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Defined Benefit plans end 2018 on a sour note
Mercer Pension Health Index
3 Jan 2019 Canada Funding and Minimum Funding Requirement, Investment - General, Investment - Performance, Scheme Issues & Trends
Key Details:
  • The solvency position of Canadian defined benefit pension plans fell sharply in the fourth quarter of 2018, more than reversing all gains from the first nine months of the year. The Mercer Pension Health Index, which represents the solvency ratio of a hypothetical plan, stood at 102% on 31 December down from 112% on 28 September and 106% at the beginning of the year. The median solvency ratio of the pension plans of Mercer clients was at 95% on 31 December down from 102% at 28 September and 97% at the end of 2017. Less than 30% of Canadian pension plans ended the year fully funded, down sharply from the 60% that achieved that level at the end of September.
  • The funded position of pension plans was pummelled in the fourth quarter with weakness in equity markets and a 30 basis point drop in long-term interest rates contributing almost equally to the drubbing. A 100 basis point decrease in interest rates typically results in an increase of 10% to 15% in pension liabilities. The pain was partly numbed by the strength of the US dollar for plans with unhedged foreign asset exposure.
  • After defying headwinds for the first three quarters, financial markets finally succumbed to the pressure of rising short-term interest rates, trade wars, and turmoil in certain emerging market economies.
  • While the decline in funded positions was sharp and sudden, the impact on pension plan sponsor funding requirements should be relatively muted because many plans were already in a surplus position and therefore had some cushion to absorb the hit. Secondly, for Ontario and Quebec based plan sponsors, the new funding legislation will result in much smaller increases to cash funding than the previous solvency-based regime.
  • It remains to be seen whether weakness in financial markets will continue into 2019. Despite the threats of continued volatility, the new funding rules will encourage some plan sponsors to maintain significant investment risk, particularly if their plans are not fully funded and they have a time horizon of a decade or more. However, sponsors of closed and frozen defined benefit plans that remain well funded should strongly consider taking risk off the table, either by changing the asset mix or through risk transfers.
From An Investment Standpoint
  • A typical balanced pension portfolio would have decreased by 3.8% during the fourth quarter of 2018. Equity markets declined significantly, while Canadian bonds advanced.
  • Canadian equity returns were significantly negative in the fourth quarter due in part to lower oil prices and higher interest rates, with the S&P/TSX Composite Index returning -10.1%. Eight of the eleven sectors posted negative returns, with Health Care (-35.3%) losing all the gains it experienced in the third quarter.
  • Canadian fixed income markets rose over the quarter amidst lower yields, with long term bonds (1.9%) slightly outperforming universe bonds (1.8%). However, real return bonds (-1.1%) fell over the fourth quarter.
  • The U.S. dragged global equity markets down with a return of -13.5% in USD terms (-8.6% CAD) following a very strong third quarter. Developed market equities were also down, with the MSCI World returning -13.0% in local currency terms (-8.4% CAD). Emerging markets continued to show weakness in the fourth quarter, returning -7.4% in local currency terms (-2.2% CAD), however given the rout in developed markets, was the strongest performer in the global equities space. Higher CAD returns, relative to local currency returns, were due to depreciation of the Canadian dollar over the quarter.
  • In October the Bank of Canada raised its target for the overnight rate by a quarter percentage point to 1.75%. The U.S. Federal Reserve raised its target rate at 2.5% at its December meeting, but suggested fewer rate hikes in 2019.
  • The Mercer Pension Health Index shows the ratio of assets to liabilities for a model pension plan. The ratio has been arbitrarily set to 100% at the beginning of the period. The new Pension Health Index assumes contributions equal to current service cost plus solvency deficit payments, and no plan improvements. The Mercer Pension Health Index assumes that valuations are filed annually on a calendar year basis and that the deficit revealed in each valuation is funded on a monthly basis over the subsequent five years.
  • Assets: Passive portfolio.  Asset mix for periods up to 31 December 2016 of: 42.5% FTSE/TMX Universe Bond Total Return Index; 25% S&P/TSX Composite; 15% S&P 500 (CAD); 15% MSCI EAFE (CAD); 2.5% FTSE/TMX 91 day T-Bills. Asset mix for periods on or after 1 January 2017 of 42.5% FTSE/TMX Long Bond Total Return Index; 15% S&P/TSX Composite; 40% MSCI World (CAD); 2.5% FTSE/TMX 91 day T-Bills.
  • Liabilities: 50% active members, 50% retired members. 60% of benefits for active members assumed to be settled through commuted values based on the Canadian Institute of Actuaries transfer value standards without the one-month lag, and the remaining 40% assumed to be settled through an annuity purchase. Benefits for retired members assumed to be settled through an annuity purchase. Annuity prices determined based on the CIA guidance for the medium duration illustrative block. Results will vary by pension plan.
source: Mercer Press Release