After reaching a near 40-year high over the past year, headline inflation started to cool in the final months of 2022 following a series of aggressive interest rate hikes by the Bank of Canada.

According to Statistics Canada, the consumer price index was up 6.3 per cent year over year in December, down from a 6.8 per cent increase in November and a 6.9 per cent rise in October.

As a result, pension plan sponsors and members are facing the dual headwinds of rising inflation and market volatility as they impact both equity and fixed income. With all of this in mind, how are retirement savings plans faring in 2023?

Decreasing liabilities offset asset losses

Inflation can hit defined benefit plan sponsors in two ways, says Bita Jenab, principal and founder of RetirementWorks Services Inc.

While pension plans without automatic cost-of-living increases can benefit from rising interest rates driving down the cost of liabilities, plan sponsors that raise pension payouts alongside inflation are seeing their real returns take a hit. In addition, actuaries at average-earnings DB plans may have to begin taking into account the expectations of higher salaries for plan members over time.

Retirement saving slows amid inflation

According to an October 2022 survey by BDO Canada, 71% of Canadians found saving for retirement to be more challenging due to inflationary pressures, up 6 percentage points from the previous year.

The survey also found:

43% of respondents have cut back their savings for retirement;

64% aren’t on track to save enough for retirement; and

78% are saving less for retirement primarily due to spending more on essentials, including groceries and housing.

Multiple major pension funds have announced significant cost-of-living increases for retirees, including: the Public Service Pension Plan, at 6.3 per cent; the Ontario Municipal Employees’ Retirement System, at six per cent; and the University Pension Plan, at 4.75 per cent. Scotiabank’s DB plan, which is closed to new members, doesn’t have built-in cost-of-living adjustments, but the bank has made ad-hoc increases over the years, including in the last two, says Ayman Alvi, vice-president of global pension and benefits.

Read: High inflation supercharging decumulation challenges

While Bank of Canada governor Tiff Macklem initially called inflation a transitory issue, Jenab says actuaries are likely building the possibility of a prolonged period of higher inflation into their assumptions, driven by structural, economic and geopolitical factors. “I think actuaries — especially the ones doing their valuations now or who are in the valuation cycle — are thinking about raising their inflation assumption. The effect of that high inflation will also be mitigated by rising rates.”

According to Aon’s latest pension risk tracker, Canadian DB plan sponsors ended 2022 in a strong financial position. The aggregate funded ratio for DB plans increased from 96.9 per cent to 100.8 per cent over the course of the year, with rising interest rates offsetting a 15.6 per cent drop in pension assets.

The long-term Government of Canada bond yield increased 160 basis points by year-end 2022 from the same time the previous year, while credit spreads widened by 45 bps, boosting the interest rates used to value pension liabilities to 4.82 per cent, up from 2.77 per cent last year. “The dynamic over 2022 that we’re seeing with our [plan sponsor] clients is this helped their overall funded position — the decrease in their liabilities more than offset asset losses,” says Carmen Staltari, senior director of investments at WTW.

De-risking conversations on the rise

Strong financial positions have prompted many DB plan sponsors to consider de-risking or even move towards a plan windup, says Jason Malone, a partner in Aon’s wealth solutions group.

“[By] some point in October, the average funded ratio of DB plans were at levels we hadn’t observed in more than a decade and they ended the year in a much more positive state than the beginning of the year. A lot of [plan sponsor] clients are saying this brings forward a lot of their end-game conversations.”

Indeed, an October 2022 survey by MetLife Inc. found 95 per cent of DB plan sponsors said higher inflation was impacting their decision to de-risk, while 92 per cent were more likely to move forward with a pension risk transfer due to higher interest rates.

Read: Canadian DB pension plan solvency up in 2022 while assets lost 15.6%: report

An estimated $1.2 billion of group annuities were placed during the third quarter of 2022, according to WTW’s latest group annuity purchase index, while year-to-date sales reached roughly $4.2 billion. “We expect a very busy fourth quarter, with multiple transactions above $500 million already confirmed,” the consultancy reported in November.

Scotiabank’s DB pension team has had discussions about the closed plan’s asset mix and the potential of de-risking, says Alvi. “It’s certainly part of the considerations we look at, particularly when it’s an unusual environment like it is at the moment.”

For DB plan sponsors not looking to wind up, it’s a good time to diversify into private debt and alternative credit strategies such as emerging market debt, securitized debt and asset-backed securities, says Staltari, noting these strategies can lower duration risk and achieve yields of anywhere between seven and 10 per cent, well above the yield offered on a Government of Canada bond.

