Purchasing Annuities For a Pension Plan: The Buy-in and Buy-out Approach
A pension fund administrator may want to acquire life annuities from an insurance company for a variety of reasons. These annuities may serve to reduce market risk, interest risk or even longevity risk.
This article takes a look at investing in annuities using the “buy‑in” and “buy‑out” approaches and considers their treatment under federal, Ontario and Quebec legislations.
Under a “buy‑out” annuity, a pension plan administrator pays a premium to an insurance company to purchase an annuity contract on behalf of each retiree. The contract is owned by the retiree. The retiree’s pension will then be paid directly by the insurer. This arrangement may discharge the plan of its obligation or fiduciary responsibility to the retirees, depending on the legislation governing the plan. This is commonly referred to as a “buy‑out” annuity.
Federally regulated plans must ensure that their solvency ratio is not reduced following the purchase of a “buy-out” annuity. If the solvency ratio is reduced, additional contributions would need to be made to the fund in order to maintain the plan’s solvency ratio. By contrast, annuity buy-outs in Ontario are not treated differently than other lump-sum payouts. [Amended August 2012]
For federally regulated plans, an administrator can fully discharge it obligation to its retirees through a “buy-out” annuity. However, plans subject to Ontario or Quebec legislation cannot discharge their fiduciary responsibilities toward retirees by purchasing annuities, except in the case of a plan wind-up. Accordingly, even though theoretically it is possible to use the “buy-out” approach, in practice the plan is not released from its obligations and responsibilities and will have to ensure that annuity payments continue to be made in the event that the insurer is unable to do so. [Amended August 2012]
Note that a buy-out annuity could have unintended consequences on the the sponsor’s financial statements as it may trigger a settlement under accounting rules.
In the case of a buy‑in annuity, a premium is paid to the insurer and a single annuity contract is issued to the pension fund. The pensions are paid to retirees by the plan fund and not by the insurer. The annuity contract is considered an investment made by the pension fund. Buy‑in annuities are clearly permitted under the federal and Quebec jurisdictions. In Ontario, contract wording determines whether the arrangement is considered an annuity or an investment product. It should be noted that few insurers offer this type of annuity purchase.
In its recently published draft Policy Advisory, the Office of the Superintendent of Financial Institutions (OSFI) stated that it has no objections to buy‑in annuities. It also stated that the transaction would not affect in any way the responsibility of the plan towards the retirees since the benefits are payable by the plan no matter what happens to the insurer. The value of the investment will have to be equal to the liability it covers, and the investment will be included in the plan’s assets. Since this type of investment does not negatively affect the plan’s solvency, the transaction does not require the Superintendent’s consent and no additional contribution are required by the plan sponsor.
As for the effects of the buy-in approach on the plan sponsor’s financial statements, it appears that the transaction would not be considered a settlement under accounting rules. For greater certainty, a confirmation from the plan’s auditor may be sought.