The solvency position of Canadian defined benefit (DB) pension plans rose sharply in the fourth quarter (Q4) of 2016 as a result of a dramatic rise in long-term interest rates and positive equity markets, especially following the U.S. election on Nov. 8, according to Mercer LLC’s quarterly pension health index.
The index, which represents the solvency ratio of a hypothetical Canadian DB pension plan, stood at 103% on Dec. 19, an increase from its standing in September of 92%. The median solvency ratio of the pension plans of Mercer’s client currently stands at 93%, which is up from where it stood in September at 85%.
“The recent run up in long-term interest rates and new equity market highs couldn’t have come at a better time for Canadian defined benefit pension plan sponsors,” says Manuel Monteiro, leader of Mercer’s financial strategy group, in a statement on Wednesday. “The election of Donald Trump seems to have cushioned the blow that many plan sponsors were bracing for in 2017.”
Although the health of DB pension plans has improved, plan sponsors worry about possible future risks. The markets are pricing in significant economic growth due to the potential of lower taxes, less regulation and increased fiscal stimulus in the U.S. under a new administration, according to the report.
However, the markets are discounting the potential implications of factors like increased protectionism and higher budget deficits. In addition, broader headwinds such as aging populations, sluggish growth in Europe and a growing anti-globalization sentiment remain factors that could affect economic growth.
The recent rebound in financial positions combined with a heightened concern about future risks is driving some plan sponsors to decrease their own investment risk by increasing their allocation to bonds that better match their liabilities or by transferring risk through annuity transactions.
The report also breaks down the success of a typical balanced portfolio, which would have returned 0.4% during Q4, with strong showings from Canadian and U.S. equities.
Canadian equities finish the year with a return of 4.2% in Q4 and approximately 21% for the year. The financials sector produced the highest return (12.2%) in Q4 with the energy sector close behind (8.1%). The health care sector suffered a dramatic loss of 31.6% in Q4.
U.S. equity returns were strong in both the U.S. dollar (US$) with a return of 4.9% and in the Canadian dollar (C$) with a return of 6.9%.
The C$ depreciated against the US$ but appreciated against the U.K.’s pound and the Euro, which affected returns from European equities. Although the MSCI EAFE index returned 7% in European currency, it only returned 0.6% in C$ in Q4.
Emerging markets underperformed during the quarter as equities from this area returned -2.7% in local currency terms and -3.8% in C$.
Long-term interest rates have risen by nearly 70 basis points since the end of the third quarter and by 44 basis points alone since the U.S. election.
The U.S.’ key interest rate has also increased to 0.75% from 0.5% in Q4 while Canada’s central bank maintains a domestic interest rate of 0.5% with relatively low expectation of any increases in the year ahead, the report states.
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