Greg Hurst highlights the hidden annuity option inside DC plans
Each month at BPM, we offer a slate of articles and content pieces that go deep on a particular topic. This month, we're exploring the assets and retirement solutions that make up defined contribution (DC) plans.
When it comes to pension risk transfers (PRTs), most industry conversations centre on defined benefit plans. But there is a quieter, less examined version of a PRT playing out in the defined contribution space, and Greg Hurst argues it deserves more attention.
"There's no institutional market PRT for DC plans. In DC plans, employers aren't exposed to investment or longevity risks, but there is interest in a broader suite of post retirement income products that address investment and longevity risk at the individual plan member level," said Hurst, managing director at Greg Hurst & Associates.
As Hurst explains, in the DB world, employers carry the weight, everything from investment risk, longevity risk, funding obligations. When they offload those through a PRT, it’s a corporate decision with institutional pricing. Whereas in DC, the risk sits with individual plan members, and any transfer happens one person at a time, often through products like variable payment life annuities.
"It's the insurers that drive the market for DC pension risk through the development of retirement income products. And their marketing efforts are designed to encourage plan sponsors to adopt those products," Hurst noted.
According to Hurst, the primary motivation for DC plan sponsors is a growing unease about whether members will have enough income to last through retirement. Before VPLAs, the options were limited, Hurst noted, pointing to RIFs and locked-in retirement income funds (LRFs), which set minimum and maximum (LRIF only) annual withdrawals but offered no certainty that the money will hold out. While life annuities have always existed as an alternative, Hurst acknowledged they’ve been largely ignored in the retail market for two reasons: because of low interest rates and how advisors are compensated.
Moreover, insurers are selective about which products they push, and the ones that might benefit members most are not always the ones getting airtime, Hurst said. For instance, life annuities have been available under group annuity contracts for decades, yet uptake has been negligible.
"A lot of advisors don't market life annuities. Why? Because they don't make as much commission as they will on a RIF or an LRIF over time," explained Hurst. "I talk to advisors who don't even know what life annuities are. Believe it or not, they're not interested because they simply don't make the same kind of money. There's a one-time upfront commission that's paid to them and that's the end. Whereas RIFs, they get trailer [fees] on an ongoing basis."
The institutional PRT market is expanding in the DB space because those plans are built around life annuities and sponsors have a clear incentive to remove longevity and investment risk from their balance sheets, especially now that funding levels and interest rates have improved, Hurst explained.
However, in DC plans, he argues the situation is very different. There is no comparable institutional market, not because the mechanism is absent, but because insurers have little interest in promoting it.
According to Hurst, many DC group annuity contracts already contain a built-in life annuity option, which can lock in both interest rate and mortality assumptions and, in some cases, may offer more favourable terms than what is available in the current retail market.
Even so, these options are rarely used because insurers do not actively market them, and brokers and advisors often prefer members to move into retail products where ongoing commissions are available. Hurst believes that’s left a little-noticed annuity feature inside DC plans largely hidden from members and plan sponsors alike.
Moreover, one of the biggest barriers DC plan sponsors face when pursuing a PRT is insurers’ resistance to offering group annuities through existing DC group contracts, even when the structure is already there. He also highlighted employer hesitation around fiduciary responsibility.
Notably, if retirees stay within a plan-based retirement income arrangement, sponsors may worry they will continue to carry oversight obligations. Contrastingly, if members move into retail products outside the plan, employers can distance themselves from those retirees and any ongoing responsibility for their retirement outcomes, he noted.
According to Hurst, demand for longevity protection in DC plans is likely to grow as people live longer and continue retiring at traditional ages, stretching the period over which their savings must last. Stable interest rates would support that trend, but volatility and inflation could make people hesitant — particularly those entering a VPLA at 65, when spending tends to be highest.
A potential increase in the CPP and OAS commencement age from 65 to 67, which has been discussed in the past, could also cut the other way by shortening retirement duration and reducing the perceived need for longevity products.
Declining interest rates would also raise the cost of buying into an annuity, though the variable payment structure may soften that impact depending on the underlying investment mix, Hurst noted.
On the regulatory side, Hurst pointed to three areas to watch: VPLA adoption across the remaining pension jurisdictions that have not yet legislated for it, any movement on CPP and OAS commencement ages, and changes to the Income Tax Act that would allow transfers to a life annuity or VPLA at later ages.
Still, Hurst acknowledged that hard data on whether DC risk transfer approaches improve retirement outcomes is relatively scarce. While group pricing carries lower fees than retail products, which should translate into better retirement incomes, he underscored no one has studied it in any rigorous way and the only evidence that exists “is anecdotal”, pointing to his own mother’s experience as an example.
She was approaching 80, holding RIFs and LIFs, when her financial advisor warned that she was at risk of outliving her money as retail alternatives offered no improvement on cost. When Hurst raised the idea of a life annuity, the advisor said she knew nothing about them.
Meanwhile an insurance-licensed colleague in the same firm produced a quote that would have lifted his mother's income by six per cent, guaranteed for life. But the commission structure around the transaction frustrated Hurst. The insurance advisor wanted to keep the full upfront commission of roughly $3700 for what he estimated was $1,500 worth of paperwork and refused to rebate the difference (legal in BC and Alberta). He turned to a former colleague in group insurance, who brokered the annuity himself, and secured a $2,200 cash rebate.
"She got bumped up 6 per cent. She never had to worry about her investment. She didn't have to think about it anymore," he said. “When people are aging, they're exposed to things like dementia and whatnot and they become less capable of handling their investment portfolio. It was a great solution, but that's how the marketplace works.”
According to Hurst, the six per cent increase in his mother’s retirement income after moving into a life annuity came from the basic mechanics of longevity pooling. In an annuity pool, members who die earlier leave value behind for those who live longer, which boosts the income available to survivors. That also means there can be an advantage to annuitizing later in life, because insurers price those products using mortality assumptions, and someone who has already outlived part of that expected lifespan may be able to secure a better rate.
He also argued that pricing can differ sharply between retail and institutional annuities because of anti-selection, noting in the institutional market, especially where annuities are linked to DB plans, members typically don’t self-select in the same way, which can produce more favourable pricing. Whereas in retail, people in poor health are less likely to annuitize, so the pool tends to be made up of healthier individuals who are expected to live longer, which pushes pricing against the buyer.
Hurst pointed to an example in the 1990s when a group annuity quote for an elderly pension member came in 15 per cent below the best retail quote, underscoring how much institutional pricing can matter.
“It’s just another interesting point that people aren't aware of, but that it can certainly make a difference when you're looking at these kinds of things,” noted Hurst.
