Dealing with pension plan longevity risk
Retirees aren’t the only ones who need to worry about outliving their money. Longevity risk is a major concern for defined benefit pension plan sponsors as well. While longevity risk largely remains with workers for defined contribution pension plans and group RRSPs, it’s the employer that bears the brunt of the risk with traditional defined benefit pension plans.
What is longevity risk?
With the advances in medical care, it shouldn’t come as any surprise Canadians are living longer than ever before. The average life expectancy in 2012 in Canada is 80 for men and 84 for women, according to the World Health Organization. While actuaries have been building longer life expectancy into mortality tables for years, what they didn’t anticipate is how quickly average life expectancy would improve.
Longevity risk isn’t about human beings living longer. Longevity risk is about human being living longer than expected. Longer life expectancy has a direct impact on the bottom line of employers by increasing liabilities. Mortality tables recently released by the Canadian Institute of Actuaries (CIA) are predicted to increase pension liabilities alone by between five and 10 per cent.
Now that we’ve acknowledged the risk posed by longevity, here are some strategies to mitigate it.
Defined contribution and Group RRSPs
The easiest and perhaps the most popular way to reduce longevity risk is to close your defined benefit pension plan to new entrants. With a defined benefit plan, it’s the plan sponsor that can run into trouble if employees live longer than expected. Meanwhile, with a defined contribution plan or group RRSP, retirees will have to stretch their savings further to make sure they don’t outlive their money.
Shared-risk pension plan
Shared-risk pension plans are the new kid on the block. Although not yet available to the private sector, they have been adopted with some success in the public sector in provinces like New Brunswick. As the name implies, in a shared-risk pension plan, both employees and employers equally share risk. If employees live longer than expected, it can lead to a reduction in benefits payable or in some cases the elimination of ancillary benefits like indexing.
Group annuity purchases are an effective way to get longevity risk off the books. There are two ways to reduce risks with annuities: a buy-out and a buy-in. In a traditional pension buy-out, pension plan assets and liabilities are transferred to the insurer in exchange for an upfront fee. The insurer then bears the responsible for making pension payments directly to retirees. While a buy-in is similar to a buy-out, in a buy-in the assets and liabilities obligations remain with the plan sponsor.
Lump sum settlement
Although a lump sum settlement can prove costly in the interim, it can significantly reduce longevity risk down the road. When you offer a lump sum settlement, not only can you get active members off the books, this presents an opportunity to get deferred vested members off the books, too. Since the mortality tables are prescribed and not updated on a regular basis, lump sum settlements are an effective and less costly way to reduce longevity risk.
There you have it, a few options available for plan sponsors to protect themselves against longevity risk. It’s prudent to plan ahead and have a strategy in place, as longevity risk is a risk that won’t disappear unless you’re willing to deal with it head on.