The solvency position of Canadian pension plans rose in the third quarter of 2016. The Mercer Pension Health Index, which represents the solvency ratio of a hypothetical plan, stands at 92 per cent on September 28th, up from 90 per cent at June 30th; and back to its level at the beginning of the year. The median solvency ratio of the pension plans of Mercer clients stood at 85 per cent, up from 82 per cent at the end of the second quarter, and back to its level at the beginning of the year.
While pension plans have benefited from strong equity market returns in 2016 (particularly Canadian equities), this has been largely offset by the decline in long-term bond yields and the strengthening Canadian dollar (which negatively impacted the return on unhedged foreign assets).
Although 2016 has been a relative benign year so far, many sponsors of defined benefit pension plans will be faced with higher pension contributions in 2017 and beyond.
“Many plan sponsors filed valuations with the regulators at the end of 2013, when the health of pension plans was significantly better than it is today,” said Manuel Monteiro, Leader of Mercer’s Financial Strategy Group. “A large proportion of these sponsors are now faced with having to file a new valuation at the end of 2016 – and these valuations will recognize the deterioration in the financial health that has occurred over the last three years.”
The situation is different in Québec, where most private sector plan sponsors will experience fairly stable pension contribution requirements as a result of a major change in funding rules introduced in 2016. Policymakers in other provinces are also considering changes to funding rules which may provide some relief to plan sponsors.
There are many lingering questions which could have even more profound implications for all pension plans: Will interest rates continue to decline even further like they have in Europe and Japan? How will equity markets react when the Federal Reserve raises short-term interest rates? What impact will the U.S. election have in the short term on global markets and in the longer term on economic growth?
With an increasingly uncertain environment, many defined benefit plan sponsors, particularly those who have closed or frozen their plans, will be looking to reduce risk by shifting their asset allocation towards fixed income and by transferring risk through annuity transactions, particularly if the funded positions of their plans improve. Plan sponsors looking to reduce risk should establish a comprehensive strategy now and monitor market opportunities so that they can act quickly when they arise. On the other hand, assuming a “lower for longer” interest rate environment, sponsors who are committed to maintain their defined benefit plans may feel the need to diversify their investment portfolio since current yields from core fixed income portfolios are not much greater than go-forward inflation expectations.
From an Investment Standpoint
A typical balanced pension portfolio would have returned 4.1 per cent during the third quarter of 2016. The stock markets recovered rapidly following the turbulence caused by the Brexit vote at the end of June.
“Canadian equities continued to perform strongly in 2016 with a return of 5.4 per cent over the third quarter,” said Brian Dayes, partner at Mercer Investments. “The outperformance was led by a rebound in Healthcare (+13.7 per cent) and Info Tech (+13.0 per cent), two sectors that have underperformed significantly in the first half of the year. Most of the other sectors either did quite well like Industrials (+9.9 per cent), Consumer Discretionary (+8.5 per cent) and Consumer Staples (+6.8 per cent) or had weak returns like Materials (+0.4 per cent) or Utilities (+0.8 per cent).”
US equity returns were modestly positive in USD (4.0 per cent) and 6.2 per cent in CAD terms. The CAD appreciated against the British pound, but depreciated against the Euro and the USD. International equities were quite strong as the MSCI EAFE returned 6.0 per cent in local currency terms and 8.5 per cent in CAD. Emerging markets were the best equity asset class during the quarter as it returned 8.7 per cent in local currency terms and 12.5 per cent in CAD.
The Canadian yield curve remained relatively unchanged as yields came down by 5-10 bps compared to the yield at the beginning of the quarter.
Both the Bank of Canada and the US Fed Federal Open Market Committee decided to hold steady their target interest rate in September at a level of 0.50 per cent for Canada and between 0.25 per cent to 0.50 per cent for the U.S.
The Mercer Pension Health Index