April 2, 2019

Canada, Toronto

The solvency position of Canadian defined benefit pension plans climbed quickly in the first quarter of 2019, reversing most of the damage incurred in December 2018. The Mercer Pension Health Index, which represents the solvency ratio of a hypothetical plan, stood at 106 per cent on March 31st up from 102 per cent at the beginning of the year. The median solvency ratio of the pension plans of Mercer clients was at 97 per cent on March 31st, up from 95 per cent at the end of 2018. Almost one out of every two Canadian pension plans is fully funded and less than 5 per cent are below 80 per cent funded on a solvency basis.

Double-digit equity market returns across the globe revived the funded position of pension plans in the first quarter. However, a 30-basis point drop in long-term interest rates, which increased liabilities, partially offset the asset gains.

“Canadian pension plans entered 2019 with trepidation, but quickly breathed a sigh of relief by the end of the first quarter,” said Andrew Whale, Principal in Mercer Canada’s Financial Strategy Group.

Many plan sponsors put a halt on risk management activity in the midst of December 2018’s market turmoil as funded positions plummeted and the cost to reduce risk increased. However, some have since opportunistically taken advantage of the quick recovery to lock in a stronger position. Sustained high activity in the Canadian annuity market has led to an estimated $1.0 billion of liabilities transferred to insurance companies in 2019 so far, matching the first quarter record set last year.

“Although many pension plans ended Q1 2019 at or close to a fully funded state, the volatility over the last few months has spooked plan sponsors and served as a reminder of how fleeting a fully funded position can be,” said Whale. “Rather than sit tight, many view the sudden drop and immediate recovery as a catalyst to take action and right-size the risk held in the plan.”

Many risks are looming on the horizon, both in Canada and abroad, as elections, trade agreements and international relations are under the spotlight in 2019. However, due to recent funding legislation, most Ontario and Quebec based plans will not feel the full impact on funding requirements from the resulting volatility until they are looking to settle benefits and it is too late. Plan sponsors, especially those of closed and frozen defined benefit plans, should strongly reconsider their funding, investment and risk management policies. “The recent relaxing of solvency-based funding in Ontario and Quebec is a gift to plan sponsors, as it provides flexibility and protects against year-over-year volatility,” continued Whale. “On the other hand, it forces plan sponsors to be proactive in setting funding policy. Funding the bare minimum will no longer get plans with short to medium time horizons to their desired destination.”

From An Investment Standpoint

A typical balanced pension portfolio would have risen by 9.0 per cent during the first quarter of 2019. Equity markets rose significantly while Canadian bonds also rose.

Canadian equity returns were significantly positive in the first quarter, gaining back all the losses they experienced in the fourth quarter, with the S&P/TSX Composite Index returning 13.3 per cent. All eleven sectors posted positive returns, with Health Care (49.1 per cent) leading the way.

Canadian fixed income markets rose over the quarter amidst lower yields, with long-term bonds (6.9 per cent) significantly outperforming universe bonds (3.9 per cent). Real return bonds (5.1 per cent) also rose over the first quarter.

The U.S. led global equity markets with a return of 13.6 per cent in USD terms (11.2 per cent CAD) following a very weak fourth quarter. Developed market equities were also up, with the MSCI World returning 12.8 per cent in local currency terms (10.2 per cent CAD). Emerging markets were positive but the weakest performer within the global equity markets, returning 9.9 per cent in local currency terms (7.6 per cent CAD). Lower CAD returns, relative to local currency returns, were due to appreciation of the Canadian dollar over the quarter.

“Although global financial markets are more settled than they were in the fourth quarter, investors still remain wary amid slowing economic growth in the global economy,” said Todd Nelson, Partner at Mercer Canada. “This economic softening combined with political uncertainty saw central banks slow their tightening path from 2018.”

Both the Bank of Canada and U.S. Federal Reserve held their targets for the overnight rate at 1.75   and 2.5 per cent, respectively, over the first quarter.

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.  Asset mix for periods up to December 31, 2016 of: 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.  Asset mix for periods on or after January 1, 2017 of 42.5% FTSE/TMX Long Bond Total Return Index; 15% S&P/TSX Composite; 40% MSCI World (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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