Amid negative returns, recession fears and inflation, DB plans’ financial positions continue to improve: Mercer 

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, increased from 119% as at June 30, 2023, to 125% as at September 30, 2023. As at the beginning of the year, the MPHP was at 113%.

This strengthening is somewhat counterintuitive, as pension fund asset returns were mostly negative in the quarter. However, bond yields increased in the quarter, which decreases DB liabilities. This decrease, along with a decrease in the estimated cost of purchasing annuities, more than offset the effect of negative asset returns, leading to stronger overall funded positions.

Plans that use leverage in the fixed income component of their assets, will not have seen this type of improvement.

Of the plans in Mercer’s pension database, at the end of the third quarter 88% are estimated to be in a surplus position on a solvency basis (vs. 85% at the end of Q2). Approximately 5% are estimated to have solvency ratios between 90% and 100%, 2% are estimated to have solvency ratios between 80% and 90%, and 5% are estimated to have solvency ratios less than 80%. 

“2023 so far has been good for DB pension plans’ financial positions,” said Ben Ukonga, Principal and leader of Mercer’s Wealth practice in Calgary. “However, as we enter the fourth quarter, will the good news continue to the end of the year?”  

As the fourth quarter begins, the global economy is still on shaky grounds. A recession is not completely off the table, despite continued low unemployment rates. Inflation remains high, potentially back on the rise, and outside central banks’ target ranges. Geopolitical tensions also remain high, reducing global trade and trust and fragmenting global supply chains – which further reduces global trade. And the war in Ukraine, ongoing for over a year, shows no sign of ending – adding economic uncertainty atop a geo-political and humanitarian crisis.  

Closer to home, will the recent labour disruptions at the US auto manufacturers be resolved quickly? Will these be prolonged disruptions and lead to a slow down of the US economy? Could they lead to a wider contagion of disruptions between other labour groups and organizations? And what impact could these labour disruptions have on unemployment rates and inflation? In Canada, how will the recent agreement between Unifor and Ford Canada impact other upcoming labour negotiations? The narrow passage of the deal by Unifor’s Ford members indicates that expectations are high from Canadian workers for large wage increases from their employers. Will these expectations materialize, leading to further inflationary pressures? The deal also contained increases to the benefit rates in the company’s flat dollar DB plan, which will be of interest to plan sponsors of flat dollar DB plans.

Central banks globally continue to keep their benchmark interest rates at elevated levels. Governments, corporations and households are already having to adjust to this new interest rate environment. How high will they have to go, and how long will they have to keep the rates at these elevated levels? Will it have the desired impact of slowing down their respective economies?

Given the delayed effect of the impact of interest rate changes on economies, care will be needed by central banks to ensure their adjustments (and quantitative tightening) do not tip the global economy into a deep recession, as the full effects of these actions will not be known immediately. As many market observers now believe, the amount of quantitative easing during the COVID-19 pandemic was more than was needed.

In Canada, most DB plans are in favourable financial positions, with many plans in surplus positions. Sponsors who filed 2022 year-end valuations will have locked in their contribution requirements for the next few years, with many being in contribution holiday territory (for the first time in a long time). However, DB plan sponsors should not be complacent. Markets can be volatile, and given that plans are in surplus positions, now more than ever is the time for action, such as de-risking, pension risk transfers, etc. These actions can now be done at little or no cost to the sponsor.

Plan sponsors should also not forget about the importance of having appropriate governance and risk management systems in place, as regulators are increasing their scrutiny of plan sponsors’ governance and risk management systems.  

Canadian DB plan sponsors should also remain cognizant of the passing of Bill C-228, which grants pension plan deficits super priority over other secured creditors during bankruptcy and insolvency proceedings. Although there is a 4-year delay in its effective date (for most DB plans), with many plans being in surplus positions, the potential implications of the bill may seem small. However, if pension deficits were to re-appear, the bill could have significant impacts on plan sponsors, their ability to raise funds, and the costs of those funds.

“Looking ahead, with interest rates expected to remain high in the short to medium term, plan sponsors should be reviewing their risk tolerances, the risks they are exposed too, and taking steps to hedge or transfer the risks they do not want,” said Ukonga. “Or else, they will be kicking themselves when the goldilocks environment DB plans are experiencing comes to an end.”

Majority of Canadian equity sectors posted negative returns except for Energy and Healthcare. Concerns regarding exposure of Canadian household debt to higher interest rates, softening labor market and wage growth remain. Commodities broadly outperformed over the quarter, while the information technology sector saw declines along with trends in artificial intelligence subsiding. In real estate, new housing constructions have declined in comparison to previous year, and sales volume remained muted but number of listings edged higher. In commercial real estate, valuations have varied widely based on location and type of property, and credit remains available for high quality assets. Vacancy in the industrials and purpose-built residential rental markets continues to be very tight.

Canadian debt market experienced large swings in yields as inflation expectations and interest rate changes detracted from performance. The yield curve remained inverted and elevated across all terms with mid and long-term maturities impacted the most. This led to especially large pricing impacts in long-term fixed income, erasing all gains made previously year-to-date as valuations adjusted to new real rates. The Canadian dollar depreciated against the US dollar, strengthening foreign equity returns in Canadian dollar terms.

“The underperformance of emerging markets (EM) relative to developed markets (DM) equities continues to frustrate investors in 2023. While DM performance was driven by the rally of a few US large cap technology stocks, in EM China’s re-opening and policy responses have disappointed. Despite the weakness, the case for EM allocation persists.” said Venelina Arduini, Principal at Mercer Canada. “EM outside of China tackled inflation early and can now cut rates to support their economies. Meanwhile in China, spare capacity and the absence of inflation provides the opportunity for authorities to engage in large scale fiscal policy support. These fundamental drivers are also supported by relatively attractive valuations and light positioning.”

The Bank of Canada followed the June rate hike with another 25 basis point hike in July. In September, the central bank decided to pause on interest rate hikes as GDP and the labour markets have slowed over the quarter. The U.S. Federal Reserve maintained a similar view with a 25 basis point hike in July and pausing in September. After 14 consecutive interest rate hikes, the Bank of England decided to maintain rates in September after new data showed inflation slowing below expectations. 

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.