OSFI’s Guidance on Buy-in Annuities
At the end of August, the Office of the Superintendent of Financial Institutions (OSFI) released a draft version of their Instruction Guide on Buy-in Annuity Products. This instruction guide replaces previous guidance on buy-in annuities that was published by OSFI back in 2012. The main updates to this guidance reflect updated requirements for the valuation of assets and liabilities for buy-in annuities in a valuation report, and a more detailed discussion on the considerations the plan administrator should consider prior to purchasing a buy-in annuity. While this instruction guide will become effective November 30, 2022, early adoption is permitted, and furthermore, OSFI is seeking stakeholder feedback on this draft guidance by October 14, 2022.
As a quick reminder, Buy-in Annuities are similar to Buy-out Annuities; however, instead of issuing individual certificates to covered members and paying pensions to them individually, the insurer makes the pension payments to the pension fund. Thus, a Buy-in Annuity is best thought of as a plan investment, as the pension plan retains the legal responsibility to pay member benefits. As a plan investment, Buy-in Annuities have certain advantages over Buy-out Annuities, including: avoiding the need to make a top-up contribution for underfunded plans, the potential to avoid an accounting settlement charge, and flexibility to be converted into a buy-out annuity at an opportune time.
Valuing an Annuity Buy-in in a Valuation Report
As outlined in the guidance note, OSFI expects liabilities for pension benefits covered by a buy-in annuity contract to be determined using one of the following approaches:
- Assumptions that reflect annuity purchase rates at the valuation date determined in accordance with the Canadian Institute of Actuaries’ annuity proxy guidance;
- An actual annuity purchase quote provided by the life insurance company;
- Assumptions that reflect the expected annuity purchase rates in the future based on the period of the contract at the valuation date;
- A replicating portfolio approach.
The guidance goes on to say that the asset value related to the buy-in annuity, which is typically referred to as the notional value of the buy-in annuity, should reflect the fair value of the investment, and that generally, OSFI would expect that this would be equal to the market value or actuarial present value of the pension benefits covered by the annuity buy-in contract. In particular, the value the notional asset for the annuity buy-in should be consistent with that used to value the corresponding liability, and that it should not be subject to an asset smoothing adjustment.
This guidance allows for my preferred approach for valuing the assets and liabilities of a buy-in annuity – which is to value both the notional asset and liability for the buy-in annuities as the assumed annuity purchase price at the valuation date (and typically calculated using the Canadian Institute of Actuaries’ annuity proxy).
Nevertheless, the guidance goes on to state that, for the solvency valuation, the termination scenario should consider whether the buy-in annuity would be converted into individual annuities, or whether a ‘surrender value’ under the annuity contract would be remitted to the plan. This distinction is especially important for 1) buy-in annuity contracts which may have a clause that requires the refund of the ‘surrender value’ in a certain circumstance, or 2) plans that are underfunded at termination and are required to reduce the benefits for the annuitized members to ensure that all plan members have a pension reduced on a proportional basis. If a ‘surrender value’ is to be provided in the termination scenario, then there would likely be a difference in the in the value of the notional asset and liability for the buy-in annuities, and the actuary would also need to consider the settlement charges and expenses in the termination expense provision.
Personally, I am supportive of the guidance that OSFI has developed on how to reflect annuity buy-ins in valuation reports.
The OSFI guidance also lists a number of items that a plan administrator should consider, as part of their fiduciary responsibilities, prior to purchasing a buy-in annuity, such as:
- consider the current investment structure and risk tolerance of the pension plan;
- understand the impact of investment and longevity risks on the pension plan (e.g. via stress testing);
- determine the appropriate time for entering into an annuity contract and whether it is in the best interest of plan members, former members with deferred pensions, retirees, and survivors;
- determine whether the annuity contract offers value for the cost of entering into the contract;
- plan the logistics of the payment of the annuity contract and consider the risks related to paying in cash or transferring assets in-kind (e.g. liquidity risk)
- consider risks to the pension plan associated with the annuity contract (e.g. counterparty risk);
- ensure that laws concerning data privacy are followed;
- understand the annuity contract (e.g. terms including in-force and termination provisions, associated costs, collateral, strength of counterparty, and benefits covered);
- ensure that the terms of the annuity contract allow for the administration of the pension benefits in accordance with the plan provisions and applicable legislation;
- ensure that individuals with the appropriate level of knowledge are involved in the decision-making process; and
- develop adequate controls and oversight to manage the risks listed above.
I wish to observe that this list would also be useful when considering a buy-out annuity.
It is nice to see OSFI update this guidance note, especially since the original guidance is now 10 years old and did not include much discussion on the administrative considerations. Also, and as noted above, I am supportive of the methodology for how to value a buy-in annuity in a valuation report as outlined in this guidance.
If I were to have one observation, it would be that, with the fairly dramatic increase in the funded status of plans in the past couple of years, there may be more incentives for plan sponsors to opt for a buy-out annuity over a buy-in annuity. But based on the data that I’ve seen, buy-in annuities are still quite prevalent.