Financial health of DB pension plans weakened in Q4, but showed an overall improvement over 2023: Mercer 

Toronto, January 2, 2024

The Mercer Pension Health Pulse (MPHP), a measure that tracks the median solvency ratio of the defined benefit (DB) pension plans in Mercer’s pension database, is 116% as at December 31, 2023, which is a decline over the quarter from 125% as at September 30, 2023, but an improvement from 113% at the beginning of the year. The solvency ratio is one measure of the financial health of a pension plan.

Throughout Q4, plans saw positive asset returns, but these returns were not enough to offset plans’ increased DB liabilities which resulted in an overall weakening of solvency ratios.  DB pension plans that used fixed income leverage may have experienced stable or improved solvency ratios over the quarter. 

While the median solvency ratio declined over Q4, it improved over the whole of 2023. In addition, compared to the beginning of year, there are more DB pension plans with solvency ratios above 100%.

“It is likely that members of DB pension plans should see improvement in the financial health of their plans,” said Jared Mickall, Principal and leader of Mercer’s Wealth practice in Winnipeg. “2023 saw strong equity performance amidst a volatile interest rate environment. The journey for a DB pension plan is very long, and successful pension plan financial management requires navigation of short-term headwinds in order to meet long-term objectives.”

Canadian inflation came down over 2023 and is approaching the upper end of the Bank of Canada’s inflation-control target of 3%. General views are that inflation will continue to decline in 2024 and reach the policy target of 2% in 2025. In 2023, the Bank of Canada increased the overnight rate to 5.00% from 4.25%, which was a continuation of increases that commenced in 2022, to mitigate inflation and to balance against the risk of a recession.

However, DB pension plan benefits are accumulated and paid over periods that are significantly longer than the overnight rate. Interest rates on Canadian bonds with longer terms were volatile during the year and finished at levels less than they were at the start of the year. It is unclear whether the interest rates that apply to DB pension plans will stabilize in 2024, and if so, at what level. As such, interest rates continue to pose a significant risk for many DB pension plans.

Canadian pension plans are also exposed to global economies which continue to see elevated levels of inflation and risks of recession. Central banks across the world are actively managing their inflation with their monetary policies. While governments, corporations and households in those regions may continue to adjust to their inflation and interest rate environments, the effect of interest rate changes to an economy is usually delayed. As such, central banks will need to monitor the effects of their policy changes to manage their economies and avoid recession. Further, geopolitical tensions continue to be elevated which can impact global trade, fragment global supply chains and disrupt the global economy.

Given the risk of a further decline to Canadian interest rates and ever-present market volatility, a review of a pension plan’s risks to be retained or transferred (e.g. annuity purchase) continues to be prudent. Pension plans with benefit payments going out that exceed the contributions coming in may need to have a heightened awareness of financial risks posed by the negative cashflow. Further, a regular review of a pension plan’s investment policy continues to be appropriate and such reviews may be expanded to include sustainable investment beliefs.    

The recent improvements in the solvency ratios of Canadian DB pension plans came after many years of declining interest rates and increases to contribution requirements and, in some cases, changes to benefits.

“Members of Canadian DB pension plans and their sponsors will be keen to maintain solvency ratios above 100%,” said Mickall. “Canadian DB pension plans should continue to be vigilant in the financial management of their plans through appropriate governance and risk management processes. A consideration in 2024 will be the role of artificial intelligence as part of pension plan risk management.”

A typical balanced portfolio would have posted a return of 11.0% over the fourth quarter of 2023. The global macroeconomic conditions remained muted going into the quarter, leading to a negative market sentiment. By the second half of the quarter, both global equities and fixed income markets rallied as investors adjusted for potential peak in inflation and interest rates.

