Defined benefit pension plan sponsors who are interested in better pension risk management for their retirees have two main strategies to consider: They can either transfer their pension risk by buying an annuity or they can retain it.
Plan hibernation for retirees refers to a strategy of retaining pension risk, but closely matching the plan’s assets and liabilities to reduce this risk. Insurance companies invest their annuity assets in a similar low-risk way – hence plan hibernation has also been referred to as a do-it-yourself annuity.
While hibernation is a strategy that every defined benefit pension plan should consider, it is sometimes incorrectly evaluated versus an annuity purchase. I want to set the record straight and give plan sponsors a fuller picture of plan hibernation for retirees.
The goal of hibernation is to retain pension risk for the long term – perhaps 50 years for a plan with young retirees – and avoid the cost associated with an annuity purchase.
But how can a plan sponsor evaluate the cost savings of plan hibernation? One approach is to compare the yield that the pension plan can earn on its assets to the yield offered by the annuity. That is, how much yield is the pension plan giving up by investing in an annuity?
In order to make an apples-to-apples comparison, the yields need to be adjusted for differences in risk and expenses between the two options. There are several steps to this adjustment.
Step 1: Asset mix
At June 30, the yield on an annuity was 75 basis points higher than the yield on a passive public bond portfolio of a comparable duration.
So in order to make a hibernation portfolio cost effective, a plan sponsor has to be willing to invest in fixed income assets that generate a much higher yield than a passive public bond portfolio. This usually involves a high allocation to illiquid assets and corporate bonds.
If the plan sponsor is uncomfortable with these sorts of investments then an annuity purchase will be more cost effective.
Step 2: Investment risk
An annuity transfers investment risk (such as bond defaults or interest rate mismatch) to the insurance company. In order to make a fair comparison between the hibernation strategy and the annuity purchase strategy, the yield on the hibernation strategy needs to be reduced to reflect the investment risk that the plan sponsor still retains.
The cost of investment risk protection is difficult to estimate. One proxy is the cost of credit default insurance, which protects the purchaser against bond defaults. The cost of credit default insurance has been in the 50 bps to 70 bps range for much of the last five years based on the Markit CDX North America Investment Grade 5 Year Index. This index is based on a basket of investment grade credit default swaps with an average BBB rating.
Step 3: Longevity risk
An annuity also transfers longevity risk to the insurance company. Under a hibernation strategy, the plan sponsor retains this risk. Longevity risk is the risk that plan members live longer than the plan actuary expects due to factors such as medical advances or healthier lifestyles.
Longevity risk has cost plan sponsors 25 per cent to 30 per cent of liabilities over the last 40 years according to Sun Life estimates. Based on this historical experience and current market prices for longevity insurance, I estimate that the cost of retaining longevity risk is in the range of 40 to 60 bps per year. The yield on the hibernation strategy should be reduced to reflect this risk.
Step 4: Future expenses
As mentioned earlier, the goal of a plan hibernation strategy is to run the plan for many more decades. The plan sponsor will continue to incur both internal and outsourced expenses such as:
- Administration fees (e.g., actuarial, legal, accounting, HR, member administration, regulatory fees)
- Investment management fees
- Pension Benefit Guarantee Fund fees (if applicable)
On the other hand, an annuity purchase eliminates some or all of these expenses for the covered retirees. The reduction in yield for administration fees will vary by plan, but could be in the range of 10 to 20 bps per year. Investment management fees for a retiree hibernation portfolio with a high allocation to illiquid assets and corporate bonds could be another 25 bps per year. The yield on the hibernation strategy should be reduced to reflect these expenses.
Where does that leave us?
Putting all this together, a plan sponsor purchasing a buy-out annuity may arrive at a yield adjustment of 150 bps. This means that for a retiree hibernation strategy to have a similar risk/expense profile to an annuity, the plan sponsor needs to earn a yield on its assets that is at least 150 bps higher than the yield on an annuity.
This hurdle rate will be different for each plan sponsor. In addition, there are several other factors to consider when deciding between a retiree hibernation strategy and an annuity purchase strategy, such as the impact on accounting results, cash contributions, benefit security and operational risk. It may be helpful to engage a consultant to evaluate all these factors.
How a plan sponsor addresses pension risk can have a material impact on the plan sponsor’s core business and on the benefit security of its members. It’s best to consider all the facts when deciding on a de-risking strategy.
This article was originally published by Canadian Investment Review on November 11, 2020 in English only.