The Bank of Canada raised its benchmark rate seven times in 2022, from 0.25 per cent to 4.25 per cent.BLAIR GABLE/Reuters
Soaring interest rates helped push more pension plans into surplus in 2022, offsetting market losses as pensions brace for another volatile year in 2023, according to two reports that measure the funding status of Canadian plans.
Consulting company Mercer Canada Ltd. said its quarterly pension health pulse, which tracks the median solvency ratio of nearly 500 Canadian defined benefit (DB) pension plans that are Mercer clients, increased to 113 per cent as of Dec. 31, up from 103 per cent at the start of the year.
And professional services firm Aon PLC said the aggregate solvency of DB pension plans of companies in the S&P/TSX Composite Index, as measured by its pension risk tracker, increased to 100.8 per cent at the end of 2022, up from 96.9 per cent a year earlier.
For DB pension plans, the solvency ratio measures the ratio of the plan’s assets to its liabilities, which are the estimated cost of paying future benefits earned by members. Plans are deemed to have a surplus if their assets exceed 100 per cent of liabilities, or a deficit if they fall short.
At the end of the fourth quarter, 79 per cent of plans tracked by Mercer were estimated to be in surplus on a solvency basis, and another 12 per cent had ratios between 90 per cent and 100 per cent. Four per cent of plans had solvency ratios between 80 per cent and 90 per cent, and 5 per cent were below 80 per cent, according to Mercer’s data.
“At least since the 2008 financial crisis, this is probably the most plans we’ve seen in decent, healthy financial positions,” Ben Ukonga, principal and leader of Mercer’s Wealth business in Calgary, said in an interview.
Canadian debt payments climb at record pace as interest rates rise
The main factor that helped boost solvency levels for many Canadian pension plans in 2022 was the rapid rise in interest rates as central banks tried to beat back surging inflation. The Bank of Canada raised its benchmark rate seven times in 2022, from 0.25 per cent to 4.25 per cent.
Pension plan administrators measure future obligations to pensioners using calculations that discount those liabilities based on current interest rates. When rates rise, a plan’s liabilities fall because a higher discount rate is applied in the calculations – the plan doesn’t need to have as much set aside now to cover those obligations.
Last year, the boost to solvency ratios from falling liabilities more than offset the negative returns that most pension plans recorded amid volatile financial markets. Pension assets broadly declined in 2022 – Aon found they fell 15.6 per cent – and the fourth quarter was also challenging, with December declines in equities after a previous rally.
Looking at the year ahead, there are important risks that could cause further headaches for pension plans that manage large investment portfolios. Inflation looks like a key headwind, even as it has started to ease from peak levels reached last year. In particular, inflation could put pressure on indexed pension plans, which pay more generous benefits as inflation rises.
Even at plans that are not inflation-linked, pensioner groups could advocate more loudly for cost-of-living adjustments to account for rising prices, Mercer predicts.
Geopolitical upheaval stemming from the war in Ukraine, surging energy prices in Europe, persistent supply chain disruptions and rising recessionary fears could also add to risks facing pension plans’ investments.
“I would expect the same volatility as we saw in 2022,” Mr. Ukonga said. “All the issues that existed in 2022 don’t go away when the clock strikes midnight on Jan. 1.”
With more plans in surplus and continuing headwinds in markets, some pension fund managers could take steps to reduce risk in their portfolios, shifting more assets to fixed income – which now offers higher yields – or contracting with insurance companies to buy annuities to pay future benefits.
“You’re sort of locking in some of your surplus,” Mr. Ukonga said. “We expect that to continue.”