Pension risk myths - Dispelling common misconceptions on pension risk transfer options

Published: 26/08/2020

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" The great enemy of the truth is very often not the lie, deliberate, contrived and dishonest, but the myth, persistent, persuasive and unrealistic”
― John F. Kennedy

At one point or another, plan sponsors reach a fork in the road. For several years, TD Asset Management Inc. (TDAM), referred to this juncture as "Two Paths, One Destination", where plan sponsors typically had two options for the future of their pension plans - to annuitize with an insurance company via a pension risk transfer or keep assets with your asset manager and tweak your pension risk strategy.

This important decision is never cut and dry, with many different variables at play that need to be analyzed before deciding what route is the best option. But like most important choices, the quality of the output or decision heavily relies on the quality of the inputs used to make this decision. This is where we feel that, often times, not all the inputs used to make this decision are fully understood or quantified and that there can be considerations missed completely.

With this in mind, we recently had a chat with Michael Augustine, Managing Director and Lead Portfolio Manager of the Asset Liability Management Team (ALM) at TDAM to help "clear the air" on some of the more common misconceptions surrounding pension risk transfer.

Q:Is it accurate to say that insurers can access investments a pension plan can't?

MA: This is a misconception.

While we know the primary ingredient in an insurer's asset allocation is investment grade private debt, and, traditionally it has been true that this is a high barrier-to-entry asset class, this dynamic has changed over the past several years. Third party asset managers, like TDAM have built private debt lending platforms and often participate alongside insurers in the same deals that go into their annuity business. These asset managers now can provide their clients these private credit offerings. Now that's what I call access!

Q:Are annuities the only way to substantially de-risk a pension plan?

MA: Again, another misconception or "myth" in the industry.

A well-crafted liability driven investing (LDI) strategy that focuses on both the liability hedging and growth allocations can substantially de-risk a pension plan. With a focus on both interest rate exposure and cashflow generation, third party asset managers can enable plans to be better aligned with their underlying actuarial valuations and liquidity needs. Taking a liability-aware growth stance for active members mindful of both diversification and liability correlation, the equity and alternative allocations can be selected to reduce a plan's total risk.

What a lot of plan sponsors often overlook is that a buy-in annuity can actually introduce new risks as it may significantly reduce a plan's flexibility. Absent a secondary market, a buy-in annuity contract cannot be sold to address a plan's liquidity needs. Furthermore, the annuity cannot be posted as collateral limiting the plan's ability to participate in many derivative strategies.

Q:Is it true that the most cost-efficient solution is to annuitize the portion of your plan that is most "attractive" to the insurance companies?

MA: This is arguably one of the bigger misconceptions in this space.

The liabilities associated with your retired members are typically the most "attractive" portion of your plan to insurance companies. This is because there is a plethora of shorter-term cash flow generating opportunities available to investors. Unfortunately, once the insurance company has taken their profit margins and covered their hefty expenses, the annuity is an extremely low yielding fixed income substitute. Our research shows that sponsors embracing a do-it-yourself approach and directly investing in similar underlying investments can save 15-30% over an insurer's annuity. These savings can then be redeployed to the more difficult to hedge active liabilities.

New resources to help clear the misconceptions

In recent weeks, the ALM Team has released a new paper - an evolution of the popular "Two Paths, One Destination" article - that can help provide clearer "inputs" to making a well-informed decision. Do-it-yourself (DIY) Annuity Portfolios 2.0, the pension landscape has changed – and so have your options explores innovations in structuring retiree focused portfolios that challenge conventional wisdom around the merits and costs of transferring risk versus retaining and managing it.

Some of the key highlights of the article include:

  • Retiree solutions emphasizing cost-effective cashflow generation are gaining in importance; as they can now offer savings of between 15% to 30% over traditional buy-in annuities
  • Barriers to accessing private fixed income instruments have come down, allowing plan sponsors to create attractive, DIY annuity portfolios
  • Commercial mortgages are an attractive addition to TDAM's next generation of DIY annuity portfolios

Michael Augustine was also recently interviewed by Benefits Canada - Canadian Investment Review around his thoughts on the current pension environment. The interview can be accessed here.

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