Uncovering investment opportunities for your defined benefit pension plan

31 January, 2024

Welcome to the second installment of Compound Interests - Mercer’s perspective on the capital markets, asset management, and how you can get the most out of your investment portfolios.

In this second installment, we’re taking a closer look at defined benefit (DB) pension plan funded positions and investment strategies - where they are after years of market volatility, what might be done with a strong funded position, and how to chart a path forward through the waters ahead.

Evaluate risk management strategies

2023 was an uncertain year for investors, with roller-coaster markets making outcomes and returns hard to predict. Nothing demonstrates this better than Q4: following multiple quarters with negative asset returns, in the final quarter of 2023, markets rebounded.

Somewhat counterintuitively, Q4 was less positive for many DB plans, as applicable bond yields declined, increasing DB liabilities. But most plans in our database ended 2023 in a stronger financial position than they began it.

While the long-term interest rates that are most relevant to pension plans climbed throughout 2022 and through the first three quarters of 2023, the roller coaster continued with rates falling by approximately 1% in November and December, before somewhat rising again at time of writing in early 2024. Interest rate volatility may persist, but there may still be opportunities to take a further step in your de-risking journey.

With changes that rapid, all plans, irrespective of funded position, will find it wise to pause, take stock and to take this opportunity to reevaluate their investment strategies. This means you may find it useful to engage in an Asset Liability Management (ALM) study. This sort of study analyzes two key components of your DB plan: your asset allocation and risk management strategies. Undertaking an ALM study can enable you to see your investment strategy in light of the modern market, helping you truly assess your financial risks, and perhaps even revisit your longer-term objectives.

Is your portfolio positioned to provide downside protection? More DB plan sponsors are evaluating how they leverage alternative asset classes, such as private markets and real assets, to help defend against inflation and volatility in public markets. Our recent Shaping the Future survey revealed that 39% of DB plan sponsors expect to increase their investment in private markets in the next three years, and 63% are doing so with the primary goal of increased portfolio diversification¹. An asset-liability management study may help identify investment opportunities you can capitalize on, to prepare your plan for the future. 

The best way to manage risk will vary from plan to plan – and taking a step back to holistically review your risk management strategy can help you identify opportunities for improvement. Our survey also found that DB plan sponsors saw reviewing strategic asset allocation as the first step towards taking risk off the table. How does your investment strategy align with your plan’s ultimate objectives and time horizon? Despite the recent drop in yields and the emergence of a realistic path towards normalized levels of inflation, bonds remain more attractive than they were only a few years ago. In light of this, is your allocation between fixed income and growth assets still optimal?  What are the additional drivers of diversification that can be brought to bear in an environment where additional risk-taking may not be as well compensated as it was before? Should risk transfer strategies also be considered? 

2023 might have been a roller-coaster year, but in 2024, as the recent trend of improving financial health of DB pension plans meets volatile market conditions, the name of the game is agility - ensuring your plan and investment strategy are poised to weather any storms ahead, and seize any opportunities that present themselves.

In an uncertain economic environment, now is the time to pause and reevaluate your investment strategy to ensure your portfolios are ready for what may come.

Today’s capital markets

What a difference a few months can make. Following several quarters where uncertainty around recession, inflation expectations and the trajectory of interest rates drove markets, we saw a sharp reversal in the latter part of the fourth quarter.

We’ve seen time and time again that sentiment can change quickly. At year’s end a slowing but resilient economy, a tangible path to normalizing inflation, and a dovish turn from the Federal Reserve led to a rapid repricing of interest rate expectations and to surging equity and bond prices.  

Our base case has not changed since last year and we remain optimistic that a “soft landing” is achievable for the global economy, but we see greater risks on the horizon for the Canadian economy compared to the US. The Bank of Canada may therefore be one of the earlier developed economy central banks to begin easing, contingent on inflation continuing to normalize to target. 

On the inflation front, we are keeping a close eye on wages in particular. While the rate of wage growth is expected to slow in 2024, absolute figures still remain higher than what is considered consistent with a 2% rate of inflation. Inflation globally is however slowing, as pressure in the goods and energy markets in particular have eased, although housing cost pressures remain in focus in both Canada and in the US. 

In this environment, fixed income allocations is an area in which we are spending more time with clients from a strategic perspective. While yields have come down and we believe that risks are now more balanced across asset classes, bond yields are still considerably higher than they were in 2021, and it is our view that long-term yields are unlikely to revert back to ultra-low levels anytime soon. 

Our Shaping the Future survey also found that 23% of DB pensions plans intended to increase their exposures to Canadian fixed income over the next three years, while 16% of respondents indicated that they were planning on reducing it. Interestingly, larger plans with over $1 billion in assets were in contrast more likely to reduce their exposures to Canadian fixed income than they were to increase it, possibly in favour of greater private markets allocations¹.  

Volatility is, however, likely to remain elevated, underscoring the importance of being agile reviewing portfolio positioning to ensure that exposures properly align with investment objectives. It is after all, not a one-way street.

¹Mercer survey conducted from June 1 to June 30, 2023.