Canadian defined-benefit (DB) pension plans are reaching record levels of solvency.
In early October, Marsh (formerly Mercer) released its Pension Health Pulse index, a measure that tracks the median solvency level of Canadian DB pension plans included in the multinational firm’s database. The index stood at 132% for the third quarter of this year, which ended in late September.
The solvency ratio measures the extent to which a pension plan’s assets would cover its liabilities if the plan were to be wound up as of the valuation date.
Marsh reports that the median rose by 4 percentage points in the third quarter, following a 5-point increase in the second quarter—which itself came after a 9-point decline in the first quarter. The drop recorded in the first quarter has therefore been entirely erased.
By the end of the third quarter, 69% of DB plans had a solvency level of 120% or higher, and 89% reached 100% or more.
“We are in record territory,” says F. Hubert Tremblay, a partner at Marsh. “At 132%, there is a much larger margin of safety for weathering major crises. Before COVID-19, the median was hovering just below 100%; at the height of the pandemic, it fell to 84%. Prior to the 2008 subprime financial crisis, it stood at 90%. Collectively, we did not have the buffers we have today.” He adds, “I have observed that, over the years, there has been an increased focus on managing and addressing risks.”
Tremblay notes that recent global geopolitical upheavals have led to volatility in the financial markets. However, he points out that rising long-term interest rates are helping to improve the solvency of pension plans: “When interest rates rise, actuarial liabilities decrease more than assets do. This creates a positive imbalance, which translates into an improvement in a plan’s financial position,” he explains.
Solvency deficits
He reminds us that the index represents a median value. Half of the plans have a solvency level above the median, while the other half fall below it. Notably, 11% of the plans currently have a solvency deficit.
“Such situations are becoming increasingly rare,” he says. Tremblay cites several factors that may explain the remaining deficits: “Weaker investment performance over the years, a lack of pre-funding when salaries are increased, and fixed benefits being adjusted upon the signing of a collective agreement…”
Interest rates
In the United States, interest rates have risen by 50 basis points. “That might not seem like much, but it is significant when it comes to actuarial liabilities,” notes Claude St-Laurent, an associate in the retirement and asset management practice at Normandin Beaudry.
Certain geopolitical events—such as the wars in Ukraine or the Middle East—have not prevented financial markets from delivering strong returns. Despite inflation, the markets have continued to perform well.
An AI bubble?
A significant portion of this performance is linked to artificial intelligence (AI), which has sparked fears of a speculative bubble. "If I were managing a pension fund, I would keep in mind the dot-com crisis of 2001 or the commercial paper crisis of 2008," says St-Laurent. "Plan administrators must therefore analyze and regularly challenge their investment strategy—while keeping a cool head. Decisions must be disciplined and not based solely on the experience of the last three years."
Some pension funds may take this opportunity to lock in gains by purchasing annuities from insurance companies, while others might adjust their asset allocation—for instance, by increasing the share of fixed-income securities in their portfolios from 45% to 50%. Others, by contrast, may choose to take on more risk, especially if their solvency ratio is at 150%. Finally, some employers might implement a contribution holiday.
"It all depends on the industry, the history of the plan, its maturity, and the composition of its participants," notes Claude St-Laurent. "Some will lock in their gains, while others will tolerate more risk. One must simply remember that the market can change direction quickly."
Recruitment and retention tool
What is certain is that defined benefit (DB) plans remain a tool for attracting and retaining talent for those employers who have not abandoned them over the years—unlike those who shifted toward defined contribution (DC) plans or group registered retirement savings plans (RRSPs).
Might some be tempted to return to the DB model? Hubert Tremblay is cautious about making predictions, but notes that in Ontario, the Jointly Sponsored Pension Plan (JSPP) model is expanding rapidly. This type of defined-benefit plan is based on shared governance and funding between employers and plan members. Some such plans also allow for the participation of multiple employers.
In a defined-benefit (DB) plan, the pension is determined by a pre-established formula, typically based on salary and years of service. The employer generally bears the bulk of the risk associated with funding the promised benefits. In a defined-contribution (DC) plan, contributions are set in advance, but the retirement income depends on the accumulated funds and investment returns. The employer is required to make the contributions stipulated by the plan, without guaranteeing a specific pension amount.
