Two actuarial consulting firms’ indexes reveal that defined benefit pension plans have maintained their enviable capital position since the beginning of the year.
According to Aon's Pension Risk Tracker, the overall funded ratio of Canadian pension plans associated with the S&P/TSX Composite Index stood at 105.3 per cent, which is unchanged from the ratio in the second quarter of 2024. This tool monitors the overall funded status on a corporate accounting basis of companies included in the S&P/TSX that offer defined benefit plans.
Mercer's Pension Health Index measures the median solvency ratio of defined benefit pension plans. According to the index, based on Mercer's pension plan database, the overall capitalization of plans ended the second quarter of 2024 in a similar situation to the beginning of the quarter.
However, Mercer's index shows that the financial health of plans measured by the solvency ratio was volatile during the second quarter of 2024. The solvency ratio stood at 118 per cent on March 29, 2024, then rose to 123 per cent on April 30, 2024, before falling to 122 per cent on May 31, 2024, and finally dropping back to 118 per cent on June 28, 2024.
Balanced returns
According to Aon's tool, pension plan assets gained 1.5 per cent during the second quarter of 2024. Long-term Government of Canada bonds saw their yields increase by 5 basis points (0.05 per cent) compared to the first quarter of 2024. Credit spreads (between long-term and short-term rates) decreased by 4 basis points, resulting in the relative stabilization of the discount rates used to value pension plan liabilities, edging up from 4.65 per cent to 4.66 per cent.
"In the second quarter of 2024, pension plans maintained their healthy funding positions," says Jason Malone, executive partner of Aon's Wealth Solutions. "The markets have continued to give plan sponsors time to take action and de-risk based on their funding positions," adds Malone.
Mercer's index reveals that "most plans saw positive asset returns from fixed income assets, US equities and international equities, which were generally offset by negative asset returns from Canadian equities and increased DB liabilities."
Mercer observes that plans using "fixed income leverage may have experienced stable or improved solvency ratios over the quarter."
Healthy plans
Additionally, the number of plans with a solvency ratio above 100 per cent at the end of the second quarter is generally similar to the result at the end of the first quarter. "The overall financial health of Canadian defined benefit pension plans remains excellent," says F. Hubert Tremblay, a partner at Mercer Canada.
Tremblay believes that the fluctuations in interest rates and market volatility during the second quarter of 2024 serve as a reminder "that the funding status of defined benefit plans can change quickly, and plan sponsors need to plan accordingly."
In an interview with the Insurance Portal, Tremblay emphasized that multiple strategies are still available for plan sponsors looking to mitigate risks. "They can transfer risk (by purchasing group annuities), manage it through investment policy, or use surplus assets for contribution holidays or plan improvements," he explains.
Tremblay notes that real return bonds remain available, even though the Government of Canada has stopped issuing them. "Several groups are advocating for their return. Many plans want them; there will be a lot of demand," he predicts. Real return bonds pay interest at a rate adjusted for inflation.
Interest rate impact
On June 5, the Bank of Canada lowered its overnight rate (policy rate) from 5.00 per cent to 4.75 per cent and expects inflation to continue nearing the 2 per cent target. Many economists predict further cuts to the policy rate. The Bank of Canada will announce its next policy rate decision on July 24, along with its Monetary Policy Report. Inflation rose to 2.9 per cent in May.
Mercer notes that the overnight rate remains higher than the yields on high-quality long-term Canadian bonds. Tremblay commented that interest rate curves are behaving unusually at the moment.
As a result, plan sponsors will closely monitor Canadian inflation and the evolution of long-term Canadian bond yields, given the long-term nature of defined benefit plans.
Mitigating volatility
F. Hubert Tremblay believes that the multiple fluctuations in solvency ratios during the second quarter of 2024 illustrate the volatility to which defined benefit pension plans are exposed. "Sponsors must be well aware of this and ensure they have a tolerance for this volatility," he advises.
Otherwise, it's a good time to take action, adds Tremblay. How to smooth it out? "It still comes down to the discussion about investment policy. Often, one way to address it is to better match the plan's assets to its actuarial liabilities," he explains. Tremblay believes that better matching often means being more conservative.
However, increasing the weight of fixed-income securities will reduce the actuarial surplus by increasing the value of actuarial liabilities. "Returns will be less forthcoming," he says.
To reduce risk while remaining positive in terms of returns, there is another option, adds Tremblay. This option “is buying annuities, whose popularity shows no signs of diminishing. My clients are constantly considering this option. Given the still relatively high level of interest rates, they perceive the price to be appropriate for entering the annuity market."
Longevity risk
While the capitalization of Canadian pension plans remains excellent, Mercer highlights that a new report from the Canadian Institute of Actuaries on mortality indicates that life expectancy in Canada is expected to improve at a higher rate than those rates used by pension plans.
Increased life expectancy means that defined benefit pension plans may pay out lifetime annuities for longer, Mercer notes. This could result in an increase in actuarial liabilities by 2 to 4 per cent, generally. Pension plan managers are advised to assess the impact of increased life expectancy on their plans.
"Canadian defined benefit pension plan managers have long discussed longevity risk and what it means for funding," adds Tremblay. He believes it is incumbent upon managers to assess their funding levels, conduct a strategic risk review, and take the necessary actions. "We encourage our clients to try to anticipate the impacts that increased life expectancy may have on their plans," adds F. Hubert Tremblay.
