Canadian DB pension plans slightly improve as market gains offset interest rate declines: Mercer 

Toronto, October 1, 2024

Amidst a backdrop of volatility, the overall financial health of Canadian defined benefit (DB) plans slightly improved over Q3 2024, according to the latest Mercer Pension Health Pulse (MPHP). The median solvency ratio of the defined benefit (DB) pension plans in Mercer’s pension database increased from 121%¹ on June 28, 2024 to 122% September 30, 2024. The solvency ratio is one measure of the financial health of a pension plan.

Throughout Q3, the positive returns many plans saw from most asset classes outweighed increased DB liabilities due to declines in interest rates contributing to a slight increase in solvency ratios. DB plans that used fixed income leverage may have experienced stable or improved solvency ratios over the quarter.

In addition, the number of plans with solvency ratios above 100% at the end of Q3 increased from the end of Q2.

“This quarter underscores the volatility Canadian DB pension plans face,” said Jared Mickall, Principal and leader of Mercer’s Wealth practice in Winnipeg. “While strong asset performance is encouraging, the decline in interest rates and subsequent rise in liabilities demonstrates the need for vigilant risk management.”

On July 24, the Bank of Canada reduced the overnight rate to 4.50% from 4.75% and on September 4, it further reduced the overnight rate to 4.25%². On September 17, Statistics Canada reported that inflation declined to the Bank of Canada’s target of 2.0% in August from 2.9% in May³. Volatility is expected to continue. The interest rates on many Canadian bonds with longer terms also decreased during the quarter, where interest rates declined more at shorter durations than interest rates at longer durations. Due to the long-term nature of DB pension plans, stakeholders should monitor the movement of long-term interest rates on Canadian bonds while keeping inflation in sight. 

New CAPSA Guidelines Highlight Need for Proactive Risk Management

The September release of the Canadian Association of Pension Supervisory Authorities (CAPSA) Guideline for Risk Management for Plan Administrators (Guideline No. 10)⁴ is particularly timely given the current environment. The guideline emphasizes the importance of identifying, evaluating and actively managing material risks, including those related to governance, administration, investments, funding, and benefit adequacy.

Effective risk management for DB pension plans requires monitoring the overall financial health of a plan. This allows sponsors to identify opportunities to mitigate risk, whether through retaining or transferring (e.g. annuity purchase) a pension plan’s risks. For DB plans in a surplus, monitoring the evolution of plan funding could shed light on the implications of using surplus for contribution holidays, granting benefit improvements, or reserving for future adverse experience.

“The release of Guideline No. 10 solidifies Canadian regulators’ risk management expectations for plan administrators,” continued Mickall. “A comprehensive risk management framework is critical to navigating market fluctuations, as recently witnessed in Q3, and protecting the long-term interests of plan members.”

Also, while the focus of the MPHP is the overall financial health of Canadian DB pension plans, members of capital accumulation plans in Canada are likely to have experienced overall positive asset performance during Q3. Further, at the same time that Guideline No. 10 was released, CAPSA published updated Guideline No. 3 - Guidelines for Capital Accumulation Plans⁵. Significant developments have occurred in the financial services industry over the past 20 years. The updated Guideline No. 3 reflects regulators’ views on the responsibilities of CAP sponsors, administrators and service providers in the current marketplace. It also clarifies expectations surrounding information to be communicated to members and for clear documentation of a governance framework. CAP sponsors and administrators should review and determine how best to implement the new guidelines.

From an investment standpoint

A typical balanced portfolio would have posted a return of 6.2% during Q3. 

The quarter began with six weeks of cautious stagnation as fears of a recession in the United States, a decline in the Asian market, and escalating tensions in the Middle East weighed on investor sentiment. However, September saw a change in market sentiment, resulting in another remarkably strong quarter for both equity and fixed income markets.

Global equities and fixed income posted positive returns during Q3, driven by major central banks implementing rate cuts in response to slowing inflation and economic weakness. Strong corporate earnings and robust income growth caused investors to continue to be optimistic. Despite a modest performance in Q3, the Information Technology sector maintained its exceptional performance over year-to-date and one-year periods. The MSCI World Information Technology sector delivered a 30.3% return year-to-date and an impressive 49.4% return over the one-year period. AI names (Nvidia, META, Tesla, etc.) continued to drive performance. This has led to further increase in concentration within indices, underscoring the importance of active portfolio management. “AI is set to revolutionize every sector, and while passive management can capitalize on the trend, skilled active management excels at identifying winners and losers, enabling client portfolios to generate alpha”. Falling yields boosted fixed income returns, bringing their performance in line with major equity indices for the quarter. The yield curve has normalized, reflecting market expectations of further rate cuts through 2024 and 2025. Real assets also performed well, benefiting from their sensitivity to interest rates. 

