A do-it-yourself approach to buy-in annuities

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Three gold nest eggs gleam against black background © Florence And Joseph McGinn /123RF Stock photosWith an aging population of baby boomers and a general trend toward closing defined benefit pensions, many plan sponsors are facing negative cash flow situations.

In response, retiree solutions are gaining more importance, says Michael Augustine, managing director of portfolio management at TD Asset Management.

While pension plans can purchase an annuity through a life insurance company, they can also create a do-it-yourself, or DIY, annuity, he says, noting the strategy can help plan sponsors save money, improve their funded status and maintain flexibility.

“This sort of strategy first took off in some of the more mature pension markets like the U.K. and the U.S,” says Augustine. “If you’re in the U.K., you might hear it referred to as a self-managed buy-in. If you’re in the U.S., you might hear the strategy often referred to as a hibernation portfolio.”

A plan sponsor can build its own DIY annuity using cash-flow generating fixed income instruments, including private credit and commercial mortgages, as well as a diversified basket of corporate bonds and provincial bonds, he notes.

DIY annuities allow investors to keep the assets, unlike a traditional buy-in annuity which can’t be used for short-term liquidity needs, Augustine says. “Traditional buy-in annuities also cannot be used as collateral. If you think about implementing any sort of derivatives strategy, and these are growing in popularity, you can’t post that annuity as collateral.”

Further, with so many new entrants coming into the Canadian annuity market, a DIY option allows a plan sponsor to maintain flexibility instead of locking in with a specific provider now. “The general idea is, with more competition in the market, pricing should come down,” he adds. “So this is a nice way of waiting and seeing if you can get better pricing in the future.”

In addition, a plan sponsor buying an indexed annuity right now would be locking in a negative yield because yields on indexed bonds are so low, Augustine says. “If someone just simply went into the bond market and bought indexed bonds, they’d pick up a substantial premium in terms of yield. And then, if you take those instruments, those real return bond instruments, and you start to overlay credit strategies, you can actually get a meaningful advantage over what an insurance company would credit you. And that allows you to create an indexed DIY annuity or something that’s going to fluctuate with the movements in [the consumer price index] and garner incremental yield over an indexed buy-in annuity.”

In addition to using a DIY annuity as a buy-in option, plan sponsors can use this approach to replace buyouts. “For some pension plans, especially those that are too large to buy annuities, they can invest in these strategies, in these type of portfolios, as sort of a replication strategy or a replacement for an annuity. And actuarial guidance in Canada actually takes this approach into consideration.”

For plan sponsors that take this approach and pair it with a longevity swap, he adds, it can provide a true synthetic annuity position.

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