Firm warns that rising rates won’t help defined benefit plans forever

In a bid to offer its liability driven investing (LDI) strategies to defined benefit (DB) pension plan sponsors, Manulife Investment Management has published a new note, indicating that policy interest rates could be on the verge of a course correction, possibly taking funded statuses of some plans with them.

Calling the current environment a unique opportunity for plan sponsors, Manulife’s researchers say “the unprecedented rise in Canadian interest rates has played a significant role in improving the financial health of DB plans over the last two years. But with many central banks nearing the end of their tightening cycles, the notion that interest rates may be heading back down to more neutral levels has suddenly become a very real possibility.” 

The note, Defined benefit plans: opportunities to secure funding progress may only knock once, states that four years ago, the average funded status on a solvency basis for DB plans in Canada was around 85 per cent. Today, interest rates have pushed that measure above 120 per cent.

Could see a reversal 

“Rising rates tend to put significant downward pressure on pension liabilities,” they write. “Conversely, falling rates are likely to have an adverse effect on DB pension schemes. But why? As rates fall, liabilities typically rise, leading to a deterioration in overall pension health. Couple this with a scenario where liabilities rise faster than asset values and plan sponsors could very well see a reversal in some of the progress made over the last two years.” 

In short, they continue, “DB pension funds that have improved their financial position need to lock in the gains they’ve made during this historic rate cycle.” 

Base case assumptions 

The note also looks at the firm’s base case assumptions – central banks are expected to begin easing around mid-2024 – at the prevalent risks to Canadian DB pension plans, at interest rate hedging ratios, and goes into some detail about the solutions plan sponsors could make use of.

Among the solutions, they recommend increasing allocations to real assets: While bonds have traditionally been a reliable way to hedge inflation, Canadian policymakers have ceased all new issuances of these instruments, they write, meaning “plan sponsors need to explore other avenues for hedging their plans against inflationary pressures.” They also recommend transitioning to an LDI approach and increasing fixed-income allocations.

“The window of opportunity for securing funding gains is narrowing and plans sponsors are surely beginning to realize that some form of derisking is needed,” they conclude.