The U.S.’s credit rating was downgraded from AAA to AA+ by credit rating agency Standard & Poor’s late Friday, raising the question of what effect this will this have on Canadian pension plans, many of which are required to hold a certain percentage of assets with AAA ratings.
For now, it appears the effect may be minimal, since the bulk of Canadian pension plans are primarily invested in Canadian assets. “Very few Canadian pension plans will invest in the U.S. fixed income market,” says Yvan Breton, Partner with Mercer and leader of Mercer’s investment management business in Canada and Latin America. “It’s a better match to invest domestically. Nevertheless, the effect is very bad for Canadian plans because stocks are down and interest rates are also down. The funded status of Canadian plans has deteriorated.”
Robin Pond, a consultant with Buck Global Investment Advisors, says if the rating is a concern for some plans, the simplest solution is to change the AAA investment requirement. “Even if it was Canada being downgraded, the obvious response would be to go and change the policies,” he says. “This could bring into question how much reliance we should be placing on ratings … A downgrade tends to be a lagging indicator rather than a leading one.”
Since Fitch and Moody’s have not downgraded U.S. debt, most investment policy statements would still consider it to be AAA-rated, says Justin Charbonneau, vice-president, portfolio manager, Matco Financial in Calgary.
“Despite the downgrade, there’s still a lot of optimism that people will get paid,” he says. “When you look at the tax rates in the developed world, the U.S. has room to raise taxes at the margin, cut entitlements and cut some spending.”
But even if it were universally downgraded, pension managers would have few options. The market for Britain’s gilts and Germany’s bunds—both AAA-rated—is large, but still nowhere near the size of the U.S. long-term bond market. And with troubles continuing to percolate through the euro zone, the British and German debt ratings may not prove any more durable than that of the U.S.
“Although Germany and the UK are not at the centre of the European debt crisis, they’re the ones supporting it,” says Charbonneau.
For Canada, the effect the plunging equity markets are having on pension plans is of more concern than the U.S. credit rating. Since the downgrade was announced, stocks have plummeted across Asia, Europe and North America. On Monday the S&P/TSX Composite Index fell 500 points and the Canadian dollar has dropped 1.27 cents.
“The first consequence of a downgrade in the market is panic,” says Breton. “It’s very volatile. Stocks and oil are down, which is not good for the Canadian market and Canadian dollar. I think the most serious impact we can see is the risk of inflation. There’s concern that at some point, it is going to hit Canada.”
This marks the first time the U.S. has been downgraded since it was first granted its AAA rating in 1917. Standard & Poor’s has also issued a negative outlook for the U.S., saying there’s a one in three chance it could further lower the rating to AA within the next two years.
Charbonneau points out that it was only the long-term debt rating that was cut. “The U.S. still has a AAA rating on its Treasury Bills,” he says. “A lot of these funds can continue to own T-Bills and two-year Treasury notes. It hasn’t impacted money market funds at all at this point.”