LDI

Liability Driven Investing (Part Two): Discipline and De-Risking

In Part Two of the series titled “Manage Complexity, Deliver Clarity,” François Hélou, Director, Head of Balance Sheet Solutions Sales, BMO Global Asset Management, and Rohit Thomas, Vice-President & Chief Product Actuary, BMO Life Assurance Company, share their expertise on the risk management discipline they believe a Canadian Defined Benefit (DB) plan should adopt throughout its de-risking journey.
April 2019

François Hélou

Director, Head of Balance Sheet Solutions Sales, Institutional Sales & Service

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In Part Two of the series titled “Manage Complexity, Deliver Clarity,” François Hélou, Director, Head of Balance Sheet Solutions Sales, BMO Global Asset Management, and Rohit Thomas, Vice-President & Chief Product Actuary, BMO Life Assurance Company, share their expertise on the risk management discipline they believe a Canadian Defined Benefit (DB) plan should adopt throughout its de-risking journey.

 

First Step of a Liability Driven Investing (LDI) Discipline: The Unrewarded Risks

LDI is a risk management discipline that seeks, as a first step, to address the unrewarded risks of a DB plan. Unrewarded risks are present in both the DB plan’s assets and liabilities; however, their greatest exposure is in the DB plan’s liabilities. Unlike the risks embedded in the plan’s assets, the unrewarded liability risks are inherent to the plan’s design and are therefore permanent for the most part.

For most DB plans, the biggest unrewarded risk is the long-term interest rate risk that affects the plan’s liability value. For a DB plan with a 16-year duration, a 1% decline in its going-concern discount rate affects the plan’s accounting valuation in a way that is equivalent to approximately 16% decrease in its asset value.¹ By all measures this is a significant exposure, especially when one considers that some traditional Canadian balanced funds declined by less than 16% in 2008, which was the market’s worst calendar year of the Great Recession. The inversion of the Canadian yield curve up to approximately 12 years² calls for difficult times ahead for DB plans’ liability valuations, since it projects lower future interest rates in an environment where interest rates are already near historic lows.

Another unrewarded risk is the longevity risk, which negatively affects the plan if its retirees live longer than anticipated. Longevity risk could be hedged separately from other risks by way of longevity swaps with an insurance company, since longevity swaps hedge plan sponsors against future increases in their members’ longevity. Alternatively, longevity risk could be hedged along with the plan’s other unrewarded risks by way of a de-risking strategy with an insurer as we explain below.

Finally, the indexing risk is an unrewarded risk that exposes the plan to an adverse, and for the most part unexpected, movement in the index to which the plan’s liabilities are linked. Most indexed plans are linked to a Canadian inflation index. Other plans are indexed to non-inflation parameters such as the past performance of the plan’s assets, effectively “locking in” a past return as a future obligation irrespective of the future performance of the plan’s assets.

For a DB plan with a 16-year duration, a 1% decline in its going-concern discount rate affects the plan’s accounting valuation in a way that is equivalent to approximately 16% decrease in its asset value.¹ By all measures this is a significant exposure, especially when one considers that many traditional Canadian balanced funds declined by less than 16% in 2008, which was the market’s worst calendar year of the Great Recession.

The DB plans’ unrewarded risks should be addressed through an asset-liability analysis process before establishing the plan’s asset allocation, in order to ensure that the asset risks reflect both the plan’s liability profile and the plan’s funding level.

 

Second Step of an LDI Discipline: The Rewarded Risks

Once the unrewarded risks have been addressed, the LDI discipline will incorporate, as a second step, the level of rewarded risks into the plan’s asset allocation. The DB plan’s liability profile and its funding level will influence both the amount and the profile of the rewarded risk the plan needs to take.

The inversion of the Canadian yield curve up to approximately 12 years² calls for difficult times ahead for DB plans’ liability valuations, since it projects lower future interest rates in an environment where interest rates are already near historic lows.

