In the past, annuities have rarely been discussed at pension committee meetings or received much of a focus at industry conferences.
That will change as annuities play a greater role going forward in helping defined benefit (DB) pension plan sponsors manage longevity and investment risk.
Some annuity highlights:
Insurers price annuities based on fixed income asset yields available in the public and private market to back annuity reserves.
In general, annuity pricing follows corporate yields with adjustments for credit default, capital requirements, profit, expenses and margins for adverse deviation. High corporate yields imply low annuity prices, even after the various adjustments.
The actual price for an annuity purchase for a plan sponsor depends on the DB plan's demographics and the assets available in the market to back the annuities at the time of the quote.
Insurance companies typically use only fixed income assets to back their annuity reserves (i.e., liabilities).
The cash flows and duration of these fixed income assets are tightly matched to the cash flows and duration of the expected annuity payments. In addition, margins for adverse deviation are included when calculating reserves.
The insurance company also holds regulatory capital, which is an additional buffer in the event that actual experience is different than expected.
Most insurers have risk management policies that require inflation-linked annuities to be backed with inflation-linked assets. However, the lack of such assets has limited the availability of inflation-linked annuities.
But not all inflation-linked annuities are the same. It's important to differentiate between annuities with capped indexing (e.g., annual increases equal to 60% of the Consumer Price Index (CPI) capped at 3%) and those with uncapped indexing (e.g., annual increases equal to 60% of CPI).
From a risk management point of view, capped indexing is easier for an insurance company to hedge against than uncapped indexing. As a result, the market for capped indexed annuities has historically been stronger.
Five common annuity myths – clarified. Did you know?
- Annuity prices have been at their lowest level in the past five years.
- Robust reserve and capital rules and comprehensive risk management practices protect the benefit security of annuitants.
- The Canadian group annuity market has more than doubled over the past four years and is likely to expand further to meet expected increased demand.
- A wide variety of annuity options are possible, including those with inflation-linked characteristics.
- The process of preparing an annuity quote is relatively straightforward and can be completed in one to two weeks.
Learn more about common misunderstandings in the Canadian Group Annuity Marketplace.