The median solvency ratio of Canadian defined benefit pension plans closed out 2016 by reaching its highest level in more than two years, according to Aon Hewitt’s quarterly pension plan solvency survey.
Based on Aon Hewitt-administered defined benefit pensions, the survey found that the average median solvency on Jan. 1, 2017 was 94.9 per cent, up 8.8 per cent compared to Jan. 1, 2016, which saw an average median solvency of 86.1 per cent for these plans. Also, around a third (35.2 per cent) of plans ended the year fully funded compared to 10.7 per cent at the beginning of 2016.
“2016 was a remarkable turnaround story for markets and for Canadian DB pension plans, whose solvency ratio had been declining for much of the year,” said Ian Struthers, partner and investment consulting practice director at Aon Hewitt, who noted that the fourth quarter of 2016 made all the difference.
According to Aon Hewitt, two themes emerged in 2016: strong equity market returns throughout the year and increasing bond yields in the fourth quarter, both of which had a positive impact on pension funds. “The steep rise in bond yields since September, and the robust equity markets despite Brexit had a remarkably positive impact on pension solvency,” said Struthers. “The question now for pension plans is, how do they leverage their strength to prepare for challenging market conditions?”
The increase in the annual pension solvency ratio was driven by equity and alternative assets, noted Aon Hewitt, especially the S&P/TSX in Canada, which was 4.5 per cent in the fourth quarter of 2016 for a 21.1 per cent year-to-date return, and the U.S. S&P 500, which was 5.9 per cent in the same quarter for 8.1 per cent year-to-date return in Canadian dollars. Meanwhile, emerging markets declined through the quarter by 2.2 per cent but still finished the year with a 7.3 per cent gain, while Europe, Australasia and the Far East gained 1.3 per cent in the last quarter but lost 2.5 per cent over the year. In alternative asset classes, global real estate lost 3.5 per cent through the fourth quarter for a 1.4 per cent year-to-date return and global infrastructure returned 8.6 per cent over the year.
The pension solvency ratio for the year was also completely turned around by soaring bond yields, which increased nearly 80 basis points in the fourth quarter of the year, according to Aon Hewitt. The combined impact of yield change on bond returns and pension liabilities accounted for 75 per cent of the increase in the pension solvency ratio for the last quarter of 2016.
Aon Hewitt says the areas for potential opportunies going forward include emerging markets, private credit markets and alternative asset classes that have reliance on market direction. For those pension plans with a focus on matching their liabilities and managing interest rate risk, on the other hand, the increase in government bond yields presents an opportunity to de-risk at a more attractive price.
“In this environment, it makes sense for pension plan sponsors to consider a ‘3-D’ approach, focusing on diversification, de-risking and dynamism in their approach to responding to market opportunities,” said Struthers.
Another factor for plan sponsors to consider in 2017, according to Aon Hewitt, is their ability to respond effectively when market opportunities and volatility return. In addition, Canadian pensions will continue to face industry and regulatory changes in 2017 that pensions can address through broader risk management assessments.
“Now is an ideal time for plan sponsors to re-evaluate their investment strategies and their governance models to ensure they can capture market shifts,” said Struthers. “Beyond capital market factors, Canadian pension plan sponsors should look at the risk in their plans and how to act on those risks.
“For instance, the solvency funding regulations for Quebec-registered plans were recently changed, and other jurisdictions might follow suit. That’s an unknown risk to existing funding strategies, and many plan sponsors are already looking at adjustments to future contribution levels. The beginning of the new year, especially one in which pensions have historically strong solvency, is the right time for plans to assess these and other issues – and to explore their options.”