Defined benefit plans in good health with opportunity to use surplus - but should prepare for risks ahead: Mercer
Toronto, April 1, 2024
The Mercer Pension Health Pulse (MPHP), a measure that tracks the median solvency ratio of the defined benefit (DB) pension plans in Mercer’s pension database, is 118% as at March 29, 2024, an improvement from 116% at December 31, 2023. The solvency ratio is one measure of the financial health of a pension plan. This financial health puts plans in good standing as new risk management guidelines from Canadian Association of Pension Supervisory Authorities (CAPSA) are due to be released this year.
Throughout Q1, most plans saw positive asset returns coupled with decreased DB liabilities, which resulted in an overall strengthening of solvency ratios. DB pension plans that used fixed income leverage may have experienced stable or improved solvency ratios over the quarter. But plan sponsors should resist complacency, taking this opportunity to revisit risk management practices, and prepare for potential adverse financial events.
In addition, compared to the beginning of year, there are more DB pension plans with solvency ratios above 100%.
“Members of DB pension plans likely saw continued improvement in the financial health of their plans over Q1,” said Jared Mickall, Principal and leader of Mercer’s Wealth practice in Winnipeg. “Solvency ratios were raised by strong equity performance and interest rate increases.”
Canadian inflation eased to 2.9% in January, which is less than the upper end of the Bank of Canada’s inflation-control target of 3%. It is the Bank of Canada’s expectation for inflation to remain close to 3% during the first half of 2024 before gradually easing. On March 6, the Bank of Canada continued its policy of quantitative tightening by maintaining the overnight rate at 5.00%1. On March 19, Canadian inflation for February 2024 came in at 2.8%2, which ignited industry speculation on the timing and amount of a cut to the overnight rate.
While the overnight rate remained unchanged during Q1, interest rates on Canadian bonds with longer terms finished the quarter at levels greater than they were at the start of the year. Due to the long-term nature of DB pension plans, long-term interest rates pose a significant risk for many DB pension plans. Monitoring long-term interest rates on Canadian bonds as well as the overnight rate, would be an ongoing focus for DB pension plan stakeholders.
For DB pension plans in the enviable position of enjoying a surplus, having an effective strategy for its use should be on the agenda. Contribution holidays, improving benefits or retaining surplus are typical options and their financial impacts should be explored.
When considering the current financial strength of a DB pension plan, given the risk of a decline to Canadian interest rates and ever-present market volatility, a review of a pension plan’s risks to be retained or transferred (e.g. annuity purchase) continues to be prudent alongside the approach to surplus usage. While a strategic annuity purchase is top of mind for many DB pension plans, a tailored investment strategy is a viable, and in some cases the only feasible, alternative to annuitization. A regular review of a pension plan’s investment policy continues to be appropriate and such reviews may be expanded to include sustainable investment beliefs.
In 2024, pension plans should expect CAPSA to release a new guideline on Pension Plan Risk Management. The most recent draft guideline underwent consultation in 2023. The draft guideline covers risk management frameworks for pensions and includes special considerations on specific topics such as: Third-party (outsourcing) risk, cyber security, Environmental, Social, Governance (ESG), use of leverage, target pension arrangements, and investment risk governance3.
“While it is likely that solvency ratios have improved, Canadian DB pension plans should take the opportunity to be strategic on their use of surplus and are advised to be steadfast in the financial management of their plans and avoid becoming complacent,” said Mickall. “Canadian DB pension plans should take the opportunity to revisit their risk management processes in anticipation of new guidelines from CAPSA. Canadian DB pension plans should also prepare for adverse financial experience. Understanding the risks associated with interest rate changes, market volatility, increasing longevity, plan maturity and other risks specific to each DB plan are necessary for a DB plan to meet its long-term objectives. Applying appropriate governance and risk management processes should set a clear path forward.”
From an investment standpoint
A typical balanced portfolio would have posted a return of 3.8% over the first quarter of 2024. Entering the new year, investor sentiment remained positive in anticipation of an early pivot away from monetary tightening by the central banks after recent trends in slowing inflation. However, better than expected macroeconomic data, stable employment figures and persistent inflation over the quarter dampened expectations. Within this environment, global equities delivered positive returns supported by strong corporate earnings, while fixed income markets fell as yields increased again.
Global equity markets began the quarter cautiously, but quickly rebounded as central banks renewed their commitment towards easing financial conditions in the later half of the year. The U.S. economy remained the key driver of global economic activity with higher employment figures, persistent consumer demand and strong corporate earnings. The U.S. equity market rose to new record highs, aided by the exceptionally strong performance of the Magnificent 7 mega-cap technology stocks, which have benefited from advancement in AI.
