It’s more bad news for Canadian pension plans. Yesterday, Mercer and Towers Watson both released their figures regarding DB plan funding in the second quarter of 2012—and both were looking pretty gloomy.
Aon Hewitt has now added to the negative outlook. According to a sample of pension plans studied by the firm, the median solvency funded ratio has decreased from 69% at the end of March 2012 to 66% at the end of June 2012. About 97% of the pension plans in the sample had a solvency deficit as of the end of Q2.
Assets have only increased by 12% over the two-and-a-half-year period since Jan. 1, 2010—despite significant contributions being made over the period. A typical pension fund earned an average annual return of 4.9% over the period, a result of disappointing equity markets performance.
And while asset returns have remained low, the significant drop in long-term interest rates over the period has led to a 46% increase in liabilities.
“A 1% drop in long-term interest rates will increase liabilities by about 18% for a typical pension plan” said Thomas Ault, an associate partner and actuary with Aon Hewitt in Vancouver “which is why the decline in interest rates since the start of 2010 has had such a dramatic effect on solvency liabilities.”
André Choquet, an investment consultant and actuary with Aon Hewitt in Toronto, says there is a lot of pressure for interest rates to stay low. “Given the size of the Canadian long bond market ($266 billion) compared to the Canadian DB pension plan market ($976 billion), no wonder yields stay low with such a strong demand for long bonds. Add to this the demand for Canadian bonds by foreign investors and the stage is set for plan sponsors having to make up deficits with contributions in the future—unless a Danish solution is adopted”.
In Denmark, the government has tackled the low-yield problem by allowing sponsors to raise the discount rate used to calculate the liabilities of pension plans. The decision sent yields on longer-maturity bonds soaring as the industry’s need to buy up debt assets to match pension obligations was reduced.
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Ault says that plan sponsors are considering several options in the face of continuing low interest rates, including the following:
- an interest rate hedge path to gradually increase the allocation toward long-term bonds as interest rates increase;
- solvency relief measures offered by provincial regulators, where available; and
- letters of credit to avoid making cash solvency contributions, in the hope that interest rates will rise in the future and erase funding deficits.