Are Your Passive Bonds Passé?

According to the Canadian Institute of Actuaries (CIA), the price of group annuities relative to provincial bonds has improved by about five per cent since early 2019. This is a very big shift in relative value. In fact, the yield on annuities is now better than the yield on a passive corporate bond portfolio after adjusting for risk and expenses.

This improvement in group annuity pricing relative to passive bonds hasn’t gone unnoticed by Canadian defined benefit plan sponsors and their consultants. It’s made passive bonds less attractive and contributed to two recent trends:

• it’s caused many plan sponsors to trade out of passive bonds and into more attractive investments
• it’s contributed to an increased demand for group annuities. Let’s discuss each of these two developments in more detail.

Trading Into More Efficient Fixed Income

Historically the yield on annuities was very close to the yield on a passive provincial bond portfolio. In early 2019 this started to shift with the yield on annuities of ten tracking more closely to the yield on a passive corporate bond portfolio. This relative improvement of about 0.5 per cent in yield compared to a passive provincial bond portfolio translates into a five per cent improvement in price.

Why would a plan sponsor invest in passive bonds when they can earn a better risk/expense adjusted return on other investments such as an annuity? Passive bond portfolios can work well for plan sponsors who prefer simple execution over either the potential value of active management or the higher yield offered by specialty fixed income asset classes.

That said, we’re increasingly seeing that plan sponsors are rethinking their fixed income investment strategies and considering more sophisticated options.

For example, an allocation to actively managed corporate bonds and investment grade private fixed income can provide better matching to a plan’s solvency liabilities, while providing a higher yield. Alternatively, multi-asset credit solutions aim to invest opportunistically across a variety of both public and private, investment and non-investment grade, and fixed income securities to provide diversified benefits, improved yields, and ease of access to investors.

These sorts of solutions can add value compared to a passive bond portfolio and better compete with an annuity.

Taking Pension Risk Off the Table

The improvement in group annuity pricing has improved the funded status of many pension plans – in many cases resulting in funded ratios above 100 per cent. In fact, according to Mercer, 72 per cent of pension plans in its database were estimated to be above 100 per cent funded on a solvency basis at September 30.

This makes purchasing annuities more affordable for pension plans and has led to more annuity purchases. According to LIMRA, the group annuity market doubled over the last four years – from $3.7 billion in 2017 to $7.7 billion in 2021.

Perhaps this isn’t surprising given that many plan sponsors have decided that they want to spend less time thinking about their DB pension plans and more time focusing on their core businesses. Annuities are a convenient way to transfer pension risk – notably investment and longevity risk ‒ to an insurer. They also include future investment expenses and annuity buy-outs include future administration expenses.

Market activity supports this hypothesis. About 88 per cent of annuity purchases in 2021 were for ongoing pension plans. This highlights how annuities are being used by plan sponsors to proactively manage their pension risk ‒ less pension risk means less potential bad news and more time to spend on their core businesses.

Here Today, Gone Tomorrow?

It’s unclear how long the relative improvement in annuity pricing will last. It could be the result of temporary supply and demand imbalances, or it could be the result of long-term market changes.

What’s clear is that dynamic plan sponsors have an opportunity to ‘trade up.’ Plan sponsors with passive bond portfolios can consider redeploying these bonds into more sophisticated investment solutions and/or using them to purchase annuities. There are a lot of elements to consider so it’s best to engage your consultant and investment manager for advice.

Brent Simmons is the Head of Defined Benefit Solutions at Sun Life.