Rapid increase in rates is helping in the solvency of defined-benefit pension plans
Of the defined-benefit pension plans in Mercer Pension Health Pulse’s database, 79 per cent are estimated to be in a surplus position on a solvency basis. Photo by Brent Lewin/Bloomberg files Higher interest rates are causing headaches for some homeowners, but one place the rapid increase in rates is helping is in the solvency of defined-benefit pension plans.
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Despite the significant volatility and market declines in 2022, the Mercer Pension Health Pulse, which tracks the median solvency ratio of the defined benefit (DB) pension plans, finished the year at 113 per cent, up from 108 per cent at the end of September and 103 per cent at the beginning of 2022.
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The improved position was primarily due to the significant increases in interest rates during 2022 because higher rates lead to lower pension liabilities.
Of the plans in Mercer’s database, 79 per cent are estimated to be in a surplus position on a solvency basis compared to 61 per cent at the end of 2021.
Despite this relative improvement, the pension consultant said some plan structures are vulnerable to macroeconomic developments.
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For example, the financial positions of plans that use leverage on the fixed-income component of their asset mix and also invest in equities would have likely decreased, said Ben Ukonga, a principal at Mercer and leader of the firm’s wealth business in Calgary.
Moreover, if there is “continued high inflation, capital market headwinds, and geopolitical tensions, 2023 could turn out just as volatile as 2022,” he said.
For sponsors of final average earnings and/or indexed pension plans, the impact of the already realized high inflation could be significant, Ukonga noted.
“Coupled with the potential for the high level of inflation to continue, even if only for the short to medium term, these plans could have large inflation-related liability risks that may not be immediately apparent to the plan sponsor and other stakeholders,” he said.
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Mercer said sponsors of non-indexed defined benefit plans, particularly those in a surplus position, could face calls for “ad hoc” cost of living adjustments from pensioner groups.
The picture in 2022 was somewhat dimmer for defined contribution (DC) plans, group RRSPs and group TFSAs which, unlike defined-benefit plans, do not guarantee annual payouts. Mercer said the majority of these plan members would have experienced “negative investment returns” in their accounts last year.
The S&P/TSX Composite Index was down 8.66 per cent in 2022, the largest one-year decline since the end of 2018.
“For members close to retirement, this may alter their retirement decisions,” Mercer said, adding that the high inflationary environment could also influence when pensioners choose to leave the workforce.
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