Pension plans’ funded positions hit their highest levels in 20 years: Mercer

April 1, 2021

Canada, Toronto

 

Fueled by a sharp rise in bond yields, Canadian defined benefit pension plans’ funded positions continued to improve, ending the first quarter of 2021 at their highest levels in over 20 years. However, the current high funded positions may be fleeting, depending on the trajectory of interest rates, inflation expectations and the performance of equity markets.

 

The Mercer Pension Health Index (MPHI), which represents the solvency ratio of a hypothetical defined benefit (DB) pension plan, increased from 114 per cent at the end of 2020 to 124 per cent at the end of March 2021. The median solvency ratio of the pension plans of Mercer clients was at 104 per cent on March 31, up from 96 per cent on December 31.

 

Despite the negative returns experienced by many pension funds in the first quarter, the funded positions of DB plans improved significantly as long bond yields increased a remarkable 77bps during the quarter. While the higher bond yields drove the negative investment returns in the quarter, this was more than offset by the decrease in liabilities resulting from higher discount rates. The Mercer Pension Health Index is at its highest level since its inception in 1999. Approximately 66% of the pension plans of Mercer clients are estimated to be in a surplus on a solvency basis.

 

 

“The first quarter of 2021 has been very good for DB plans,” said Ben Ukonga, Principal in Mercer’s Financial Strategy Group. “In March 2020, as markets were experiencing a gut-wrenching freefall, nobody would believe that pension plans would be breaking funded position records only a year later.”

 

With the continued rollout of COVID-19 vaccines, re-opening of the global economy, stimulus spending by governments in attempts to re-ignite their respective economies, there is cause for optimism for continued improvements in DB plans’ funded positions for the rest of 2021 and beyond. But risks still exist, such as emergence of new variants of the COVID-19 virus, significant increases in Government debt levels, inflation and interest rate worries, and geo-political tensions.

 

Increases in inflation expectations and interest rates in particular could negatively affect the economic recovery, corporate earnings, equity market returns, and the ability of Governments, corporations and individuals’ to service their debts.

 

“Despite the good news, plan sponsors should not be complacent. We all saw how quickly DB plans’ funded positions deteriorated at the outset of the pandemic. The improved positions we now see could be short lived,” said Ukonga. “Now is the time for plan sponsors to revisit their risk preferences (or tolerances) and take appropriate actions.”

 

Well-funded closed and frozen plans have little upside reward for taking on significant risk, and should consider taking risk off the table, by increasing their 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.  Yields on fixed income investments remain low despite the increases in the first quarter.  These plans must therefore remain significantly invested in growth assets in order to remain affordable. However, large allocations to growth assets make them more sensitive to market volatility. 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 -2.3 percent during the first quarter of 2021. While falling COVID-19 cases and vaccination rollouts across the globe fueled optimism in the equity markets, that same optimism over stronger growth led to a rapid rally in bond yields which translated into negative returns for fixed income assets.

 

Equity markets ended the quarter with slightly positive returns. While performance earlier in the quarter was driven by optimism over medium term growth and an ongoing recovery in corporate profits, weakness towards the end of the quarter was fueled by rising Treasury yields tempering appetite for the most highly valued areas of the equity market. The most cyclical segments of the market were rewarded, as value continued to outperform growth stocks by a large margin. Canadian equities outperformed their global counterparts, driven mostly by the market’s concentration in the energy and financials sectors, which had double-digit returns. In non-domestic markets, the US outperformed the rest of the world while emerging markets lagged, driven by negative performance in China as onshore markets weakened amid concerns over tighter credit and slowing profit growth. Continuing with the trend seen in the fourth quarter of 2020, returns for Canadian investors were muted in the first quarter of 2021, as the Canadian dollar appreciated against most major currencies.

 

Bond yields have risen sharply since the beginning of the year, resulting in significantly negative returns for universe and long term bonds. Long term bond yields have risen by 77 basis points since the beginning of the quarter, while universe bond yields have risen by 52 basis points. Investors appear to expect that the economy will recover at a much quicker pace than previously expected, and the combination of these rising long-term yields and continued low policy rates could lead to a continued yield curve steepening, to reflect an improving longer-term economic outlook.

 

Gold fell sharply over the quarter as interest rates increased and the demand for safe haven assets was weak in a continued risk-on environment. Global REITS were in positive territory, but the sector has been slow to recover from its 2020 decline, as uncertainty over the future of commercial real estate will linger for much longer than in other sectors.

 

“While the continued optimism in equity markets is encouraging, and an eventual rise in interest rates was to be expected following a period of extraordinary low yields, the pace and size of the recent movements have been more significant than many market watchers had forecasted,” said Todd Nelson, Partner at Mercer Canada. “DB Plan sponsors should take this opportunity to assess the impact of rising yields on both their investment strategy and long-term journey plan.”

 

Both the U.S. Federal Reserve and Bank of Canada held their target rates at 0.25 per cent throughout the first quarter of 2021, following several individual rate cuts throughout the first quarter of 2020.

 

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 believes in building brighter futures by redefining the world of work, reshaping retirement and investment outcomes, and unlocking real health and wellbeing. Mercer’s approximately 25,000 employees are based in 43 countries and the firm operates in 130 countries. Mercer is a business of Marsh McLennan (NYSE: MMC), the world’s leading professional services firm in the areas of risk, strategy and people, with 76,000 colleagues and annual revenue of over $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