October 1, 2018

Canada, Toronto

Funded position of defined benefit plans approaching an 18 year high

The solvency position of Canadian defined benefit pension plans reached its highest level since November 2000 at the end of the third quarter of 2018. The Mercer Pension Health Index, which represents the solvency ratio of a hypothetical plan, stood at 112 per cent on September 28th up from 107 per cent on June 29th and 106 per cent the beginning of the year. The median solvency ratio of the pension plans of Mercer clients was at 102 per cent on September 28th up from 99 per cent at June 29th and 97 per cent at the end of 2017. More than 60 per cent of Canadian pension plans are now fully funded and less than 5 per cent of plans are below 80 per cent funded on a solvency basis.

The funded position of pension plans was boosted in the third quarter by a late surge of 20 basis points in long-term interest rates during the last few weeks of September. A 100 basis point increase in interest rates typically results in a decrease of 10 per cent to 15 per cent in pension liabilities. Strength in the U.S. and international equity markets provided a further boost, although the Canadian equity markets continued to lag.

“Canadian pension plans have not been this well-funded since November 2000,” said Manuel Monteiro, Leader of Mercer Canada’s Financial Strategy Group.

However, financial markets remain volatile, with uncertainty regarding the pace at which central banks will raise interest rates and escalating trade wars. However, the late breaking announcement of the new USMC agreement to replace NAFTA will calm some fears.

The dramatic improvement in funded positions since the 2016 U.S. election and the fundamental changes to funding rules in Ontario and Québec have caused many plan sponsors to revisit their risk management strategy. Some plan sponsors, particularly those that are not fully funded and that remain open to new members, feel emboldened by the new funding rules to maintain or even increase investment risk. On the other hand, this seems like a particularly opportune time for sponsors of closed and frozen defined benefit plans to take risk off the table, either by changing the asset mix or through risk transfers. “The group annuity market has been slower than expected in the first three quarters of 2018. We expect very favourable pricing conditions in the fourth quarter as insurers will be looking to meet their aggressive sales quotas,” continued Monteiro.

From An Investment Standpoint

A typical balanced pension portfolio would have decreased by 0.1 per cent during the third quarter of 2018. Most developed market equities advanced, led by strong U.S. performance, while Canadian, emerging markets and broad-market Canadian bonds declined.

Canadian equity returns were slightly negative following a strong second quarter, with the S&P/TSX Composite Index returning -0.6 per cent. Six of the eleven sectors posted gains, with Health Care (+31.4 per cent) extending its second quarter rally due to surging cannabis stocks.

Canadian fixed income markets were down over the quarter amidst rising yields, with long-term bonds (-2.4 per cent) underperforming universe bonds (-1.0 per cent). Real return bonds (-2.2 per cent) also fell over the third quarter.

The U.S. led global equity markets with a return of 7.7 per cent in USD terms (5.8 per cent CAD). Developed market equities were generally strong, with the MSCI World returning 5.4 per cent in local currency terms (3.3 per cent CAD). Emerging markets continued to show weakness in the third quarter, returning 0.1 per cent in local currency terms (-2.7 per cent CAD), as headwinds including trade war tensions, tariffs and currency crises weighed down on performance. Lower CAD returns, relative to local currency returns, were due to appreciation of the Canadian dollar over the quarter.

Trade disputes continued to dominate headlines in the third quarter, as President Trump imposed a further round of tariffs on China. “Market sensitivity to geopolitical issues and rising trade tensions remains a significant concern,” said Todd Nelson, Principal at Mercer Canada. “While developed market equities continued to advance in the third quarter, growth has become less synchronized. Emerging markets have shown particularly sensitive to falling demand and a strengthening U.S. dollar.”

Central banks continued on their tightening path over the third quarter. In July, the Bank of Canada raised its target for the overnight rate by a quarter percentage point to 1.50 per cent, while in September the U.S. Federal Reserve raised its target rate to between 2.00 and 2.25 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.

Mercer delivers advice and technology-driven solutions that help organizations meet the health, wealth and career needs of a changing workforce. Mercer’s more than 22,000 employees are based in 44 countries and the firm operates in over 130 countries. Mercer is a wholly owned subsidiary of Marsh & McLennan Companies (NYSE: MMC), the leading global professional services firm in the areas of risk, strategy and people. With more than 65,000 colleagues and annual revenue over $14 billion, through its market-leading companies including Marsh, Guy Carpenter and Oliver Wyman, Marsh & McLennan helps clients navigate an increasingly dynamic and complex environment. For more information, visit Follow Mercer on Twitter @MercerCanada.