Defined benefit (DB) pension plans in Canada are facing higher deficits than advertised, according to new research from Toronto-based DBRS Ltd.

The new study, which examines historical data from 25 large Canadian-based DB plans from between 2002 and 2011, concludes that the current funded status of DB plans is overstated, as the aggressive discount rates used do not reflect the current low interest rate environment.

Currently, reported discount rates — almost 5% — are significantly higher than the risk-free rate plus 90 basis points, which is how discount rates should be calculated DBRS says, meaning discount rates should be about 3.75%. The use of higher discount rates understates the actual obligations, and overstates the funded status of the plans.

For example, the study reports that in 2011, the funded status using the reported, average, and conservative, discount rates were 87%, 76% and 63%, respectively. Most plans appear to be in relatively healthy condition as their reported discount rates are overstating their funded status.

“If assumptions were more conservative,” notes Eric Eng, vice president at DBRS, “pension plans would see much higher deficits, and companies would be required to significantly increase their contributions.” Additionally, DBRS warns that companies with non-investment grade ratings, or those with limited access to capital markets, could have difficulties funding their pension liabilities.

The report suggests that the over the medium-term, current discount rate assumptions of between 5% and 7% are reasonably in line with the average rate of the past decade. However, DBRS believes the long-term outlook is concerning.

While asset returns over the past decade (averaging 7.1%) have been sufficient to fund payouts to plan participants over the past decade, the payouts are set to accelerate dramatically as baby boomers reach retirement age, it says.

“Potential problems arise over the next generation of pensions as the first wave of baby boomers (those born between 1946 and 1964) reaches retirement age. As a result, DBRS anticipates that payouts to plan participants will likely increase dramatically between 2011 and 2029,” it says. “This could create potential future shortfalls for pension plans that will require significant contributions from plan sponsors and could be very difficult to manage over the long term.”