DB pension plans remain well funded at the end of 2021. But what will 2022 bring?

January 4, 2022

Canada, Toronto


The Mercer Pension Health Pulse (MPHP), a measure that tracks the median solvency ratio of the defined benefit (DB) pension plans within Mercer’s pension database, was 103% as at December 31, 2021, an increase of 2% from the ratio as at September 30, 2021, and 7% higher than the ratio at the beginning of 2021.    


For most DB plans, investment returns were positive in the fourth quarter of 2021.  Yields on longer-term bonds decreased during the quarter, which increased plan liabilities, offsetting some of the positive investment returns on plans’ funded positions.  However, despite the decrease in yields during the fourth quarter, the yields on longer-term bonds are still significantly higher than they were at the beginning of 2021.  


As funded positions continue to improve, more and more plan sponsors are finding their pension plans to be in surplus positions.  At the end of the fourth quarter, of the plans in Mercer’s pension database, 61% are estimated to be in a surplus on a solvency basis (vs. 53% at the end of the third quarter).  In addition, 27% of plans are estimated to have solvency ratios between 90% and 100%, 7% have solvency ratios between 80% and 90%, and 5% have solvency ratios less than 80%.  


“As DB plans’ financial positions continue to improve, many plan sponsors are now finding themselves in the enviable position of having DB surpluses,” said Ben Ukonga, Principal and leader of Mercer’s Wealth Business in Calgary.  “Although surpluses are preferable to deficits, they do pose their own set of implications and challenges that will need to be managed”. 


2021 has been a good year for DB plans.  The re-opening of the global economy, increases in vaccination rates and availability of vaccines, and with many plan sponsors seeing their pension plans starting 2022 in strong financial positions, will put them in a good position to brace for the significant headwinds that may be on the horizon.


As for headwinds, there are many including the impact of the Omicron variant of the COVID-19 virus, the potential emergence of new variants, availability of vaccines in developing countries, increasing geo-political tensions, US political gridlock and the uncertainty of the November US midterm elections in 2022.  Additional concerns include inflation, and whether or not it will truly be transitory as many policy makers have stated. Related to this are central banks’ monetary policies in response to inflation and the overall management of their economies, and the markets’ reactions to these policies.  Other headwinds include wage increase pressures in response to the higher levels of inflation, turnovers and job vacancy rates, which in turn will add to inflationary pressures.  


“We continue to believe, given the improved positions of many DB plans, that plan sponsors should be revisiting their risk exposures, and where it makes sense locking-in some of these gains,” said Ukonga.  “Plan sponsors will not want to see their surplus positions turn into deficits due to their inaction.”  


With the asymmetry of pension plan funding for single employer pension plans, well-funded closed and frozen plans may have little reward for continuing to take market risk.  They should be thinking of taking risk off the table by increasing their allocations to defensive assets, and better matching of plan investments to plan liabilities.


For open plans and plans with longer time horizons, given the continuing low yields on fixed income investments, they must continue to remain invested in growth assets in order to remain affordable, and will need to manage the volatility that comes with investing in growth assets.  This volatility can be managed by broader diversification of their public market investments, increasing allocations to private markets, strategic use of margins, and including risk-sharing features in their plan design.  


From an investment standpoint

A typical balanced pension portfolio would have posted a return of 5.6 percent during the fourth quarter of 2021. In local currency terms, global equity markets sold off sharply at the end of November over elevated inflation, tapering concerns and news of the latest COVID variant. Sentiment had already been gradually weakening due to a return of restrictions in some countries in continental Europe as well as concerns that persistently high inflation rates could accelerate monetary tightening.


Global equities had positive returns, with the US outperforming other developed market counterparts. Market trends observed in the third quarter continued through to the end of 2021, as Canadian equities underperformed global markets, and Canadian value stocks outperformed growth stocks. Regulatory pressures on China’s tech sector continued to cause headwinds for emerging markets overall. Returns for Canadian investors were muted in the US and European markets, as the Canadian dollar appreciated against both the US dollar and Euro. 


Canadian universe bonds were positive over the fourth quarter, despite a rise in yields of 11 bps. Long term bond returns were also positive, as yields fell by 24 bps. Corporate bonds underperformed their government counterparts as spreads rose amid a risk-off environment.


Demand for real estate in most sectors continues to be underpinned by a strong weight of capital, low interest rates, and in some regions a rebounding economy. Strong demand for core, well-leased real estate is expected to continue, while opportunities from distressed or motivated sellers are also joining the market. Within the Canadian real estate market, investor preferences remain highly segmented as it relates to sector selection. Investors will continue to seek exposure to industrial and multifamily, as these sectors continue to exhibit favorable characteristics. While we note that select essential retail assets are also seeing interest, the enclosed mall segment of the sector remains out of favor. We expect these trends to persist, as uncertainty remains within the broader office, retail and hospitality sectors.


“Heading into 2022, we are broadly positive on the economic outlook” said Venelina Arduini, Principal at Mercer Canada. “Strong income growth coupled with healthy consumer balance sheets should continue to support consumption. Government spending and investment is also set to remain elevated for an extended period. Resurgence of virus-related restrictions might weaken growth at the start of the year, but we expect growth to recover after the Omicron wave, returning economies to their trajectories toward full recovery.”


Both the U.S. Federal Reserve and Bank of Canada held their target rates at 0.25 per cent throughout the fourth quarter of 2021. The Federal Reserve confirmed that tapering will go ahead as planned and markets continue to price in rate increases next year.


The Mercer Pension Health Pulse

Source: Mercer


The Mercer Pension Health Pulse tracks the median ratio of solvency assets to solvency liabilities of the pension plans in the Mercer pension database, a database of the financial, demographic and other information of the pension plans of Mercer clients in Canada.  The database contains information on over 500 pension plans across Canada, in every industry, including public, private and not-for-profit sectors.  The information for each pension plan in the database is updated every time a new actuarial funding valuation is performed for the plan.  The financial position of each plan is projected from its most recent valuation date, reflecting the estimated accrual of benefits by active members, estimated payments of benefits to pensioners and beneficiaries, an allowance for interest, an estimate of the impact of interest rate changes, estimates of employer and employee contributions (where applicable), and expected investment returns based on the individual plan’s target investment mix, where the target mix for each plan is assumed to be unchanged during the projection period. The investment returns used in the projections are based on index returns of the asset classes specified as (or closely matching) the target asset classes of the individual plans.


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