Risk Management Best Practice

An Improved Application of the Variable Annuity

Author: Stephen A. Eadie FCIA, FSA
Mr. Stephen Eadie is an independent contributor to the Global Risk Institute on pension and income security issues. He is solely responsible for the content of the article. This is the second article Stephen has submitted to GRI. Stephen’s biography is at the end of the article.

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EXECUTIVE SUMMARY

Variable annuities have been used as a payout mechanism in some US pension plans that are qualified under the U.S. Internal Revenue Code for many years. This innovative payout technique has also been introduced in a large pension plan in British Columbia that is registered under the Canadian Income Tax Act. Under this technique, the registered pension plan establishes a “hurdle rate”. The hurdle rate is the pension plan fund’s targeted r eal rate of investment return. The difference between the hurdle rate and the plan fund’s actual investment return is used to adjust monthly pensioner payments each year.

For example, if the hurdle rate selected for the registered/qualified plan is 4% per annum and actual investment returns for a particular year are 6%, then all members participating in this payout scheme would receive a 2% increase in their monthly pensions. The key is to select a hurdle rate that is expected to be close to the average real rate of return of the plan’s underlying assets over the long term. In that way, the pension increase average will be close to the average rate of inflation over the long term.

The variable annuity technique has been used to provide the plan’s pensioners with increases that offset inflation in order to maintain the buying power of the pensioner ’s retirement income. With a well selected hurdle rate that approximates the pension plan fund’s real rate of return, and well managed investments, variable annuities have performed very well and average annual pension increases have been comparable to inflation over time.

The variable annuity can result in volatile adjustments to pensions in pay when investment markets are volatile. This is the main complaint for many considering implementing a variable annuity.

We have assessed two potential improvements to the variable annuity for current application in qualified US pension plans or r egistered Canadian pension plans. Our goal is to provide a more stable increase to member’s monthly pensions and to better control all post-retirement risks that pensioners are confronted with during retirement.

As a result of our assessment we recommend two important changes to the administration of a variable annuity for registered and qualified pension plans.

First, we would introduce an averaging mechanism to stabilize the year by year pension increases under the variable annuity. This would be accomplished by using a five-year recognition of each annual adjustment. We would calculate the annual adjustment over a five year period that would change the pensioner liabilities by exactly the difference between the actual investment return and the agreed upon hurdle rate. For example, if the actual change in the market value of assets was 2% more than the hurdle rate, then there would be an increase scheduled of a little more than 0.4% each year for the next five years (the actual increases would be determined so that the total pensioner liability increased by exactly 2% in this example).

In the following year, the new “adjustment” would be added to the existing adjustment. For example, if the actual change in the market value of assets was 1% less than the hurdle rate, then this year’s increase would be 0.2% (i.e. an incr ease of 0.4% carried forward from last year and a decrease of 0.2% from this year’s results). In this way, adjustments should be less volatile but the goal of providing pensioner increases over the long term while maintaining the balance between assets and liabilities is preserved.

Second, we would introduce a longevity risk control mechanism by introducing the concept of a “hurdle annuity”. The hurdle annuity for any member would be determined using the “hurdle rate” and the “hurdle mortality assumption” that is established for the pension plan. In this way the hurdle annuity would be uniquely defined for any pensioner.

We would then determine the ratio of the assets held for the pensioners at the end of the year to the liability for the remaining pensioners. The liability for each pensioner would be equal to the pensioner ’s “hurdle annuity”. For example, if the total assets exceed the sum of the “hurdle annuity” for all of the pensioners by 2%, then we would schedule increases equal to 2% in aggregate over the next five years.

In this way, we will provide well defined pensioner increases to control the post-retirement inflation risk, control the investment risk and control the longevity risk for the pensioner group. The key will be to define a proper “hurdle annuity” basis, to establish proper control procedures for the “hurdle annuity” basis and to establish appropriate investment strategies.

With the above proposals we would have a more stable pension increase pattern
and better equity for pensioners who are members of a variable annuity.

Many pension plan sponsors use an insured annuity  to provide for pensioner payments. We estimate that an insured annuity is at least 45% more expensive than the variable annuity in today’s environment despite the fact that the expected benefits are very similar. Is it prudent to continue using insured annuities as a payout strategy if a well-designed variable annuity is available?

In addition, we do not believe that it is prudent for pensioners to continue to manage their own assetsbeyond retirement. Most people do not have the expertise to manage retirement assets well and many who do have the expertise will lose that expertise as they age.

Finally, expenses could easily be accommodated in this model by simply using net investment returns after expenses in determining hurdle annuities which result in scheduled increases. In this way, actual expenses could be supported by the underlying fund assets. There would be no need to pay for unexpected losses from investment returns, increased longevity or additional expenses from outside sources. The fund supporting the variable annuities established in this way would be self-sufficient. This would be a tremendous benefit to both plan sponsors and plan members alike.

New pensioners in defined contribution retirement savings arrangements currently have two options at retirement. Purchase an annuity or continue to manage their retirement program alone.

A variable annuity program will provide a new pensioner a third option at retirement.

This updated variable annuity concept could be used as a payout strategy for defined benefit, defined contribution or target benefit pension plans. It could even be offered as a payout option for a collection of RRSP contracts. It would offer many advantages to all pension plan stakeholders as explored in this article.

It could be used to provide better access to good pensions for everyone. 

 


About the Author

Stephen A. Eadie

Stephen A. Eadie

Stephen is a founding partner of Robertson, Eadie & Associates, a pension consulting firm in Toronto, Canada. He provides complete pension consulting advice and services to his clients across Canada. He is a past General Chair of the Society of Actuaries’ Education Committee. He is vice-chair on the Canadian Institute of Actuaries Committee on Professional Conduct. He has been an education Review Panelist for the Global CERA initiative since its inception in 2010. He is co-vice chair of the Education Committee of the International Association of Actuaries.

 

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