Pension Risk Bulletin Readiness Paid Off in a Turbulent Year

Pension Risk Bulletin Readiness paid off in a turbulent year

Volume 2 | Issue 1 | January 2021

Editorial Team Morneau Shepell publishes original content

Marc Drolet, FCIA, FSA, CFA that provides insights for pension plan Principal, Asset & Risk Management sponsors and pension plan administrators 514 293-1571 on the topic of pension risk. [email protected] Our goal is to draw upon our research and our experience to advance the conversation Véronique Lauzière, FCIA, FSA on a spectrum of topics related to pension Principal, Asset & Risk Management risk management and transfer. 514 231-3352 [email protected]

Benoît Labrosse, FSA, CERA Partner, Asset & Risk Management 514 641-4556 [email protected] Key points • Overall, the Canadian Group Annuity Market was resilient in 2020

• Buy-in group annuities are becoming more popular, reinforcing the notion that they can produce a superior net risk adjusted return than LDI strategies

• Market dislocations offer pension risk transfer opportunities

• Level of pension risk transfer activities is expected to be high for 2021 and beyond

2020: Anatomy of the group annuity market In the face of the public health crisis caused by the COVID-19 pandemic, the Canadian group annuity market, sponsors and insurers, has proven to be strong and resilient with an estimated volume of $4.5 billion, a figure not too far from 2019’s record-breaking year for Canada.

Figure 1 – Canadian Pension Risk Transfer Market Evolution

5.5 $5.2B +13% 5.0 $4.6B ≈$4.5B

$ Billions +25% 4.5 -13% 4.0 $3.7B +35% 2,630 3.5 1,759 1,700 3.0 $2.7B $2.5B $2.6B +6% 1,123 +11% +4% 2.5 $2.2B 2.0 1,120 694 1,194 733 1,070 1.5 1,474 2,269 1,280 717 659 1.0 871 1,342 595 332 178 693 0.5 1,020 580 705 379 935 457 435 0 180 356 47 260 108 2013 2014 2015 2016 2017 2018 2019 2020 Q1 Q2 Q3 Q4

The economic uncertainty and some regulatory restrictions introduced as a result of the crisis led to a volume of only $540M (12% of the 2020 volume) to be transacted during the first two quarters, which is a noticeable drop compared to prior years. The third quarter saw a record-breaking transaction of $1.8 billion completed in a single day, of which approximately $1.1 billion was with a single insurer. This jumbo transaction accounted for the vast majority of the volume transacted in Q3. As the year progressed, a combination of plan sponsors’ confidence and easing of regulators’ restrictions translated into, once again, a very busy fourth quarter in 2020 with an approximate volume of $1.7 billion transacted.

The year 2020 has been a testament to how a single transaction can significantly affect the total volume in a given year, stressing the importance of transparent communication between the plan sponsor or administrator, the advisor and insurers to carefully plan transactions. During the course of the year, certain insurers may reach their capacity to underwrite or may have to prioritize quotation requests. This is exactly what happened

Pension Risk Bulletin | January 2021 | Volume 2 | Issue 1 Morneau Shepell 2 after the large transaction in the third quarter. Bids were less competitive because some insurers no longer had attractive assets or their annual target was reached. This often occurs when a few large transactions hit the market in a short time period, making communication with insurers even more important in busy times. Being prepared in advance allows a plan sponsor to choose the appropriate time to achieve its objectives.

Buy-in annuities continue to be popular, representing about 1/3 of the transactions but 80% of the volume in 2020, which is consistent with the increased appetite for further de-risking plan assets by putting to good use the money invested in a Liability Driven Investing (LDI) strategy, for example. The purchase of buy-in annuity contracts is considered an investment decision and the plan fiduciaries have an obligation to evaluate what sources of similar risk adjusted returns can produce the best yield for plan members. 2020: Behavioral analysis under extreme conditions The liquidity crunch affecting the bond market, particularly corporate bonds, in March and April of 2020, and the volatility observed in the financial markets has reminded all stakeholders how volatile the funded status of a pension plan can be. At the end of the first quarter, equity valuations had tanked and risk-free interest rates were at record low levels. According to the Morneau Shepell Solvency Pension Index1, a sample pension plan’s solvency ratio had deteriorated by about 13%. For anyone concerned about day-to-day valuation of liabilities and assets, this was a very stressful period as no one could confidently quantify the lasting impacts of the crisis on the global economy.