In contrast, economic conditions in the UK and Eurozone experienced a slightly negative start to the quarter, reflecting their relative softness compared to the U.S. Nevertheless, during the latter half of the quarter, there were signals of a rebound in the UK and Eurozone, as suggested by the monthly PMI surveys. For the UK, this represents signals that the economy is recovering from the technical recession experienced last year. Within the Eurozone, the data represents stability following a period of contraction, with stagnant GDP growth and lower-than-anticipated retail sales. In Japan, the Nikkei 225 reached an all-time high for the first time since 1989 as the Bank of Japan finally ended the world’s only negative rates regime and made its first rate hike in 17 years. Emerging markets experienced volatility, as political instability was later offset by strong consumer demand following the Lunar New Year in February. The EM markets end the quarter behind developed market counterparts
Bond returns were negative overall amid increasing yields. The markets were overly optimistic last year leading to significant rallies, but the data has been mixed, with global inflation showing positive trends. The Federal Reserve and Bank of Canada are expected to be patient, requiring more progress in addressing inflation and seeing clear signs of economic weakness before considering interest rate cuts. The current stance is likely to be maintained for an extended period. Global commodities have delivered strong returns in Q1, with the greatest gains coming from energy and oil prices that have been increasing due to supply cuts from OPEC and allies. In Real Estate, REITs posted negative returns, and the market continues to experience headwinds from higher yields, borrowing costs and ongoing fair value adjustments.
The majority of Canadian equity sectors posted positive returns with the exception of REITs, Communications, and Utilities. Health Care, Energy and Industrials were the highest performing sectors as demand was strong and commodity prices rose. Canadian GDP growth has been relatively flat and a recent contraction in capital investment will be key to monitor going forward. Inflationary pressures continue with the highest increases coming from Shelter costs given elevated interest rates. Home prices remain high, offsetting housing affordability improvements brought by softened mortgage rates.
Canadian debt markets posted negative returns as hopes for an early interest rate cut in 2024 have not materialized. The yield curve remained inverted with rates increasing across the curve. The long-term fixed income market saw the largest underperformance as yields remained volatile, partially offsetting gains from the end of 2023. The current market conditions provide a favourable environment for private credit investors, as the demand for capital exceeds its supply. This situation is further amplified by the prolonged elevation of interest rates, resulting in increased borrowing costs and reduced excess liquidity in the economy. To capitalize on these market dynamics, investors should consider exploring private credit opportunities. The Canadian dollar depreciated relative to the US dollar and other developed currencies this quarter, strengthening non-Canadian developed market returns in Canadian dollar terms.
“Private debt offers the opportunity to invest in companies across the real economy and provides protection in both inflationary and disinflationary environments. Current opportunities remain attractive due to double-digit yields and increased structural protections to lower leverage levels,” said Nataliya Stasyuk, Principal at Mercer Canada. “The rising number of strategies has made it harder to discern the best managers. We believe that manager dispersion is inevitable, making it even more important to partner with top-quartile managers.”
The Bank of Canada’s messaging remained open towards a reduction in rates this year and an end to quantitative tightening in 2025, but maintained its policy interest rate at 5.0%. The U.S. Federal Reserve held a similar view, introducing the possibility of rate cuts this year, while emphasizing the need for more positive data that shows sticky inflation is sustainably moving towards the long-term goal of 2%. Finally, the Bank of England continues to monitor economic data as there are signs towards a positive shift, while avoiding explicit signals that rate cuts are imminent.
The Mercer Pension Health Pulse
The Mercer Pension Health Pulse tracks the median ratio of solvency assets to solvency liabilities of the pension plans in the Mercer pension database, a database of the financial, demographic and other information of the pension plans of Mercer clients in Canada. The database contains information on almost 500 pension plans across Canada, in every industry, including public, private and not-for-profit sectors. The information for each pension plan in the database is updated every time a new actuarial funding valuation is performed for the plan.
The financial position of each plan is projected from its most recent valuation date, reflecting the estimated accrual of benefits by active members, estimated payments of benefits to pensioners and beneficiaries, an allowance for interest, an estimate of the impact of interest rate changes, estimates of employer and employee contributions (where applicable), and expected investment returns based on the individual plan’s target investment mix, where the target mix for each plan is assumed to be unchanged during the projection period. The investment returns used in the projections are based on index returns of the asset classes specified as (or closely matching) the target asset classes of the individual plans.
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