The solvency health of Canadian pension plans continued to improve sharply in the fourth quarter of 2013 due to strong equity returns and rising long-term interest rates. The Mercer Pension Health Index stood at 106 per cent on December 31st, up from 82 per cent at the start of the year and 98 per cent at September 30thsup>. The Mercer Pension Health Index is now at its highest level since June 2001.
The Mercer Pension Health Index tracks the funded status of a hypothetical defined benefit pension plan. While there is wide variance in the funded status of Canadian pension plans, most plans have exhibited a considerable improvement in funded status in 2013. The chart below compares the distribution of the estimated solvency ratios of Mercer clients (covering 607 plans) at January 1, 2013 and January 1, 2014:
Almost 40% of pension plans are now fully funded, compared to 6% at the beginning of the year. Even more remarkably, only 6 per cent of pension plans entered 2014 less than 80 per cent funded, compared to 60 per cent being below 80% funded at the beginning of the year.
“It’s hard to overstate how good 2013 was for most defined benefit pension plans. Stock markets soared, long-term interest rates rose sharply, and the Canadian dollar weakened which further magnified foreign returns” said Manuel Monteiro, Partner in Mercer’s Financial Strategy Group. Long-term Government of Canada bond yields ended the year at 3.2 per cent, up from 2.3 per cent at the beginning of the year. A 1 per cent increase in long-term interest rates would reduce the liabilities of most pension plans by 10 per cent to 15 per cent.
“A typical balanced pension portfolio returned 12.8 per cent in 2013,” noted Diane Alalouf, Principal in Mercer’s Investments business. “During the year, global equity markets did very well, as the global economy continued to recover from the financial crisis. In Canadian dollar terms US and international equities had their strongest performance in over 20 years, with returns of 41 per cent and 32 per cent respectively, the stronger economy being the main reason but the falling Canadian dollar being another. The strong equity performance more than offset negative returns on bonds arising from the continued rise in interest rates experienced this year.
“Overall, economic trends are continuing to improve. Companies are issuing higher amounts of debt (to take advantage of low interest rates) allowing them to invest further; unemployment rates have been improving, and economic activity has continued to grow or has revived in the larger European economies So overall, the outlook remains positive, but there remain some concerns about the fragility of this growth. Higher than expected GDP growth for Canada (and the US) has been fuelled largely by growing inventories; consumer spending has continued to increase, albeit at a slower rate.
“The overall outlook remaining positive, combined with the fact that Federal Reserve continues to indicate that it will soon start scaling back on its asset purchase program over the coming months, has kept the longer term interest rates on the rise since the beginning of the year." noted Alalouf.
“After 12 stomach-churning years of turbulence, many plan sponsors will agree in retrospect that they were too exposed to pension risk. With plans approaching full funded status again, this is the perfect opportunity for plan sponsors to hit the reset button and re-consider their strategy. Sponsors need to act decisively – as we have seen in 2001/2002, 2008 and again in 2011 the situation can reverse rapidly” noted Monteiro.
“For most plan sponsors, the rationale for maintaining a significant level of interest rate and equity risk weakens considerably once their pension plan is fully funded. This is particularly true for sponsors of plans with significant retiree obligations, and those that are closed to new entrants or future accruals. We expect that 2014 will be the year that many sponsors decide to significantly reduce their pension risk exposure. In the fourth quarter of 2013, we saw a significant increase in the number of plan sponsors exploring risk reduction strategies such as lower risk asset mixes and settling a portion of their liabilities through the annuity market” noted Monteiro.
Canadian equities returned 7.3 per cent in the fourth quarter which brought the 2013 return to 13.0 per cent. For the year:
- The best performing S&P/TSX sectors were Health Care (+72.1 per cent), Consumer Discretionary (+43.0 per cent) and Industrials (+37.5 per cent). The worst performing sectors were Materials (-29.1 per cent), Utilities (-4.1 per cent) and Telecom Services (+13.1 per cent).
- Large cap stocks (S&P/TSX 60 Index) returned 13.3 per cent, outperforming small cap stocks (S&P/TSX SmallCap Index) which returned 7.6 per cent during 2013.
- Value stocks outperformed growth stocks as measured by the S&P Canada BMI Value and Growth indices, which returned 17.2 per cent and 9.1 per cent respectively in 2013.
During the year, the Canadian dollar weakened against all major currencies except the Japanese Yen, which had an overall positive impact on foreign equity returns when expressed in Canadian dollars. In Canadian dollar terms, the S&P 500 Index returned 14.2 per cent for the quarter and 41.3 per cent for the year. International equities, as measured by the MSCI EAFE (CAD) index, generated a return of 9.3 per cent for the quarter and 31.6 per cent for the year. Emerging markets, as measured by the MSCI Emerging Markets (CAD) index, returned 5.3 per cent and 4.3 per cent in the fourth quarter and in the year respectively.
The DEX Universe Bond Index returned 0.4 per cent in the quarter and -1.2 per cent in 2013. The DEX Long Bond Index returned -0.2 per cent in the quarter and -6.2 per cent in the year. At the end of the year, the yield on the DEX Universe Index was 2.75 per cent as compared to 4.05 per cent for the Long Bond Index.
The Mercer Pension Health Index shows the ratio of assets to liabilities for a model pension plan. The ratio has been arbitrarily set to 100% at the beginning of the period. The new Pension Health Index assumes contributions equal to current service cost plus solvency deficit payments, and no plan improvements. The Mercer Pension Health Index assumes that valuations are filed annually on a calendar year basis and that the deficit revealed in each valuation is funded on a monthly basis over the subsequent five years.
Assets: Passive portfolio with asset mix of: Asset mix: 42.5% DEX Universe Bond Total Return Index; 25% S&P/TSX Composite; 15% S&P 500 (CAD); 15% MSCI EAFE (CAD); 2.5% DEX 91 day T-Bills
Liabilities: 50% active members, 50% retired members. 60% of benefits for active members assumed to be settled through commuted values based on the Canadian Institute of Actuaries transfer value standards without the one-month lag, and the remaining 40% assumed to be settled through an annuity purchase. Benefits for retired members assumed to be settled through an annuity purchase. Annuity prices determined based on the CIA guidance for the medium duration illustrative block. Results will vary by pension plan.
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