DB pension plans’ financial positions remain on a roll. How long will the party last?

October 1, 2021

Canada, Toronto

 

The Mercer Pension Health Pulse (MPHP), which tracks the median solvency ratio of the defined benefit (DB) pension plans within Mercer’s pension database, was 101% at September 30, 2021, and is a slight improvement from the ratio of 100% at June 30, 2021.

 

The investment returns for pension plans were mostly flat during the third quarter. Equity returns were mostly positive, however, bond yields increased in the quarter. The increase in bond yields led to negative returns on fixed income investments, but also resulted in lower solvency liabilities. As a result, there was a slight improvement in the financial position of most pension plans during the quarter. Of the plans in Mercer’s pension database, just over half (53%) are estimated to be in a surplus on a solvency basis, 31% have solvency ratios between 90% and 100%, 11% have solvency ratios between 80% and 90%, and 5% have solvency ratios less than 80%.

 

“The financial positions of pension plans continue to chug along in 2021, and unless an unexpected event occurs, are on track to ending 2021 in a much better position than they started,” said Ben Ukonga, Principal in Mercer’s Financial Strategy Group.

 

As vaccination rates continue to increase, economies continue to re-open, global supply chains re-established, there is cause for optimism in the continued strength in equity markets and pension plan financial positions. However, potential headwinds still exist, including stagnation of increases in vaccination rates, risk of new vaccine resistant strains of the COVID-19 virus, inflation, future levels of interest rates, and markets’ reactions to central banks’ approach to monetary policies as we emerge from the pandemic.

 

When these risks are considered alongside geo-political tensions, political gridlock (especially in the US) and political interference in capital markets and with private companies, pension plan financial positions could still be in for a bumpy ride.

 

“As the funded position of their pension plans improve, plan sponsors should re-assess their plans’ risk exposures, and decide whether given the improved positions, it’s time to lock in some of these gains. As we all saw in March of 2020, markets can change quickly. Having the right plan and strategy in place is essential to ensure a plan can take advantage of market gains, and be protected from market declines,” said Ukonga.

 

With the asymmetry of pension plan funding for single employer pension plans, well-funded closed and frozen plans have little upside reward for taking 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, with yields on fixed income investments at historical lows, these plans must continue to remain invested in growth assets to remain affordable, and will need to manage the volatility that comes with investing in growth assets. However, the volatility can be managed by broader diversification in their public market investments (asset classes and across geographies), increased 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 -0.1 percent during the third quarter of 2021. There was more evidence that the global surge in the delta variant has begun to impact economic growth. While highly vaccinated countries such as the US and UK are doing well by remaining open, countries in the Asia-Pacific, where vaccination rates are lower, are still struggling.

 

Global equities had positive returns, with the US outperforming all developed market counterparts. Canadian value stocks reversed course and outperformed growth stocks over the third quarter. Canadian equities underperformed global markets with the exception of emerging markets, driven by the market’s cyclical makeup and the underperformance of the materials sector. Emerging markets were a notable underperformer, as regulatory pressures on China’s tech sector continued to mount on the investment landscape. Reversing the trend observed in the first half of 2021, returns for Canadian investors were strong as the Canadian dollar depreciated against most major currencies. The US dollar on the other hand strengthened against almost all major developed and emerging market currencies.

 

Both Canadian universe and long-term bond returns were negative over the quarter, as yields rose by 11 bps and 14 bps, respectively. Corporate bonds outperformed their government counterparts as the risk-on environment continued throughout the third quarter.

 

Investor preferences within the Canadian real estate market remain highly segmented as it relates to sector selection. Investors continue to seek exposure to the industrial and multifamily sectors, as they continue to exhibit favourable characteristics. While the broader sector remains out of favour, we are also seeing interest in select essential retail assets. Canadian vaccination numbers have now surpassed levels seen across the United States, however there remains lingering concerns of a potential variant resurgence and accompanying restrictions. As a result, uncertainty remains within the broader office, retail and hospitality sectors.

 

“Headlines within emerging markets continue to be dominated by China. Since the beginning of the year we have seen a number of regulatory actions in the areas of antitrust, data security, private education and cryptocurrencies. We have also witnessed the financial troubles of high-profile companies like China Huarong and Evergrande. These events highlight the importance of choosing an active mandate through an investment manager with a specialist knowledge in China” said Venelina Arduini, Principal at Mercer Canada. “While the decline in equity markets has reduced valuations, presenting a cheaper entry point, investors should allow more time for the current regulatory dust to settle before increasing their allocation to this region.”

 

Both the U.S. Federal Reserve and Bank of Canada held their target rates at 0.25 per cent throughout the third quarter of 2021. The Federal Reserve has indicated that moderation in the pace of asset purchases may soon be warranted if progress toward its dual goals continues broadly as expected.

 

The Mercer Pension Health Pulse


 

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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