Overall equity markets performed well, with the Canadian equities leading the way. Volatility spiked in August as weaker than expected data readings led to recessionary fears in the US and a global unwinding of carry trades in the Japanese Yen. Concerns eased quickly as the Bank of Japan reassured markets of its commitment to financial stability and the US displayed economic strength and potential for a soft landing scenario. US companies demonstrated robust earnings growth, with the S&P 500 expected to report its highest year-over-year growth rate since Q4 2021. The US labour market showed signs of normalizing with unemployment gradually rising, while robust income growth is expected to help support consumption following the depletion of pandemic savings. The Federal Reserve’s 50 basis point interest rate cut in September had a strong positive impact on markets. Both, Dow and the S&P500 indices reached new record highs, and the Nasdaq Composite also climbed sharply. As the US Presidential election on November 5th draws closer, market volatility continues to remain high. The run up to the election has been marked by a series of remarkable events, including assassination attempts, influential debates, and the surprising announcement by President Biden that he will not run for re-election. To safeguard investors from increased market volatility, it is important to assess all asset classes within the broader portfolio context. A well-diversified portfolio is better positioned to capitalize on market upswings and provide protection during market downturns. This is where alternative asset classes play a crucial role. Today, private debt remains one of the fastest-growing areas in private markets and is increasingly becoming a staple in client portfolios.”

International equities outperformed US equities during the quarter, fueled by a weaker US dollar and reduced political uncertainty following elections in Europe and the UK. Economic conditions in the Euro area were softer due to weak manufacturing data and slower exports, particularly to China. Looking forward, in the UK, PMI data suggests strong momentum and a robust labour market potentially leading to slower rate cuts from the Bank of England.

Yields fell across the curve as markets priced in looser monetary policy, with further rate cuts expected as inflationary pressures trend down in developed markets (e.g., Japan). As a result, fixed income markets experienced strong performance. In Canada, long-term bonds delivered the strongest returns while the short-end of the curve had the largest decrease in rates. Credit spreads remained tight with little change over the quarter. Throughout Q3, the Canadian dollar appreciated against the USD but depreciated against other major currencies, particularly the GBP and the Euro.

Central banks have implemented interest rate cuts throughout the quarter, with the Federal Reserve, Bank of Canada, Bank of England, and European Central Bank all releasing cuts. The Federal Reserve surprised markets in September with a 50 basis point cut, signaling the start of an easing cycle. The Bank of England and European Central Banks have each cut rates twice in response to soft economic conditions, while the Bank of Canada has led developed counterparts, implementing a third rate cut in September. These rate cuts have generated optimism among investors, but central bankers remain cautious due to softer economic growth. They emphasize the need for continued economic data to support each decision.

Global commodities were negative over the quarter, driven by falling oil returns while gold posted positive returns. Real assets outperformed equities driven by their sensitivity to declining interest rates.

The Canadian equity market experienced a significant rebound in Q3, outperforming their US and International counterparts during the period. Several key factors contributed to this performance, including the Bank of Canada’s decision to ease montetary policy and strong corporate earnings. All sectors posted positive returns with Real Estate, Financials, and Utilities leading the way, benefiting from expectations of lower interest rates in capital-intensive sectors. Rate cuts had a lower-than-expected impact on the property market, as new mortgage lending slowed, further bolstering confidence in the easing of monetary policy. Although Ottawa's recent announcement to increase the mortgage insurance limit and extend amortization periods is a significant step, it is important to take additional measures to address the housing supply shortage. As a result, this announcement had minimal impact on the performance of the sector.

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 approximately 450 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.

¹ A refinement was made to the methodology which resulted in results for 2024 previously disclosed being updated

² Bank of Canada, 2024

³ StatCan, 2024

⁴ Guideline No. 10 - Guideline for Risk Management for Plan Administrators, dated September 9, 2024  https://www.capsa-acor.org/Documents/View/2101

⁵ Guideline No. 3 - Guideline for Capital Accumulation Plans, dated September 9, 2024  https://www.capsa-acor.org/Documents/View/2099