The solvency position of Canadian pension plans rose sharply in the fourth quarter of 2016. The Mercer Pension Health Index, which represents the solvency ratio of a hypothetical plan, stands at 103 per cent on December 19th, up from 92 per cent where it stood at September 29 and the beginning of the year. The median solvency ratio of the pension plans of Mercer clients currently stands at 93 per cent, up from 85 per cent where it stood both at the end of the third quarter and the beginning of the year.
The improvement has been propelled by a dramatic rise in long-term interest rates as well as buoyant equity markets. Most of the improvement has occurred following the U.S. election on November 8.
Although 2016 is ending on an optimistic note, most sponsors of defined benefit pension plans should still expect higher pension contributions in 2017 and beyond.
Many plan sponsors filed valuations at the end of 2013, when the health of pension plans was better than it is now. A large proportion of these sponsors are now faced with having to file a new valuation at the end of 2016 – and most will show a deterioration in the financial health over the last three years. The primary exceptions would be plans registered in Québec where different funding rules apply and those that are sponsored by federally regulated companies (banks, airlines, transportation companies etc.) who have to file valuations annually.
“The recent run up in long-term interest rates and new equity market highs couldn’t have come at a better time for Canadian defined benefit pension plan sponsors. The election of Donald Trump seems to have cushioned the blow that many plan sponsors were bracing for in 2017,” said Manuel Monteiro, leader of Mercer’s Financial Strategy Group.
While the improvement in the financial health of pension plans is certainly welcome news, plan sponsors are increasingly concerned about the heightened risks on the horizon. The markets seem to have reacted positively to the outcome of the US election and are pricing in significant economic growth due to lower taxes, less regulation and large stimulus, and discounting the potential implications of factors like increased protectionism and greater budget deficits. Furthermore, the broader headwinds such as aging populations, sluggish growth in Europe and a growing anti-globalization sentiment remain present.
The recent rebound in financial positions combined with a heightened concern about future risks is driving some plan sponsors to take risk off the table by increasing their allocation to bonds which better match their liabilities or by transferring risk through annuity transactions. “The fourth quarter has been one of the busiest periods in the group annuity market, and 2017 seems to be shaping up to be a banner year for these types of risk transfer transactions,” continued Monteiro.
Annuity transactions and shifts to fixed income will not make sense for all sponsors. However, plan sponsors should be reviewing their risk profile and assessing whether it continues to makes sense in the new world order.
Long-term interest rates have risen by nearly 70 basis points since the end of the third quarter and by 44 basis points alone since the US election. Interest rates are now above levels observed at the beginning of year.
A typical balanced pension portfolio would have returned 0.4 per cent during the fourth quarter of 2016. Equity markets were slightly negative in October but rallied following the US election.
“Canadian equities are on track to finish the year strong with a return of 4.2 per cent over the fourth quarter and up around 21% for the year,” said Sofia Assaf, principal at Mercer Investments. “The outperformance in the fourth quarter was led by Financials (+12.2 per cent) and Energy (+8.1 per cent), two sectors that could potentially benefit from president-elect Trump policies. On the other hand, Healthcare (-31.6 per cent) continued its decline ending the year with nearly 80 per cent loss in its value.
US equity returns were also strong in USD (4.9 per cent) and 6.9 per cent in CAD terms. Over the fourth quarter, the CAD appreciated against the British pound and the Euro but depreciated against the USD. International equities did well in local currency as the MSCI EAFE returned 7.0 per cent but only 0.6 per cent in CAD. Emerging markets underperformed during the quarter as it returned -2.7 per cent in local currency terms and -3.8 per cent in CAD.
As expected, the US Federal Open Market Committee raised their target interest rate in December by a quarter point from 0.50 per cent to 0.75 per cent and signalled a faster pace of increase in 2017. The Bank of Canada interest rate target is currently set at 0.50 per cent with a relatively low expectation of rate increases in the year ahead.
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 with asset mix of: Asset mix: 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
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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