The level of rewarded risk suitable to a DB plan’s asset allocation should adapt to a number of parameters including, amongst others, the plan’s funding level, its proportion of active members, its regulatory funding requirements, and the effect of the plan’s asset allocation on its going-concern discount factor.

 

Unrewarded and Rewarded Risk Managements: What is the End Game?

Many DB plans seek a total de-risking once they achieve a predetermined funding level. In some cases, this is achieved with a hibernation strategy. However, the hibernated plan, along with all its associated risks including the longevity risk, remains on the sponsor’s balance sheet. Longevity swaps could be used in combination with a hibernation strategy to manage the overall unrewarded risk exposure.

Another pension de-risking strategy involves a Pension Risk Transfer with an insurer. Depending on the structure, the plan is either totally removed from the sponsor’s balance sheet or remains on its balance sheet with the sponsor’s administrative role maintained. If a Pension Risk Transfer is the sponsor’s end game, its LDI strategy could progressively adopt an investment portfolio that reflects the insurer’s hedge profile. This investment strategy, combined with a transfer-in-kind of the portfolio, minimizes both the market risks and the transfer costs as the sponsor transfers its plan from an LDI strategy with the asset manager to a Pension Risk Transfer with the insurer.

Pension Risk Transfer? Hibernation? Benefits Improvements?

In the past few years, most plan sponsors that have de-risked their pension liabilities have looked for a complete discharge as highlighted by the large volume of buy-out annuities in 2018. This also explains why longevity swaps have not become prevalent in the Canadian pension market; plan sponsors that have looked to focus on their core business have opted for a buy-in or a buy-out annuity solution instead of maintaining their exposure to market and interest rate risks.

 

Pension De-Risking – An Insurer’s Point of View

In 2018, the total Pension Risk Transfer (PRT) market increased to $4.5 billion from $3.7 billion in 2017 and $2.7 billion in 2016. With an annual growth rate of over 30%, the PRT market continues to gain traction, as plan sponsors look to execute ongoing risk management on their DB pension plans.³

It is interesting to note that in 2016 and 2017, 30% and 57% of transactions were buy-in annuities, while in 2018 only 14% of transactions were buy-in annuities. Moreover, as of Q3 2018, only 8% of transactions were buy-in annuities.³

A buy-in annuity occurs when a plan sponsor purchases an annuity from an insurance company to eliminate longevity and market risk, but continues manage the day-to-day administration of the plan and pays members directly. A buy-in annuity is an investment or hedge from a plan sponsor’s perspective; therefore, no accounting settlement is required. The plan remains on the sponsor’s balance sheet.

A buy-out annuity occurs when an insurance company takes on the full pension liability for all retirees, former members and/or surviving spouses, including the plan’s administration. The plan is transferred away from the sponsor’s balance sheet. Depending on the funding status of the plan, this could require a top-up and an accounting settlement.

The increase in buy-out activity in 2018, compared with 2017 and 2016, could partly be attributed to the following reasons:

  1. According to Aon’s Median Solvency Ratio, Q3 2018 hit an all-time high at a median solvency ratio of 103.2%; at a strong funding ratio, companies minimized their top payment to execute a buy-out annuity, which is why as of Q3 2018, only 8% of transactions were buy-in annuities.³

  2. On July 1, 2018, Ontario amended the Pensions Benefits Act to provide a full discharge for buy-out annuity purchases, thereby eliminating what is known as the “boomerang risk.” This would apply for all buy-out annuity purchases after and prior to July 1, 2018.

  3. As market volatility increased in Q4 2018, plan sponsors began evaluating buy-in versus buy-out options during the quoting process, which led to an uptick in buy-ins as plan sponsors looked to manage their top-up payment.

If a PRT is the sponsor’s end game, its LDI strategy could progressively adopt an investment portfolio that reflects the insurer’s hedge profile. This investment strategy, combined with a transfer-in-kind of the portfolio, minimizes both the market risks and the transfer costs as the sponsor transfers its plan from an LDI strategy with the asset manager to a PRT with the insurer.

