Are Canadian plan sponsors seeing the light on inflation-linked annuities?

After nearly a decade of favourable conditions in the equity markets, pension plan sponsors are confronting what’s arguably the most challenging inflationary environment in living memory. For many, that means playing catch up on some much-needed de-risking within their portfolios.

“In 2021, we saw about $600 million of inflation-linked annuities purchased by plan sponsors, almost double the regular annual volume of activity,” says Brent Simmons, Head of Defined Benefit Solutions at Sun Life. “It’s hardly surprising given how inflation has been in the headlines, and it’s back on plan sponsors’ radar screens.”

According to Simmons, many plan sponsors had relied on excess returns in equity markets to cover for the inflationary increases to benefits that they were providing to their plan members. While that might have been a workable strategy during the great stability, it has proven costly as inflation accelerated to multi-decade highs in 2021 and continuing into 2022.

“We’re seeing a lot of plan sponsors revisit the way that they should hedge out inflation,” Simmons says. “There are different formulas plan sponsors use to determine members’ benefits, so the simplest approach is to buy a group annuity that matches those liabilities.”

The most straightforward variations, he says, involves indexing a retired member’s pension to a certain percentage of the current consumer price index. There are also more interesting formulas, where an annuity product can have offsets, floors, and ceilings to their inflation indexing benefits. Depending on their needs, a plan sponsor can be creative in hedging their risks.

Over the past few years, Simmons says sponsors have been emphatic in asking for a way to purchase inflation-linked annuities. In response, the insurance industry has innovated and thought up different ways to provide those products at a lower cost. A proxy measure that tracks the cost of CPI-linked annuities in Canada, he says, has come down by about 3% in the last year and a half.

“When it comes to the annuity market, typically pricing goes down by tenths of a percent,” he says. “So a 3% decrease is pretty material.”

A few plan sponsors are taking their annuity purchases to the next level by buying a basket of annuities, each following a slightly different formula in mitigating the risk of inflation. For those transactions, known as annuity buy-ins, the plan receives the payments directly from the insurance company, and the plan sponsor pays the benefits to the members.

“From the plan sponsor’s point of view, it lets them sleep well at night to know that their plan members are in the hands of an insurance company that keeps its promises,” Simmons says. “For retiree members, the benefit comes from a guaranteed annuity paid by an insurance company rather than a pension plan whose funded status could fluctuate significantly over time.”

One rough barometer that market participants use to gauge the cost of hedging inflation, Simmons says, is real-return bonds, which are priced based on market expectations of future inflation. Looking at inflation in the past six months, it might be reasonable to bake 4% or 5% inflation into the cost of real-return bonds.

But while they have become more expensive, their cost hasn’t risen by nearly as much as what recent experience around inflation might justify. In other words, the cost of hedging against inflation hasn’t quite kept up with the dramatic increases in headline inflation seen in the past months.

“You might say it would have been better to buy a real return bond a year ago,” Simmons says. “But most people are saying that it’s still really good value to buy a real return bond right now, given that the inflation that’s baked in hasn’t increased as much as what the headline inflation is.”