The solvency position of Canadian defined benefit pension plans fell sharply in the fourth quarter of 2018, more than reversing all gains from the first nine months of the year. The Mercer Pension Health Index, which represents the solvency ratio of a hypothetical plan, stood at 102 per cent on December 31st down from 112 per cent on September 28th and 106 per cent the beginning of the year. The median solvency ratio of the pension plans of Mercer clients was at 95 per cent on December 31st down from 102 per cent at September 28th and 97 per cent at the end of 2017. Less than 30 per cent of Canadian pension plans ended the year fully funded, down sharply from the 60 per cent that achieved that level at the end of September.
The funded position of pension plans was pummelled in the fourth quarter with weakness in equity markets and a 30 basis point drop in long-term interest rates contributing almost equally to the drubbing. A 100 basis point decrease in interest rates typically results in an increase of 10% to 15% in pension liabilities. The pain was partly numbed by the strength of the U.S. dollar for plans with unhedged foreign asset exposure.
“Canadian pension plans took a significant hit in the fourth quarter, but thankfully they were starting from a very strong position” said Manuel Monteiro, Leader of Mercer Canada’s Financial Strategy Group.
After defying headwinds for the first three quarters, financial markets finally succumbed to the pressure of rising short-term interest rates, trade wars, and turmoil in certain emerging market economies.
While the decline in funded positions was sharp and sudden, the impact on pension plan sponsor funding requirements should be relatively muted because many plans were already in a surplus position and therefore had some cushion to absorb the hit. Secondly, for Ontario and Quebec based plan sponsors, the new funding legislation will result in much smaller increases to cash funding than the previous solvency-based regime.
It remains to be seen whether weakness in financial markets will continue into 2019. Despite the threats of continued volatility, the new funding rules will encourage some plan sponsors to maintain significant investment risk, particularly if their plans are not fully funded and they have a time horizon of a decade or more. However, sponsors of closed and frozen defined benefit plans that remain well funded should strongly consider taking risk off the table, either by changing the asset mix or through risk transfers. “The fourth quarter was the most active quarter in Canadian annuity market history, with an estimated $1.5 billion of liabilities being transferred from pension plans to insurance companies. As we expected, plan sponsors benefited from very favourable pricing as insurers worked hard to meet their aggressive sales quotas”, continued Monteiro.
A typical balanced pension portfolio would have decreased by 3.8 per cent during the fourth quarter of 2018. Equity markets declined significantly, while Canadian bonds advanced.
Canadian equity returns were significantly negative in the fourth quarter due in part to lower oil prices and higher interest rates, with the S&P/TSX Composite Index returning -10.1 per cent. Eight of the eleven sectors posted negative returns, with Health Care (-35.3 per cent) losing all the gains it experienced in the third quarter.
Canadian fixed income markets rose over the quarter amidst lower yields, with long term bonds (1.9 per cent) slightly outperforming universe bonds (1.8 per cent). However, real return bonds (-1.1 per cent) fell over the fourth quarter.
The U.S. dragged global equity markets down with a return of -13.5 per cent in USD terms (-8.6 per cent CAD) following a very strong third quarter. Developed market equities were also down, with the MSCI World returning -13.0 per cent in local currency terms (-8.4 per cent CAD). Emerging markets continued to show weakness in the fourth quarter, returning -7.4 per cent in local currency terms (-2.2 per cent CAD), however given the rout in developed markets, was the strongest performer in the global equities space. Higher CAD returns, relative to local currency returns, were due to depreciation of the Canadian dollar over the quarter.
The impact of trade wars, the U.S. Federal Reserve, oil prices and Brexit negotiations that we saw in the third quarter continued to dominate the markets in the last quarter of the year,” said Todd Nelson, Principal at Mercer Canada. “The global economy will face a challenging 2019 with the expectation of central banks continuing on their tightening path and the unsettling political backdrop”.
In October the Bank of Canada raised its target for the overnight rate by a quarter percentage point to 1.75 per cent. The U.S. Federal Reserve raised its target rate at 2.5 per cent at its December meeting, but suggested fewer rate hikes in 2019.
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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