From the plan sponsor’s perspective, there are several motivating factors behind a PRT, but the underlying reason continues to be the sponsors’ willingness to focus on their underlying business instead of taking on the four types of risks that we described in Part One of our LDI series, which are all skewed against the plan sponsor.

In addition, PRT deal flow has started to follow industry trends. If competitors within a certain industry are investigating de-risking, other plan sponsors follow suit in order to maintain their competitiveness or shareholder value. These could be in industries that might have undergone challenging market conditions or industries where there is significant cost pressure and narrow margins. As plan sponsors look to manage their risks, focus on their core business and stay competitive, the demand for PRT continues to increase.

In 2018, the insurance industry absorbed $4.5 billion in PRT,⁴ and it was clear that capacity and interest for PRT was stronger than ever. Insurance companies are going to continue to focus in this area and the following points detail why demand by insurance companies is not expected to slow:

  1. With additional data sources, increased quoting volume, the volume of data available to insurers to get comfortable with longevity has increased. Insurers are able to price a wider variety of longevity profiles and price them competitively, due to increased confidence in the risk profile.

  2. In 2018, the Office of the Superintendent of Financial Institutions (OSFI) released new capital rules called the Life Insurance Capital Adequacy Test (LICAT). Under these rules, insurance companies receive a diversification credit with offsetting risks (i.e., mortality and longevity risks). As a result, having a portfolio with mortality and longevity risks allows insurers to optimize capital and obtain diversification credits.

  3. Based on past quotes, a majority of buy-in and buy-out annuities have liability duration of approximately 8-12 years. For an insurer, this is a relatively short duration business, compared to traditional life insurance, which may have liability duration of at least 30 years. Therefore, with shorter duration business, insurers are able to match their liabilities better, react and adapt to actual experiences, in addition to shortening their overall liability duration at their corporate level.

  4. Finally, insurers leverage their scale and expertise to take on credit risk, and this provides competitive pricing for DB plan sponsors, while attracting high-quality assets to the insurer’s balance sheets.

In 2018, the insurance industry absorbed $4.5 billion in PRT,⁴ and it was clear that capacity and interest for PRT was stronger than ever. With an annual growth rate of over 30%, the PRT market continues to gain traction as plan sponsors look to execute ongoing risk management on their DB pension plans.

In conclusion, overall insurance capacity and appetite for the PRT business are expected to increase as their balance sheets grow in size and the underwriting capabilities advance with increased data capabilities.

Stay tuned for our next article in the Fall 2019 edition of IQ, in which we’ll discuss specific risk management solutions applicable to various plan funding levels, as well as the optimal investment portfolio transfer to an insurer as the plan approaches its target of full de-risking with an insurer.

BMO Global Asset Management is both an award-winning⁵ and a global market leader in balance sheet and LDI solutions to DB plans, ranking among the world’s top LDI managers.⁶ We bring our LDI expertise to more than 525 clients, managing over $186 billion in pension liabilities globally. Our global industry endorsements include first-rate rankings in flexibility, innovation, client service, and responsiveness.

BMO Insurance is a leader in the pension industry and an innovator in de-risking solutions. It provides life insurance and annuity expertise to companies seeking ways to limit balance sheet volatility due to their Defined Benefit pension liability. Backed by the strength of BMO Financial, BMO Insurance offers customized solutions and specialized risk mitigation strategies to support pension de-risking.

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¹ Ignoring convexity – all else remaining equal.

² As of March 21, 2019.

³ LIMRA Canadian Pension Market Summary (2016, 2017, 2018).

⁴ Aon Hewitt Canada, “Financial health of defined benefit pension plans rebounds to start 2019,” April 2, 2019.

⁵ Provider of the Year (2017, 2016, 2015, 2014, 2013 and 2012), Pension and Investment Awards; Risk Management Provider of the Year (2017 and 2015), Irish Pensions Awards; UK Manager of the Year (2017), Professional Pensions Investment Awards; Manager of the Year (2016), LAPF Investments Awards; Manager of the Year 2013, 2012 and 2011, European Pensions.

⁶ Greenwich UK Investment Consultant Survey 2018.

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