The solvency position of Canadian defined-benefit (DB) pension plans increased in the third quarter (Q3) of 2016 and are now back to the level at which they stood at the beginning of the year, according to Mercer LLC’s quarterly pension health index.
The index, which represents the solvency ratio of a hypothetical DB pension plan, rose to 92% as of Sept. 28, up from 90% as of June 30. In addition, the median solvency ratio of DB pension stood at 85%, up from 82% at the end of the second quarter, also back to its level at the beginning of the year.
Although DB pension plans have benefited from strong equity market returns in 2016, this has been largely offset by the decline in long-term bond yields and the strengthening Canadian dollar (C$), which impacted the return on unhedged foreign assets negatively.
As well, many sponsors of DB pension plans will be faced with higher pension contributions in 2017 and beyond.
“Many DB plan sponsors filed valuations with the regulators at the end of 2013, when the health of pension plans was significantly better than it is today,” says Manuel Monteiro, leader of Mercer’s financial strategy group, in a statement. “A large proportion of these sponsors are now faced with having to file a new valuation at the end of 2016 — and these valuations will recognize the deterioration in the financial health that has occurred over the past three years.”
The situation is different in Quebec, where most private sector DB plan sponsors will experience fairly stable pension contribution requirements as a result of a major changes in funding rules introduced in 2016. Policy-makers in other provinces are also considering changes to funding rules, which may provide some relief to DB plan sponsors.
There are many lingering questions that could have even more profound implications for all pension plans, including: Will interest rates continue to decline even further like they have in Europe and Japan? How will equity markets react when the U.S. Federal Reserve Board raises short-term interest rates? What impact will the U.S. election have in the short term on global markets and in the longer term on economic growth?
Given this increasingly uncertain environment, many DB plan sponsors, particularly those who have closed or frozen their plans, will be looking to reduce risk by shifting their asset-allocation toward fixed-income and by transferring risk through annuity transactions, particularly if the funded positions of their plans improve.
On the other hand, assuming a “lower for longer” interest rate environment, DB pension plan sponsors who are committed to maintain their DB pension plans may feel the need to diversify their investment portfolio as current yields from core fixed-income portfolios are not much greater than inflation expectations.
A typical balanced DB pension portfolio would have returned 4.1% during Q3 2016 as stock markets recovered rapidly following the turbulence caused by results of the U.K.’s Brexit referendum on June 23.
“Canadian equities continued to perform strongly in 2016 with a return of 5.4% in Q3,” says Brian Dayes, partner with Mercer Investments, in a statement. “The outperformance was led by a rebound in health-care (13.7%) and information technology (13%) stocks, two sectors that have underperformed significantly in the first half of the year.”
U.S. equity returns were modestly positive, rising by 4% in U.S. dollar terms and 6.2% in C$ terms. International equities were quite strong as the MSCI EAFE asset class rose by 6% in local currency terms and 8.5% in C$. Emerging markets were the best equity asset class during the quarter, rising by 8.7% in local currency terms and 12.5% in C$.
The Canadian yield curve remained relatively unchanged as yields came down between five and 10 basis points compared with the yield at the beginning Q3.
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