Mercer Canada | Brexit affects Canadian pension plans

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Brexit puts a damper on the health of Canadian pension plans in second quarter of 2016

  • June 28, 2016
  • Canada, Toronto, ON

The solvency ratio of a typical Canadian pension plan has fallen by almost 3% since the Brexit vote results were announced.  The Brexit impact pushed the solvency ratio of most pension plans firmly into negative territory for the first half of 2016.  The median solvency ratio of the pension plans of Mercer clients stood at 82% on June 27, 2016 down from 85% at the beginning of the year and from 85% just before the Brexit vote. The Mercer Pension Health Index, which represents the solvency ratio of a hypothetical plan finished the first half of the year at 88%, down from 93% at the beginning of the year.

The decline in funded status during the first half of 2016 is also due to declines in long-term bond yields, weak global equity markets and the strengthening Canadian dollar (which negatively impacted the return on unhedged foreign assets).  “The Brexit vote has clearly increased the level of geo-political and economic uncertainty – which probably means increased volatility for pension plans for months if not years to come,” said Manuel Monteiro, Leader of Mercer’s Financial Strategy Group. “Pension plan sponsors should ensure they remain comfortable with their current risk exposure.”

With an increasing volatile environment many defined benefit plan sponsors will realize that they are more exposed to pension risk than perhaps they recognized or would like to be. Sponsors need to be mindful and thoughtful regarding rebalancing to their policy asset mix in extremely volatile market environments. Many plan sponsors will be looking to reduce risk by shifting their asset allocation towards fixed income and by transferring risk through annuity transactions, particularly if the funded positions of their plans improve.  Plan sponsors looking to reduce risk should establish a comprehensive strategy now and monitor market opportunities so that they can act quickly when they arise.

Individuals should be mindful of how increased market volatility will affect members of defined contribution plans, particularly individuals close to retirement.

FROM AN INVESTMENT STANDPOINT

Market pundits were surprised by the Brexit “Leave” manifesting in a steep sell-off of risk assets, with the UK Pound and European equities hardest hit – especially the still-fragile European banking sector.  Safe haven assets, such as US Treasuries and gold rallied strongly on Friday following the referendum results.  Selling pressure resumed Monday as global equity markets continued their slide, alongside the falling Pound and oil prices as investors adjust to the new risk environment and assess the economic impacts and the potential for political “contagion.”

Notwithstanding the quarter-ending ‘panic’, a typical balanced pension portfolio would have returned 0.6% during the second quarter of 2016. Detailed market returns for the quarter are summarized in the table.

Canadian equities were the best performing broad equity asset class for the second quarter in a row, with a return of 2.1% over the quarter,” said Brian Dayes, partner at Mercer Investments. "The outperformance was led by  materials (24.2%) as commodity prices rebounded by 11.1% during the period, and gold was sharply higher following the Brexit vote." Despite the oil sell-off late in the quarter, the energy sector rose 4.6% during the quarter.  On the other hand, the health care sector continued to suffer (-19.1%), which was driven primarily by Valeant Pharmaceuticals.

US equity returns were modestly down in USD (-2.4%); a Canadian investor would have a loss of -1.1% in CAD terms owing to the strength of the USD following the Brexit vote. The CAD gained 7.9% against the British pound and 2.5% against the euro, the majority of it following the results of the Brexit vote. International equities underperformed as the MSCI EAFE returned -5.3% in local currency terms and -5.4% in CAD. Emerging markets also underperformed and returned -2.4% in local currency terms and -2.9% in CAD.

The Canadian yield curve benefitted from the risk-off trade and flattened slightly with long bonds tightening 24 bps while mid-term and short-term bond yields fell 17 bps and 11 bps respectively versus yields at the end of the first quarter. 

The Bank of Canada (BoC) maintained its target overnight rate at 0.5% following the May meeting. The US Fed Federal Open Market Committee also decided to hold steady its benchmark interest rate between 0.25 and 0.50. In response to the Brexit “Leave”, the Bank of  England and ECB pledged continuing monetary support, and this result most certainly has put the Fed on hold – supporting the “lower for longer” case for global interest rates.

 

THE MERCER PENSION HEALTH 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% FTSE/TMX Universe Bond Total Return Index; 25% S&P/TSX Composite; 15% S&P 500 (CAD); 15% MSCI EAFE (CAD); 2.5% FTSE/TMX 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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