Pension plans end a wild 2020 as well-funded as they began it: Mercer

January 4, 2021

Canada, Toronto

 

Driven by equities, Canadian pension plans’ funded position continued to recover in Q4 2020, according to the Mercer Pension Health Index (MPHI). However, major risks lie ahead due to the economic damage caused by the pandemic.

 

The Mercer Pension Health Index (MPHI), which represents the solvency ratio of a hypothetical defined benefit (DB) pension plan, increased from 107 per cent at the end of September to 114 per cent at the end of December, and is up 2 per cent from the beginning of 2020. The median solvency ratio of the pension plans of Mercer clients was at 96 per cent on December 31, up from 93 per cent on September 30, but lower from 98 per cent at the beginning of the year.

 

During the fourth quarter, funded positions of DB plans continued to recoup the losses incurred in the first quarter. The improvement was primarily driven by equity markets, aided by slightly higher bond yields, and the impact of the recent changes to the Canadian Institute of Actuaries’ commuted value standards.

 

 

“The funded positions of defined benefit plans endured a gut-wrenching decline in Q1, but most are now back at or close to their pre-pandemic level,” said Ben Ukonga, Principal in Mercer’s Financial Strategy Group. “Canadian DB plans remain well-funded by historical standards, even with liabilities measured at today’s ultra-low interest rates.”

 

Many plan sponsors elected to file 2019 year-end valuations, thereby locking in their contribution requirements for the next few years. Recent changes to DB plan funding rules will also alleviate funding requirements for most plan sponsors. A notable exception is plans in federally-regulated industries (banks, airlines, telecommunications etc.) which continue to be subject to annual valuations and solvency funding requirements. However, the federal government is considering yet another round of temporary funding relief for these plans.

 

With the recovery in funded positions from the lows of March 2020, the rollout of the COVID-19 vaccine, and the anticipated re-opening of the global economy, there is cause for optimism for 2021 and beyond. However, significant risks will linger, including the pace at which the pandemic subsides, significant increase in debt levels, persistent low interest rates and geo‑political tensions.

 

“Looking ahead, we have to expect continued volatility as markets react to how governments and business leaders transition to the post-COVID global economy,” said Ukonga. “Plan sponsors should not be complacent now that the end of the pandemic appears in sight.”

 

Many well-funded closed and frozen plans have very little upside reward for taking on significant risk. For many of them, it may be prudent to take risk off the table, through increased allocations to defensive assets, better matching of plan investments to plan liabilities, annuity transactions, wind-ups or even merging into jointly-sponsored pension plans if possible.

 

Open plans and plans with long time horizons face a more difficult challenge. Given the persistent low yields on fixed income investments, they must remain significantly invested in growth assets in order to remain affordable. However, large allocations to growth assets come with exposure to the volatility of the markets. The challenge will be to strike the right balance that best meets the objectives of the plan sponsor and plan members. Realistic contribution rates, risk-sharing design features, broad diversification across asset classes and geographies, and selecting the right investment managers will become even more important going forward.

 

From an investment standpoint

A typical balanced pension portfolio would have posted a return of 5.5 per cent during the fourth quarter of 2020, as equity markets continued to trend upwards while bonds rose slightly.

 

Equity markets rallied, as fears over new COVID-19 restrictions were offset by very favourable developments on the vaccine front, as well as investors reacting positively to the outcome of the US elections. Emerging market equities led the way followed by global equities in local currency terms. Returns for Canadian investors were muted however, as the US dollar weakened against most currencies and in particular plummeted against currencies of commodity exporters, as investors lowered their demand for safe haven currencies. The Canadian equity market was also in positive territory over the quarter, with Energy reversing the negative trend observed in the third quarter. Oil represents one of the pro-cyclical sectors that benefited most by the expected end of the pandemic and full reopening of the economy.

 

Value stocks bucked the historical trend and outperformed growth stocks over the fourth quarter after several quarters of underperformance. Value stocks are expected to benefit disproportionally in a fully reopened post COVID-19 world, especially after the massive rally tech and other ‘stay at home’ stocks predominantly represented in growth indices have seen year‑to‑date.

 

Global REITs posted significant gains over the fourth quarter, as investor optimism spilled into a sector that has faced major setbacks year to date. Credit spreads narrowed as investors flocked into risk assets across the board. As a result, corporate bond returns were modestly positive, outperforming universe and long‑term bonds.

 

“While the development of a vaccine and the U.S. election outcome triggered an equity rally over the fourth quarter, political concerns remain elevated and could be a source of volatility and downside risk over the near-term,” said Todd Nelson, Partner at Mercer Canada. “Entering 2021, forecasting the exact profile of the growth path ahead is difficult, but we expect the global economy to continue to grow strongly and makeup lost ground, especially as the hope of large-scale vaccinations look increasingly likely.”

 

Both the U.S. Federal Reserve and Bank of Canada held their target rates at 0.25 per cent throughout the fourth quarter, following several individual rate cuts throughout the first quarter of the year.

 

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%.

 


About Mercer
Mercer builds brighter futures by redefining the world of work, reshaping retirement and investment outcomes, and unlocking real health and well-being. Mercer’s more than 25,000 employees are based in 44 countries and the firm operates in over 130 countries. Mercer is a business of Marsh & McLennan Companies (NYSE: MMC), the world’s leading professional services firm in the areas of risk, strategy and people with 76,000 colleagues and annualized revenue approaching $17 billion. Through its market-leading businesses including Marsh, Guy Carpenter and Oliver Wyman, Marsh & McLennan helps clients navigate an increasingly dynamic and complex environment. For more information, visit www.mercer.ca. Follow Mercer on Twitter @MercerCanada. 

Contact information