Canadian Pension Plans Look to Annuities, Fixed Income to Preserve Pension Surpluses

With funded ratios at their highest levels in years, pension risk transfers are among the ways firms are trying to de-risk their portfolios.

Many Canadian pension plans are in the enviable position of having a funded surplus, as of the year’s second quarter, thanks to positive market returns and higher interest rates that increased assets and lowered liabilities.

The Mercer Pension Health Pulse, a measure that tracks the median solvency ratio of Canadian corporate defined benefit pension plans in the firm’s pension database, increased to 119% at the end of the second quarter. Mercer estimates 85% of these plans were in a surplus position on a solvency basis as of June 30.

The Aon Pension Risk Tracker also noted an increase in Canadian pension plans’ solvency in Q2, pointing out the long-term Government of Canada bond yield increased 7 basis points during the quarter and credit spreads widened by 4 bps, leading to an increase in the interest rates used to value pension liabilities to 4.71% from 4.60%.

The Bank of Canada’s key policy rate sits at 4.75% as of June 2023, considerably up from 0.25% in January 2022.

Aon’s research shows Canadian pension plans’ funded ratios hovered around 80% in March 2020 but have gradually increased and recently reached 101%. The biggest factor for the gains in the past three years is the drop in liabilities as interest rates rose, moreso than asset gains, says Erwan Pirou, Aon’s Canada CIO of wealth solutions.

The strong financial position allows Canadian corporate pension managers to consider how to protect those surpluses and de-risk their portfolios. Sources familiar with Canadian pension plans say managers are taking steps such as increasing liability-driven investments, buying annuities from life insurance companies to transfer pension risk and taking advantage of higher interest rates to swap out shorter-dated bonds with longer maturities to match specific liabilities.

“Pension plans have been on a bit of a roller coaster ride for the last 20 years or so, with funded statuses being up and down and up and down,” says Brent Simmons, senior vice president and head of defined benefit solutions at Sunlife. “They’re asking a lot of questions and trying to figure out how they can make sure that they get off that roller coaster before it starts doing another circuit.”

Different Ways to De-Risk

Pirou says many of Aon’s corporate clients with closed plans are on glide paths, which de-risks the plan as the funding ratio improves, selling equites and alternative assets and moving into liability-driven investments as interest rates rose. He says those actions became more prevalent in the past year and a half as the Bank of Canada increased its policy rate.

Pension risk transfers are growing in popularity, Simmons says: 15 years ago, about C$1 billion of these transactions occurred annually, mostly undertaken by companies winding up their plans, but in the last few years, about C$8 billion in transactions has occurred annually, now by plans actively seeking out annuities.

Simmons says pension plans are looking at annuities as investment decisions, reviewing the yield baked into the price of the annuity and comparing it to other fixed-income yields. He says in the past few years, the yields on annuities have increased substantially compared to Canadian government bonds and corporate bonds.

Citing data from the Canadian Institute of Actuaries, the yield on annuities is close to a duration-equivalent corporate bond yield and above the yield of a duration-equivalent provincial bond yield, Simmons says. That makes pension risk transfer attractive.

“A lot of people are considering annuities almost as a super bond, because you get that great yield, and you also get to transfer risk,” he says.

Ben Ukonga, a principal in Mercer and leader of its wealth business in Calgary, says annuities are an excellent de-risking tool, but they have a cost, because the insurance companies selling annuities need to make a profit. Deciding whether to buy an annuity to de-risk or to go another route is a complex analysis.

“But in the end, the decision will depend on many factors, including the plan sponsor’s risk tolerance, cost of annuities versus the cost of maintaining the plan, size of plan versus size of the plan sponsor, plan sponsor capability and/or desire in continuing with the plan, to name just a few,” he says. 

Changing Asset Allocation to De-Risk or Diversify

Pirou says Aon is starting to extend the duration on some of the bonds in pension plan portfolios, switching from shorter-dated bonds to longer maturities, being able to match liabilities with the appropriate bond. That is something they were unable to do before the Bank of Canada and other central banks began tightening rates.

Katie Pries, president and CEO of Northern Trust Canada, says in addition to using LDI strategies or buying annuities, the bank’s outsourced CIO practice is seeing greater client interest in adding real assets such as real estate, infrastructure and natural resources to better hedge against inflation.

If pension plans have surpluses greater than specific thresholds, some are required to take contribution holiday and use the excess funds to cover the plan’s current service costs, reducing contributions.

“We’ve observed that this trend is increasing, especially on hybrid plans that have a defined benefit and defined contribution component where plan sponsors are using the surplus in the DB plan to fund their DC,” she says.

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