In a discussion with CanadianSME Small Business Magazine, Jared Mickall, Principal of Mercer’s Wealth business, shed light on the factors that influenced the financial health of DB pension plans during Q2 2024. He highlighted how fluctuations in interest rates and asset returns contributed to the volatility in solvency ratios. Despite these challenges, Jared pointed out that Canadian DB pension plans have maintained their resilience through diversified asset strategies and better alignment between assets and liabilities. He also shared advice for managing future financial challenges, especially for plans that currently enjoy a surplus.
I joined Mercer in 2000 and I’m currently the Wealth practice leader for Mercer’s Winnipeg office. I’m a pension consultant and actuary (FCIA and FSA). I’ve also consulted on self-insured long-term disability plans. I manage client relationships and consult on the full life-cycle of defined benefit (DB) pension plans, including implementation and design, strategic risk management, funding and sustainability policies, pension plan conversions and plan wind-ups. I also communicate all aspects of pension plans to a wide range of audiences, including boards of trustees, pension committees, plan members and regulators.
I’m a member of Mercer’s Wealth Resource Network on the funding of DB pension plans and Mercer’s Manitoba pension legislation team. I have been a presenter for CPBI Manitoba on pension topics.
What were the primary factors that contributed to the volatility in the financial health of DB pension plans during Q2 2024?
The solvency ratio is the ratio of a DB pension plan’s market value of assets to its liabilities and is one measure of the financial health of a defined benefit (DB) pension plan. The Mercer Pension Health Pulse (MPHP), a measure that tracks the median solvency ratio of the defined benefit pension plans in Mercer’s pension database, was 118% at March 29, 2024, rose to 123% as at April 30, 2024, slipped to 122% as at May 31, 2024 and declined back to 118% as at June 28, 2024. During the quarter there was volatility in the assets that clients in Mercer’s database have their DB pension assets invested in. Also, during the quarter applicable interest rates were volatile, which resulted in volatility in DB liabilities. These asset and liability volatilities led to volatile solvency ratios for DB plans in Q2 2024.
Can you elaborate on the impact that positive asset returns from fixed income assets, US equities, and international equities had on maintaining the solvency ratios of DB pension plans?
Each DB pension plan’s assets will be invested according to its investment policy, which typically includes allocations to asset classes such as Canadian fixed income, Canadian equities and foreign equities. In Q2, index returns for Canadian universe fixed income as measured by FTSE Canada Universe was 0.9%; US equities as measured by S&P 500 in Canadian dollars was 5.4%; Global equities as measured by MSCI World in Canadian dollars was 3.9%. Positive returns on assets would increase a DB pension plan’s solvency ratio and would improve the MPHP, all else being equal.
How did the negative asset returns from Canadian equities and the increased DB liabilities affect the overall solvency ratios of DB pension plans?
In Q2, index returns for Canadian equities as measured by S&P/TSX Composite was negative 0.5%. Negative returns on assets would decrease a DB pension plan’s solvency ratio and would reduce the MPHP, all else being equal.
A key assumption that drives the solvency liability of a DB pension plan is the rate of interest used to discount the plan’s expected benefit payments, which are generally paid for the life of each DB pension plan member. Due to their long-term nature, DB pension plans are generally focused on the movement of interest rates of Canadian bonds at terms that are well beyond the overnight rate. If applicable interest rates decline, then we would see a positive return on fixed income assets with a similar duration and quality, but we would also see higher DB liabilities. In Q2, index returns for Canadian universe fixed income assets as measured by FTSE Canada Universe was 0.9% and for Canadian long-term fixed income assets as measured by FTSE Canada Long Term was 0.2%. This resulted in higher DB liabilities, which would decrease a DB pension plan’s solvency ratio and would reduce the MPHP, all else being equal.
The report states that the financial health of DB pension plans in Canada remains strong. What factors contribute to this resilience?
DB pension plans’ overall funded positions at the end of the quarter were in a position similar to that at the beginning of the quarter.
In general, DB pension plans have diversified asset mixes with allocations to Canadian fixed income, Canadian equities and foreign equities as well as alternative asset classes such as real estate and infrastructure. In addition, many DB pension plans have increased the degree to which the DB assets are aligned with the DB liabilities. The combination of the above has contributed to the overall stability in the financial health of Canadian DB plans Q1 to Q2, despite the volatility seen within the quarter.
What strategies should DB pension plans consider to manage future financial headwinds, especially those plans currently in a surplus?
DB pension plan sponsors are advised to periodically revisit the risks to be transferred versus those to retained within the pension plan . For risks that are retained, it is typical to review the investment strategy where a key consideration is understanding the degree that the DB assets are aligned with the DB liabilities, the degree of mismatch, and the risk/return tradeoffs. The role of sustainable investment beliefs has expanded into investment strategy reviews. A traditional consideration for transferring the risk would be annuitization.
DB pension plan sponsors should also be keen to understand the conclusions of a new report by the Canadian Institute of Actuaries, which examines mortality among Canadians. The report concludes that life expectancy in Canada is generally expected to improve at rates greater than those predominantly used by the pension industry, currently. While living longer may be good news for Canadians, it signals challenges ahead for DB pensions as lifetime pensions may need to be paid for longer, which could mean higher DB liabilities in the range of about 2% to 4%, in general.
For DB pension plans in a surplus, using the surplus to provide for benefit improvements or contribution holidays continue to be valid uses. However, the financial impact of surplus usage should be explored and the risk of a future shortfall arising should be understood in advance. In addition, creating a buffer for future adverse experience, to the extent permitted, continues to be a valid use of surplus.
