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Marvel Comics introduces Annuity Woman!

I have written about annuities before and my admiration for the super powers of the annuity in risk management.  There is no other place where you can put all your investment and longevity risks in the hands of another party and live a peaceful retirement knowing that you have a cheque coming in every month for the rest of your life.  Well that is almost true because the Canada Pension Plan offers that same comfort.

My recent commentary about the advantage of a DB pension plan over a DC pension plan was an attempt to partially refute the media saturated message that DB plans are better than DC plans which is being made by self-interested managers of DB plans that are sponsored by taxpayers.  I say partially refute because I conceded that super-large DB plans can have an investment advantage over small DC plans and also because my work only looked at the ‘accumulation phase’.  The DB plan cheerleading team rightly points out the advantage for DB plans also continues through the decumulation phase.  I address this issue this time around. {Readers should note that I received some pushback on my last commentary – but not by the DB cheerleaders but by the DC boosters who suggest my ‘management fee’ estimates were too generous to DB and unfair to DC.  More on that in a future commentary.}

The Annuity Guarantee

I won’t go over all the details of how annuities work.  I want to focus on one point of comparison between annuities and the monthly income delivered by its sister the DB plan.  Both the annuity and the DB plan deliver monthly payments for the life of a retiree – both can offer various survivorship options.  So how is it that the DB plan can take the same accumulated nest egg and pay a higher monthly amount than the insurer selling the annuity?

The answer to this question is simple – but like the game of Three Card Monte, it is elusive and the trick is to keep your eyes on all three moving cards at once in the monthly-income game – they are, the payment, the backing investment, and the guarantor.

The payments, for both the annuity and the DB plan, are determined by the lump-sum accumulated at the time payments commence and the ‘expected’ return on the investments to be earned in the future from these funds.  Where things get interesting is the choices that the insurer and the DB plan sponsor make when it comes to investments.  The insurer generally invests the assets backing the annuity promise in bonds and mortgages.  This decision is made because bonds and mortgages promise fixed periodic coupon payments which, if lined up properly with the income promised by the annuity, keeps the risk low of running out of money before payments cease to be due.  In contrast, the DB plan administrator invests its assets in a mix of stocks and bonds and, as of lately, a number of ‘alternative investments’.  The DB plan investments are ‘expected’ to earn a higher return and so a higher monthly pension can be promised.

So why don’t the insurance companies follow suit and invest in these ‘better’ investments?  Keep your eyes on the three cards!  It is because of the guarantor.  The insurer, carefully regulated in Canada by OSFI, cannot make bets that it cannot afford to lose.  If the somewhat riskier investments don’t pay off – the insurer is the guarantor of the pensions and payments must be made in full.  That means that the shareholders of the insurer will lose money if the investment don’t work out and OSFI is careful to make sure that management doesn’t gamble with more than it can afford to lose.

So doesn’t OSFI demand the same care and caution with the investment in DB plans?  Nope.  First of all, OSFI only regulates a handful of DB plans – many are regulated by the provinces.  Regardless, DB plans, as noted at the outset of my last commentary, are not designed to deliver fool proof guarantees.  Rather, historically, the rules governing the funding of pension plans were designed to deliver ‘all of their promises most of the time and most of their promises all of the time’ (thanks Gerry Schnurr).  In recent years, changes in the rules have eroded the strength of DB plan funding which is not something the public understands at all.

So where is the Queen of Hearts?  It is the guarantor – the lovely lady who is there to make sure the money is there when the payments are due.  In the DB plan, there is a guarantor that is outside of the assets already on hand – an option not available to the cautiously regulated insurer that is required to have the needed assets already in the building.  Sometimes the guarantor of a DB plan is the corporation sponsoring the pension promise, sometimes it is taxpayers, and sometimes, as is the case with our large multi-employer plans, it is the members of the plan themselves.  You now see how this all works – you get more money up-front, but someone is running the risk that they will pay if there is not enough money on the back end.

So when we say DB plans are better than DC plans, we need to be honest and include the cost of the guarantee that in a DC plan clearly falls to the plan member until they make the decision to buy an annuity and swap future investment gains and losses for the comfort of a well managed guarantee that the money won’t run out.