Despite improvement in Q3, major risks lie ahead for Canadian pension plans: Mercer

October 1, 2020

Canada, Toronto

 

Recent recovery in DB plans’ funded position may be short-lived, as COVID-19 cases climb and a contentious election south of the border draws near

 

Driven by equities, Canadian pension plans’ funded position continued to recover in Q3, according to the Mercer Pension Health Index (MPHI). But major risks lie ahead: a second wave of the novel Coronavirus, as well as the possibility of a disputed election in the United States.

 

The MPHI, which represents the solvency ratio of a hypothetical defined benefit (DB) pension plan, increased from 101 per cent at the end of June to 107 per cent at the end of September, but still down from 112 per cent at the start of 2020. The median solvency ratio of the pension plans of Mercer clients was at 93 per cent on September 30th, up from 91 per cent on June 30th, but down from 98 per cent at the beginning of the year.

 

During the third quarter, funded positions of DB plans continued to claw back some of the losses incurred in the first quarter. The improvement was driven by equities, which delivered solid returns across most markets. Despite a mid-quarter rise, bond yields fell in September to end the quarter roughly unchanged from the end of June.

 

“Most defined benefit plans have proved resilient to the tremendous challenges that the first nine months of 2020 have delivered” said Manuel Monteiro, Partner and Leader of Mercer Canada’s Financial Strategy Group. Plans remain very well funded by historical standards, even with liabilities measured at today’s ultra-low interest rates.

 

Unlike prior crises, pension plan sponsors are not facing a looming increase in pension contributions, thanks to recent changes to funding rules. However, sponsors in industries most affected by the pandemic may be facing challenges to meet their ongoing obligations, including pension contributions.

 

Some jurisdictions, including Ontario, have offered relief to these sponsors in the form of temporary contribution deferrals, subject to meeting certain conditions including restrictions on dividend payments and executive compensation.  The conditions attached to these relief measures make them unattractive except for plan sponsors hardest hit by the pandemic.

 

While pension plans have held up well so far, many large risks lurk in the fourth quarter, including the U.S. election outcome and potential for protracted disputes and unrest, the impact of the resurgence of the virus on economic activity, and the timing and effectiveness of a vaccine. All these factors could trigger significant volatility in the fourth quarter of 2020 and beyond.

 

“The level of uncertainty we face today is unprecedented,” said Monteiro. “Plan sponsors should evaluate the impact of alternative scenarios, and adjust their risk profile accordingly.”

 

Many well-funded closed and frozen plans remain exposed to significant risk. They should evaluate whether they can withstand a downside event and if there is sufficient reward for taking risk. Many of these plans should take risk off the table, through increased allocations to defensive assets, annuity transactions, wind-ups or even merging into jointly-sponsored pension plans if possible.

 

Plans with long time horizons face a difficult challenge. Given the ultra-low yields on bonds, they have to remain significantly invested in growth assets in order to remain affordable. However, large allocations to growth assets will make them more susceptible to market volatility, particularly in the short-term. The challenge will be to strike a balance that best meets the objectives of the employers and plan members. Realistic contribution rates, risk-sharing design features, broad diversification across asset classes, and selecting the right investment managers will become even more important going forward.

 

From an investment standpoint

 

A typical balanced pension portfolio would have posted a return of 3.0 per cent during the third quarter of 2020, as equity markets trended upwards and bond yields remained roughly unchanged from the second quarter of the year.

 

All equity markets were positive over the quarter.  Emerging market equities led the way, returning 8.8 per cent in local currency terms (7.6 per cent CAD) as investors sought future growth prospects. Small cap and growth-oriented stocks continued to outperform their large cap, value-oriented counterparts; a trend that has continued to persist for several quarters. The S&P/TSX Composite Index returned 4.7 per cent; 9 out of the eleven sectors posted positive returns with Industrials leading the way.

 

Private assets have also been affected by the pandemic. The rapid and largely successful move to virtual workplaces necessitated by the pandemic have caused many organizations to re-evaluate their need for office space, adversely affecting the value of some commercial real estate investments. Conversely, the acceleration of e-commerce has propped up the value of warehouse space.

 

Long-term bond returns were close to zero  in comparison to their double-digit returns in the second quarter, as bond yields were relatively unchanged. Universe bonds were modestly positive (0.4 per cent), while real return bonds significantly outperformed (4.4 per cent).

 

“The rally in risk assets continued throughout the first half of the third quarter over supportive monetary policies and signs of a global economic recovery” said Todd Nelson, Partner at Mercer Canada. “However, the recent spike in global COVID-19 cases and the uncertainty around the upcoming U.S. election has unnerved investors, leading to losses in global equity markets in September. Concerns have also resurfaced regarding the possibility of an increase in medium to long-term inflation following the unprecedented monetary and fiscal policy actions in response to the crisis”.

 

Both the U.S. Federal Reserve and Bank of Canada held their target rates at 0.25 per cent throughout the third quarter, following several individual rate cuts throughout the first quarter of the year.

 

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.

 

The median solvency ratio of the pension plans of Mercer clients is based on a projection of data within Mercer’s client database. The data and projection methodology were refreshed retroactively at September 30, 2019. The approximate impact of the change in data and methodology was a reduction in median solvency ratio of approximately 2%.

 

 

ABOUT MERCER
Mercer builds brighter futures by redefining the world of work, reshaping retirement and investment outcomes, and unlocking real health and well-being. Mercer’s more than 25,000 employees are based in 44 countries and the firm operates in over 130 countries. Mercer is a business of Marsh & McLennan Companies (NYSE: MMC), the world’s leading professional services firm in the areas of risk, strategy and people with 76,000 colleagues and annualized revenue approaching $17 billion. Through its market-leading businesses including Marsh, Guy Carpenter and Oliver Wyman, Marsh & McLennan helps clients navigate an increasingly dynamic and complex environment. For more information, visit www.mercer.ca. Follow Mercer on Twitter  @MercerCanada.

 

CONTACT INFORMATION