Figure 2 – Morneau Shepell Solvency Pension Index

110

105 104.0

100 100.0 100.7 99.2 97.8 95 96.3 95.3 94.6 93.4 93.5 90 89.8 90.4 87.0 85 Index (Jan. 1, 2020 = 100) 1, 2020 (Jan. Index 80

75 Jan. 01 Jan. 31 Feb. 29 Mar. 31 Apr. 30 May 31 Jun. 30 Jul. 31 Aug. 31 Sep. 30 Oct. 31 Nov. 30 Dec. 31

Year 2020

Financial market volatility was such that an off-cycle solvency proxy was published on April 30, 2020 by the Canadian Institute of Actuaries. The narrowing of credit spreads since the prior proxy (March 31, 2020) resulted in discount rate reductions of 20 bps across all durations. Most insurers were still open for business to transact despite these extreme conditions. It is worth mentioning that some insurers decided to adopt additional risk management measures, such as requesting intra-day premium adjustments and considering in ‑kind premium payment for much smaller transactions than we had previously experienced. Insurers were also willing to quote on smaller transactions than usual until the market would become more stable.

1 Refer to Morneau Shepell Pension Indices Report as of December 31, 2020 for disclosures and details on methodology https://www.morneaushepell.com/ca-en/insights/morneau-shepell-pension-indices-december-31-2020.

Pension Risk Bulletin | January 2021 | Volume 2 | Issue 1 Morneau Shepell 3 As is often the case, bad news for some can be good news for others and the market dislocations created some group annuity opportunities. The widening of credit spreads during the peak of the crisis allowed insurers to find higher yielding fixed‑income assets, which improved the group annuity pricing for the transactions that went to market at that time or shortly thereafter. The graph below illustrates the spreads for accounting and solvency purposes over federal bond yields. Rarely in the recent past have we seen as much variability in the relative spreads. These dislocations created opportunities to transact at attractive prices vis‑à‑vis the accounting liabilities, thereby reducing the negative impact of such transactions on the balance sheet. Great opportunities were seized by organizations that were ready to transact on short notice.

Figure 3 – Solvency vs Accounting spreads

CIA Solvency Spread Accounting Spread 3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0% 09 10 11 12 01 02 03 04 05 06 07 0809 10 11 12 01 02 03 04 05 06 07 0809 10 11 12 01 02 03 04 05 06 07 0809 10 11 12 2017 2018 2019 2020

The crisis highlighted many key risks, such as market valuation, liquidity, rebalancing, and basis risk to name a few. The shortcomings of LDI strategies during market turmoil were also revealed to some extent by the presence of a higher tracking error with the underlying liabilities but overall, plan sponsors that de‑risked a good portion of their plan assets before the crisis were less impacted and preserved in large part their ability to purchase annuities. As the year progressed, the interventions of central banks and governments to boost local economies took effect, which led to an incredible turnaround for the equity markets given the continued economic uncertainty. As corporations continued to manage and adapt to the pandemic, the willingness to discuss and mitigate risks was and remains a key topic of conversation with plan sponsors and plan administrators. Longevity risk, the forgotten risk Canada saw its third longevity insurance agreement completed at the beginning of 2020 for the Co-operative Superannuation Society (CSS) pension plan. The agreement allowed the CSS plan, a defined contribution type arrangement, to transfer longevity risk for $660 million of liabilities to Cooperators Life Insurance Company2.

Despite the higher mortality rates in 2020 related to the pandemic, at this point in time insurers and reinsurers suggest that the long-term mortality rates are unlikely to change significantly and that mortality improvement rates should continue to rise slowly, as expected prior to the pandemic. The sustained improvements in life

2 http://newsreleases.cooperators.ca/2020-01-28-The-Co-operators-and-CSS-Pension-Plan-reach-longevity-insurance-deal

Pension Risk Bulletin | January 2021 | Volume 2 | Issue 1 Morneau Shepell 4 expectancy continues to draw the attention of Canadian plan sponsors to longevity risk and the potential ways to mitigate their exposure. Longevity is a risk pension plans are not rewarded for assuming. An insurer can mitigate some of the mortality risk present in their other insurance products by underwriting longevity risk from pension plans or by reinsuring it.

