The financial health of defined benefit pension plans in Canada improved again in the second quarter of 2021, the analyses of two leading actuarial consulting firms illustrate. However, one firm sees several risks on the horizon.

Aon's Pension Risk Tracker shows an increase in the funded status of the largest Canadian companies. Its overall funded ratio for Canadian pension plans in the S&P/TSX Composite Index increased from 94.8 per cent in the first quarter of 2021 to 95.6 per cent in the second quarter of 2021. The Aon tool calculates the overall funded status on an accounting basis for S&P/TSX Composite Index companies with defined benefit plans.

At the end of the three-month comparison period, pension plan assets tracked by Aon's tool gained 4 per cent in value in Q2 2021, driven by positive returns on fixed income assets and strong equity performance.

Good performance

“Equity markets continue to do well in the second quarter and, combined with interest rates being fairly stable, this led to further improvement in the funded ratios of Canadian pension plans," said Erwan Pirou, Canada Chief Investment Officer, Retirement Solutions for Aon. Alternative investments are paying off for his clients, he adds. The US has set an ambitious infrastructure agenda, and many of our clients have been investing in this asset class for a long time, benefitting from high returns and stock market diversification, he says.

Perfect bill of financial health

As of June 30, 2021, the Mercer Pension Health Index (MPHI) stood at 125 per cent. What’s more, the median solvency ratio for Mercer's clients’ pension plans was 100 per cent at June 30.

The MPHI represents the solvency ratio of a hypothetical defined benefit (DB) pension plan. It shows the ratio of assets to liabilities (obligations to retirees) for a model pension plan. The ratio was arbitrarily set to 100 per cent at the beginning of the period. Mercer's index remains at its highest level since its inception in 1999.The actuarial consulting firm estimates that about half of its clients' pension plans have a surplus, and just under 6 per cent have solvency ratios below 80 per cent.

“With the continued increase in the number of vaccinated individuals, an end to lockdowns, the re-opening of the global economy, and the anticipated increases in consumer spending, markets are expected to continue to improve,” Mercer forecasts in its index report, hoisting defined benefit plans in the process.

The firm points out that a typical balanced pension portfolio would have yielded a 5.3 per cent return in Q2 2021.

For how long?

Mercer reports that high plan funding levels have persisted in the second quarter of 2021, but questions how much longer the trend will last. Wealth Management Principal F. Hubert Tremblay observed that 2021 continues to be favorable for defined benefit pension plans. “The recovery from the lows of March 2020 has been remarkable. But only time will tell whether the improvements will be sustained,” he says.

Tremblay still sees significant risks on the horizon. One is linked to the emergence of COVID-19 vaccine-resistant variants, and the possibility that vaccination rates will fall short of herd immunity levels. This would prevent some economies from fully reopening, the firm adds.

Tensions and protectionism

Risks of geopolitical tensions, increasing protectionism and calls for a slowdown in the rate of globalization and the global supply chain are other factors of concern to Mercer. Each of these trends poses its own set of threats to the markets and, consequently, to plan funding levels, the firm notes.

“We continue to believe plan sponsors should not be complacent with their pension plans’ improved funded positions. Now is the time for plan sponsors to revisit their risk appetite, align their risk exposure with the risks they are comfortable taking, and where it makes sense, lock in these improved positions and take risk off the table,” Tremblay continues.

Beware of inflation

In financial terms, Mercer is also concerned about high valuations in the equity markets compared with recent years, as well as inflation and the future level of interest rates. Raising interest rates to counter high inflation rates could have a negative impact on market returns, corporate earnings and the ability of governments, corporations and individuals to service their debts.

“While the recovery is in full swing, inflation pressures continue to mount, as the scenario of inflation overshooting official targets during this decade is now more likely than before the pandemic,” says Jean-Pierre Talon, a partner at Mercer's Wealth business.

"Investors therefore need to watch for inflationary surprises, which many portfolios may not be well protected against. A sensible option would be a review of the inflation-sensitive portfolio sleeve to ensure the total portfolio will perform well if there is a moderate increase in inflation over the next three to five years,” Talon cautions.