DB OBLIGATIONS REACH NEW HEIGHTS, PUTTING MORE PRESSURE ON FINANCIAL STATEMENTS AS INTEREST RATES REACH NEW LOWS

January 2, 2020

Canada, Toronto

 

Plan sponsors will see an annual increase in the DB obligation on their balance sheet of close to 15 per cent due to record low interest rates and a flattening yield curve in 2019.

 

The solvency position of Canadian defined benefit pension plans increased in the fourth quarter of 2019. The Mercer Pension Health Index, which represents the solvency ratio of a hypothetical plan, increased to 112 per cent on December 31st up from 105 per cent at the end of the third quarter and up further from 102 per cent at the beginning of the year. The median solvency ratio of the pension plans of Mercer clients was at 98 per cent on December 31st, up from 94 per cent on September 30th and 93 per cent at the end of 2018.

 

Positive equity market performance throughout 2019 drove an impressive year for the typical DB pension plan in spite of reaching the lowest yields on long-term bonds in 60+ years.

 

“DB plans with substantial equity allocations owe the markets once again for saving them from what could have been a disastrous year,” said Andrew Whale, Principal in Mercer Canada’s Financial Strategy Group.

 

While solvency funded positions continued to improve in the fourth quarter, DB obligations for financial statement purposes increased with all-time low interest rates and credit spreads. “A one year increase of 15% on the balance sheet may cause CFOs and investors alike to take notice of legacy DB liabilities that they may have otherwise glossed over,” said Whale.

 

The silver lining is that transferring the obligation to an insurer may have become suddenly more appealing for some plan sponsors. The difference between the cost to settle the DB obligations via annuity purchase and the DB obligations held on the balance has shrunk, thus resulting in a much smaller financial statement impact upon transaction. Many plan sponsors see this financial impact as a barrier to risk transfer and “we have seen their appetite for annuities increase tremendously,” said Whale.

 

Transferring risk may be a path to right sizing the DB obligation, but it will not be an appropriate solution for all plan sponsors. Others are looking for different ways to manage DB asset volatility and seek yield in this era of ultra-low interest rates, yield inversion and uncertainty in the equity markets. This has led to increased allocations to alternative assets and a movement of assets from public to private markets.

 

“Canadian plan sponsors can look to Europe and other geographies, where low or negative interest rate policy is not new,” continued Whale. “Those countries saw increased demand for and access to alternative assets, which we are starting to see here in Canada.”

 

From An Investment Standpoint

 

A typical balanced pension portfolio would have risen by 2.3 per cent during the fourth quarter of 2019. Equity markets advanced in all regions while Canadian bonds fell modestly.

 

Canadian equity returns were positive in the fourth quarter. The S&P/TSX Composite Index returned 3.2 per cent. Seven of the eleven sectors posted positive returns with Information Technology leading the way, while Health Care dragged.

 

Canadian fixed income markets fell amidst higher yields. Real return bonds detracted the most value (-2.0 per cent), while long-term bonds (-1.9 per cent) underperformed universe bonds (-0.9 per cent).

 

The U.S. equity market returned 9.1 per cent in USD terms (6.8 per cent CAD). Developed market equities were also up, with the MSCI World returning 7.6 per cent in local currency terms (6.4 per cent CAD). Emerging markets returned 9.6 per cent in both local currency terms and Canadian dollar terms.

 

“Investors breathed a cautious sigh of relief to close out 2019,” said Todd Nelson, Partner at Mercer Canada. “While major stock indices reached record highs over the year, concerns about geopolitical risks, slowing economic growth and uncertain monetary policy persist into 2020.”

 

The Bank of Canada held its target for the overnight rate at 1.75 per cent, while the U.S. Federal Reserve cut its target rate by 25 basis points to 1.75 per cent over the fourth 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.

 

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%.

 


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