The solvency ratio of defined benefit pension plans is improving steadily. The trend continued in the third quarter of 2021. Yet employee benefits consultants warn that volatility and economic uncertainty could pose hurdles.
The Mercer Pension Health Pulse (MPHP) tracks the median solvency ratio of the defined benefit pension plans in its database. It includes both the private and public sectors. This index computes pension plans’ solvency at 101 per cent as of September 30, 2021, up slightly from 100 per cent at June 30, 2021. It was 96 percent at December 31, 2020, and 93 percent at September 30, 2020.
Pension investment returns remained fairly flat in the third quarter, Mercer adds. In a release summarizing its index results, the consultant notes that equity returns were generally positive.
Negative bond yields
Aon reports thattheoverall funded ratio of Canadian pension plans associated with the S&P/TSX Composite Index has increased from 95.6 per cent as of June 30, 2021 to 96.8 per cent as of September 30, 2021. The Aon Pension Risk Tracker follows the risks associated with defined benefit pension plans of companies in the S&P/TSX Composite Index.
In its release, Aon notes that the yield on long-term Government of Canada bonds increased by 14 basis points (100 basis points equals 1 percent) from first quarter 2021. Credit spreads did not budge, driving up the interest rate that plan sponsors use to value their pension liabilities. This rate climbed from 2.92 per cent to 3.06 per cent between the two comparison quarters.
Mercer points out that rising bond rates have resulted in negative returns for fixed income investments.
In his Economic Overview for the week ending Friday, October 8, 2021, Sebastien McMahon, Interim Chief Economist for iA Financial Group, reports that the FTSE TMX Long Bond Index was down -0.96 per cent. Year-to-date, the index return was -9.22 per cent, iA states. McMahon predicts that the markets are headed for a rare negative year for bond returns.
Rising bond rates also lowered plans’ solvency liabilities, Mercer's index shows. “As a result, there was a slight improvement in the financial position of most pension plans during the quarter,” the summary reads.
Of the plans in Mercer's pension database, just over half (53 per cent) are estimated to have surplus assets on a solvency basis, 31 per cent of plans have a solvency ratio between 90 per cent and 100 per cent, 11 per cent of plans have solvency ratios between 80 per cent and 90 per cent, and 5 per cent of plans have a solvency ratio below 80 per cent.
“The financial positions of pension plans continue to chug along in 2021, and unless an unexpected event occurs, are on track to ending 2021 in a much better position than they started,” says F. Hubert Tremblay, Mercer's senior wealth advisor.
Volatility and uncertainty
“The third quarter of 2021 saw a return of volatility,” says Nathan LaPierre, Partner, Retirement Solutions at Aon.
Plan sponsors need to be wary of the continuing uncertainty and look for ways to reduce risk and locking in some of the gains, Lapierre says. “With the pullback in equity markets in September, equities were up only slightly over the quarter. Coupled with an increase in interest rates which lowered liabilities, funded ratios continued their upward trajectory,” he adds.
Mercer believes that the progress of vaccination and the economic recovery are causes for optimism about the strength of equity markets and plan’s financial position.
Yet he sees risks on the horizon. “However, potential headwinds still exist, including stagnation of increases in vaccination rates, risk of new vaccine resistant strains of the COVID-19 virus, inflation, future levels of interest rates, and markets’ reactions to central banks’ approach to monetary policies as we emerge from the pandemic,” Mercer says.
Political risks to be reckoned with
In addition to the risks above, political risks could augur turbulence for pension plan positions, Mercer continues. The consultant highlights the possibilities of geopolitical tensions, political gridlock, particularly in the U.S., and political interference in capital markets and with private companies.
“As the funded position of their pension plans improve, plan sponsors should re-assess their plans’ risk exposures, and decide whether given the improved positions, it’s time to lock in some of these gains. As we all saw in March of 2020, markets can change quickly. Having the right plan and strategy in place is essential to ensure a plan can take advantage of market gains, and be protected from market declines,” Tremblay says.
With fixed income investment returns at historical lows, Mercer says plans must continue to invest in growth assets. Although growth investing is marked by volatility, he believes this risk can be managed by broader diversification. Mercer suggests avenues such as public market investments, diversified by asset class and geography, increasing the plan's allocations to private markets, strategic use of margins and including risk-sharing features in plan design.