Global equity markets rebounded over the quarter, rallying with subsiding yields as the ‘higher-for-longer interest rates’ narrative faded under weakening economic conditions. The U.S. remained the key driver of global economic growth with the forward-looking purchasing manager index (PMI) in expansionary territory. Consumer confidence, driven by stable demand and strong employment numbers along with declining yields, indicated a higher potential for soft landing. Outside of the U.S., growth remained weak in developed markets with suppressed demand for manufacturing and an uncertain economic environment for 2024. In the U.K. and Eurozone, declining energy costs along with weakness in goods and services led to a moderate slowdown in domestic inflation. However, wage growth remained elevated with quarter-on-quarter employment gains. On the other hand, Japan continued to maintain its accommodative monetary policy to promote growth, as declining commodity and wholesale prices over the period impacted its inflationary targets. Emerging markets underperformed against their developed peers, driven by unexpected conflict in the Middle East, declining oil prices, and some countries like Turkey experiencing a resurgence of inflation.

Bond returns were positive overall as yields declined, with the majority of global central banks opting to pause on further rate hikes as inflation is cooling down. China saw its sovereign debt credit rating downgraded by Moody’s due to the ongoing property sector crisis.  Global commodity returns finished the quarter in the negative, mostly driven by oil prices. Energy prices have moved lower despite OPEC’s announcement to cut production, addressing reduced demand from slowing business conditions and increased supply from North America. REITs posted positive returns due to their more cyclical attributes and higher rate sensitivity, leading to a positive adjustment of valuations with falling yields.

The majority of Canadian equity sectors posted positive returns except for Energy. Economic growth remained stalled, reducing inflationary pressures in both goods and services sectors and negatively impacting consumer confidence with elevated interest rates. There was an emphasis on the real estate sector over the quarter, with increased government attention towards immigration and international students putting pressure on shelter inflation and availability. Vacancy in the purpose-built residential rental market continues to be very tight.

Canadian debt markets experienced positive performance as yields declined significantly over the quarter due to interest rate and inflation expectations. The yield curve remained inverted, but rates declined across the curve. Long-term fixed income saw the greatest pricing gains with its higher sensitivity to interest rate changes, recovering from losses from previous quarters. The Canadian dollar appreciated against the US dollar, weakening U.S. equity returns in Canadian dollar terms, but depreciated against other developed currencies.

“Heightened geopolitical risk, inflation volatility, diverging global policies and transition risks all point to greater market instability, dispersion, and dislocation. These conditions are ripe for dynamic alpha generation.” said Venelina Arduini, Principal at Mercer Canada. “Investors should engage with experienced partners and explore dynamic mandates. Agile managers across public and private asset classes can capitalize on opportunities created by these dispersions and risks.”

The Bank of Canada maintained its policy interest rate at 5.0%, emphasizing the need to further observe its impact on domestic inflation. The U.S. Federal Reserve maintained a similar view, choosing to pause its monetary policy tightening cycle given trends in inflation. However, unlike the Bank of Canada, the Federal Reserve expressed potential for interest rate cuts next year depending on economic conditions. Finally, the Bank of England also decided to maintain its current rates given a slowing economy and material reduction in inflation over the period.

The Mercer Pension Health Pulse tracks the median ratio of solvency assets to solvency liabilities of the pension plans in the Mercer pension database, a database of the financial, demographic and other information of the pension plans of Mercer clients in Canada.  The database contains information on almost 500 pension plans across Canada, in every industry, including public, private and not-for-profit sectors. The information for each pension plan in the database is updated every time a new actuarial funding valuation is performed for the plan. 

The financial position of each plan is projected from its most recent valuation date, reflecting the estimated accrual of benefits by active members, estimated payments of benefits to pensioners and beneficiaries, an allowance for interest, an estimate of the impact of interest rate changes, estimates of employer and employee contributions (where applicable), and expected investment returns based on the individual plan’s target investment mix, where the target mix for each plan is assumed to be unchanged during the projection period. The investment returns used in the projections are based on index returns of the asset classes specified as (or closely matching) the target asset classes of the individual plans.