The past few years have been difficult for DB pension plans in Canada. Continued equity market volatility and, until recently, extremely low interest rates have made financial management of DB plans extremely challenging, especially for those subject to solvency valuations.
Long interest rates (defined as the 10-year Government of Canada bond) declined to 1.95% at Dec. 31, 2011, touched 1.69% in April 2013, and did not increase markedly until June 2013, when they increased to 2.44%. Not surprisingly, solvency funded positions were affected as a result. As at Dec. 31, 2011, the solvency funded rate for a typical non-indexed DB plan, according to Towers Watson, was approximately 75%. This increased to approximately 86% as at June 30, 2013, on rising interest rates and strong equity market returns.
While it’s possible that long rates could decline again, it’s more likely that they will increase toward their long-term average, somewhere between 3.5% and 4%. Many DB plan sponsors are grappling with how to deal with rising interest rates, especially if they are not subject to solvency funding. As well, there is a general sense that they want their bonds to work harder for them. Clients are responding in a number of ways.
I work with a number of jointly trusteed and multi-employer pension plans that are not subject to solvency funding. These sponsors have been responding to the interest rate challenge in two major ways.
The first is that they are lowering their allocation to bonds, feeling that they are riskier at this point than other asset classes. The allocation for many has decreased to 30% of total plan assets, though many do have allocations to real estate and infrastructure as well.
Second, many plan sponsors are also shortening the duration of the bonds that they do hold to a more intermediate time period (duration of around six years). For some, this is simply reducing the duration of their bond portfolio.
However, we are seeing an increasing appetite for credit, either in a stand-alone mandate or as part of a core-plus allocation. While credit strategies (corporate credit, high-yield bonds, emerging market debt, for example) will also be impacted by rising interest rates, it’s felt that the ability to access a credit spread over Government of Canada bonds will help shield the portfolio. As well, many plan sponsors feel that if they have to hold some bonds, they may as well be earning more for them. A few of my clients are even considering private credit strategies, including distressed credit, fixed income hedge fund strategies and bank loans.
Even those plans subject to solvency are taking some of these same steps. Some who had already moved to long bonds are reducing their allocation in the near term (either actively or through not rebalancing). There is certainly more discussion around core-plus mandates or even dedicated corporate credit mandates. For those plan sponsors that have not yet completed the move to long bonds, the question of when they should do so is being actively discussed. Responses vary depending on the financial position of the sponsoring company and the risk appetite of the responsible fiduciaries: from “We can’t afford the risk so let’s just do it” to “We’ve waited this long, let’s just wait until long bonds increase further.”
Many DB plan sponsors are also revisiting their position on annuities, given the recent increase in long rates. As funded positions improve, corporate DB plan sponsors—many of which have closed and/or frozen their DB plans—are seeking exit strategies. Discussions are actively being held regarding how much more rates have to rise before annuitization is a viable strategy.
I would be remiss if I didn’t discuss how endowments and foundations are dealing with the same issue. Many of these entities were unable to meet their disbursement requirements in 2008/09 due to their high equity allocation and the low ongoing yield from their bonds. Endowments and foundations began to seriously explore hedge funds, real estate and infrastructure as a result of the 2008/09 crisis, lowering their overall bond allocations to fund these. They also lowered the duration of their bonds to protect against rising interest rates.
While the strategies employed by various plan sponsors will depend on their ultimate goals and risk/return appetite, it’s fair to say that there will be healthy discussion around the level of interest rates and the various strategies available for some time to come.