Defined benefit plans are not immune as COVID-19 spreads and funded positions plummet

March 5, 2020

Canada, Toronto

 

2020 has opened with a roller coaster ride for DB plan sponsors as long-term bond yields plunged below the all time lows set in 2019 and expectations of economic growth deteriorate amongst fears of a pandemic.

 

The Mercer Pension Health Index, which represents the solvency ratio of a hypothetical plan, decreased from 112 per cent at the end of 2019 to 103 per cent at the end of February. The median solvency ratio of the pension plans of Mercer clients was at 92 per cent on February 29th, down from 98 per cent on December 31st.

 

As February closed, equities sold off to make way for a rally in safe-haven assets amid concerns about the coronavirus, including a flight to government bonds that drove down long-term yields that are down a further 10 basis points in March.

 

“The market reaction to the virus is a twofold blow to DB plans as the equity market decline erodes the assets and drops in bond yields directly increase the liabilities,” said Andrew Whale, Principal in Mercer Canada’s Financial Strategy Group.

 

Many DB plan sponsors may not immediately feel the impact of decreased financial positions, but it should initiate a review of both short-term and long-term risk management strategies. “Uncertainty around the ultimate extent of the outbreak has widened the range of outcomes for DB plans in 2020 and beyond,” said Whale.

 

“Funded ratios have fallen rapidly from their peak in 2019 and the time to implement better risk management strategy is now,” continued Whale. Plans sponsors should consider multiple approaches including implementing funding strategies, diversifying their growth portfolio, decreasing interest rate risk and seeking opportunities for risk transfer where appropriate. The strong equity returns in 2019 provided many Canadian DB plans with some margin to absorb the impact of such an adverse scenario, but any remaining buffer is dwindling.

 

From An Investment Standpoint

 

A typical balanced pension portfolio would have fallen by 0.5% over the QTD period to the end of February. Equity markets declined significantly across all regions as coronavirus fears continue to mount, while Canadian bonds rose.

 

The S&P/TSX Composite Index returned -4.3 per cent. All sectors posted negative returns with the exception of Information Technology, Utilities and Real Estate.

 

Canadian fixed income markets rose amidst lower yields with long-term bonds (6.0 per cent) outperforming universe bonds (3.6 per cent). Real return bonds (5.2 per cent) also rose.

 

On a global basis, international equities detracted the most value, with the MSCI EAFE returning -9.2 per cent in local currency (-7.8 per cent in CAD). The U.S. equity market returned -8.3 per cent in USD terms (-5.0 per cent in CAD). Emerging markets also detracted value in both local currency (-7.0 per cent) and Canadian dollar terms (-6.5 per cent).

 

“The end of February saw global equity markets experience sharp sell-offs on growing coronavirus fears, and several equity markets entered correction territory” said Todd Nelson, Partner at Mercer Canada. “However, while markets could fall further, it’ll be nearly impossible for investors to catch the low, and the recent history of market corrections shows that recoveries can be rapid.”

 

The U.S. Federal Reserve cut its target rate by 0.50 per cent on March 3rd from 1.75 per cent to 1.25 per cent in an effort to combat the economic fallout from the coronavirus. It was the first unscheduled emergency rate cut since the 2008 financial crisis. The Bank of Canada responded on March 4th with a similar cut to its target for the overnight rate from 1.75 per cent to 1.25 per cent.

 

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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