falling interest rates resulting in the deterioration of the funded status of many pension plans and less favorable annuity prices, the Canadian annuity market was still quite active in 2014. Unofficial estimates indicate that the volume of annuities placed in 2014 exceeded the previous record of $2.2 billion of annuities placed in 2013 by a few hundred million. More and more plan sponsors are looking at ways to reduce their pension plan risk exposure, and buy-in and buy-out annuities continue to be at the forefront of the options available. With the benefit of hindsight, the last quarter of 2013 and the first half of 2014 was a favorable time to be purchasing annuities. However, the opportunity was short lived, which reinforces the importance of being prepared to act quickly when such opportunities present themselves.
The chart below illustrates the growth in the Canadian annuity market over the last few years (up to the end of 2014, based on an unofficial estimate for Q4):
The Index is provided for a sample group of non-indexed retired members and is only intended to illustrate general trends. The actual premium can vary significantly for individual plans based on a number of factors that may include:
Therefore, the Index should not be used to make any final decisions. If you are interested, we would be happy to help you gain greater insight into expected insurer pricing for your specific plan(s) as well as the implications of settling some or all of your plan obligations through the purchase of annuities.
The Index is based on an estimate of settling non-indexed pension obligations through purchase of annuities and an accounting discount rate based on a proprietary model developed by Mercer to assist our clients with selection of the discount rates used for the purpose of corporate financial reporting.
Mercer is a leading global provider of investment services, and offers customized guidance at every stage of the investment decision, risk management and investment monitoring process. We have been dedicated to meeting the needs of clients for more than 30 years, and we work with the fiduciaries of pension funds, foundations, endowments and other investors in some 35 countries. We assist with every aspect of institutional investing (and retail portfolios in some geographies), from strategy, structure and implementation to ongoing fiduciary management.
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