The focus of pension plans across Canada has been in large part to strike the right balance between cost and risk exposure and most often longevity risk has been the forgotten risk. As the investment risks related to defined benefit (DB) and defined contribution (DC) plan are better managed, it is only a matter of time before longevity risk is being assessed and products are developed to meet the needs of various stakeholders. The United Kingdom has seen about $150 billion CAD of DB liabilities transferred through a longevity insurance product. When Canadian stakeholders of DB and DC plans realize the potential benefits of mitigating longevity risk, one would expect customized longevity insurance products to gain in popularity in Canada. Notable news impacting insurers of the pension risk transfer market • Effective January 1, 2020, SSQ Insurance decided to re-enter the group annuity market after a hiatus of nearly 20 years. As of July 1, 2020, SSQ Insurance merged with La Capitale, creating the largest mutual insurance company in Canada3. With an existing block of business and the structure already in place, SSQ Insurance participated in smaller annuity bids and successfully transacted in the third quarter of 2020. The merged company has been rebranded Beneva.

• Effective January 1, 2020, The Great-West Life Assurance Company, London Life Insurance Company and The Canada Life Assurance Company announced they would be coming together under one brand, Canada Life4. As a result of this structural change, Canada Life is no longer able to provide double Assuris protection for new policies. All existing buy-out policies with double Assuris protection are not impacted by this change. Expectations for 2021 and beyond While we continue to manage and navigate our way through the effects of the public health crisis, we expect the pension risk transfer market to remain strong in 2021 and beyond:

We experienced for the third time in less than 20 years how volatile the capital markets can be. Corporate plan sponsors have great awareness of pension risks and are more determined than ever to find solutions to manage or transfer these risks. Carefully reducing the size or reducing the volatility caused by the defined benefit plan through group annuities or longevity insurance is a solution most sponsors should seriously consider and evaluate.

The appetite from insurers and the industry as a whole continues to grow for group annuities. A growing number of insurers are allocating an increasing amount of financial and human resources to pension risk transfers. The size of transactions is still growing and we continue to expect more frequent jumbo transactions.

3 https://ssq.ca/en/about-us/news/birth-of-the-largest-mutual-insurance-company-in-the-country-with-la-capitale-ssq- insurance-merger-of-equals#:~:text=La%20Capitale%20and%20SSQ%20Insurance,integration%20will%20take%20place%20 gradually 4 https://www.canadalife.com/about-us/news-highlights/news/introducing-the-new-canada-life--one-brand-for-three-iconic- canadian-companies.html

Pension Risk Bulletin | January 2021 | Volume 2 | Issue 1 Morneau Shepell 5 A buy-in annuity can be a sound and well-priced alternative to a LDI strategy. Considering the buy-in also eliminates the longevity risk, acting essentially as a super bond. The specific benefits of one alternative over the other will vary based on the plan administrator’s objectives, the underlying population, the plan characteristics and the economic environment at the time of the comparison. We expect buy-in annuities to continue to be a popular risk transfer strategy for pension plans.

A plan sponsor has plenty of control over several factors that influence a transaction and can deal with many of them in advance. Steps such as alignment of investment portfolio, data cleanliness and completeness, governance structure and understanding of fiduciary implications can be sorted out beforehand. We expect sponsors and fiduciaries to continue undertaking risk transfer feasibility studies to identify a group annuity strategy that could help them meet both corporate and fiduciary objectives.

We believe that data-driven longevity insurance product will eventually become more prevalent, particularly for plan sponsors or administrators seeking plan sustainability over the long term, such as those in the public and quasi-public sectors. Plan administrators can find that transferring the longevity risk to a third party can be done at a price that is advantageous for the plan.

Pension Risk Bulletin | January 2021 | Volume 2 | Issue 1 Morneau Shepell 6 This publication contains general information only and it is not meant to be a substitute for professional advice or services. Morneau Shepell Inc. and its affiliates shall not be responsible for any loss whatsoever sustained by any person who relies on this publication.

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