Read: Withdrawal of real return bonds could financially impact DB pension plans: CIA

In addition, he says the federal government’s November announcement that it would cancel real return bond auctions dealt a surprise blow to DB plan sponsors. “That was really the only direct way for Canadian DB plan sponsors to hedge against inflation. A lot of market participants, including ourselves, were disappointed with that decision — it takes away part of an already narrow market.”

Silver lining for DC plan members

If inflation ultimately settles at a higher baseline rate than prior to the pandemic, it will dampen the value of fixed income holdings across the board, says Roman Kosarenko, senior director of pension investments at Loblaw Companies Ltd.

However, the fixed income that’s typically available to DC plan members is Canada universe bonds with a shorter duration of six to seven years, which lowers their duration risk, he adds. “It’s not that long, so when bonds come to maturity, they’ll be reinvested at a higher rate and there’s a smoothing mechanism to that.”

Aaron Bennett, chief investment officer at the University Pension Plan, says the UPP is disappointed with the decision. “In a market with increased uncertainty and inflation, a lack of primary issuance complicates what historically has been a core allocation to any portfolio with inflation sensitivity.”

In a January letter to the Ministry of Finance, the Pension Investment Association of Canada warned the government the change could prompt plans to “seek alternative investments in potentially riskier markets. Now, more than ever, investors face greater pressure to seek out inflation-sensitive assets.”

Watching members’ voluntary contributions

Defined contribution plan members were perhaps hardest hit by the combined pressures of skyrocketing inflation and poor investment returns — particularly those nearing retirement who were likely to be invested more conservatively and would have taken a hit as fixed income tanked, says F. Hubert Tremblay, a principal at Mercer Canada.

Also, with Canadians facing higher costs for food and housing, DC plan members may be taking their feet off the gas by reducing voluntary contributions to attend to other financial needs, says David Morton, senior director and Canadian DC co-leader at WTW. However, he hasn’t yet seen data to this effect. “I’m optimistic . . . [and] hoping they’re finding other ways than paring back contributions.”

Kraft Heinz Canada has seen hints of this behaviour, says Tracy Fogale, senior manager of compensation and benefits. The company has a mandatory DC plan with a five per cent employer contribution and three per cent mandatory employee contribution, along with a voluntary employee contribution. While 86 per cent of plan members were taking advantage of the full company match by participating in the voluntary component (well above a 60 per cent industry benchmark), “we have seen a slight decrease in this area and continue to closely monitor this metric,” she says.

Read: DC plan members nearing retirement need employers’ help to achieve financial security: report

In 2022, Kraft Heinz Canada introduced an automatic maximum company match program, which requires plan members to opt out of the maximum voluntary contributions rather than opting in. “We anticipate that this will encourage members to maximize the plan,” says Fogale.

It may also be reasonable to expect that some pre-retirees will delay or reconsider their retirement, says Tremblay, though he notes data on this is still lacking. “If they work an additional year or two or three, they might be able to recoup some losses from the last year and get additional contributions in their accounts.”

Focusing on financial education

Scotiabank hasn’t yet heard from plan members concerned about the impact of inflation on their pension, which Alvi attributes to the bank’s relatively young DC plan.

Key takeaways

• More DB plan sponsors are considering plan windups and de-risking in the wake of rising inflation and interest rates improving their funded statuses.

• DB plan sponsors and experts are speaking out about the recent end to the federal government’s real return bond auctions, which have historically been key to helping pensions hedge against inflation.

• DC plan members were likely the hardest hit by the double whammy of inflation and market turbulence, but it’s too early to say whether that resulted in changes to their planned retirement dates or plan contribution levels.

However, over the past year, the bank has doubled down on its general education around pensions and retirement savings, including hosting live sessions in early 2023 to focus on both its DB and DC plans and give employees the opportunity to ask questions.

Read: Scotiabank supporting employee financial well-being with pension info sessions

For Scotiabank, the starting principle is that the pension plan is a long-term investment, says Alvi. “The best defence against inflation or anything else is putting aside savings from an earlier time in your life . . . [and] maxing that out as much as you’re able. So we’re really trying to educate people on the power of compounding money over time and taking advantage of that match and giving yourself enough time to buttress against the forces of inflation.”

Indeed, the past year has demonstrated to plan sponsors the importance of encouraging members to maximize their contributions, says Tremblay, as well as providing more information on the other pieces of their retirement income, such as the Canada Pension Plan and old-age security, which are both inflation-linked.

But while the rising cost of living may be central for plan members right now, Fogale cautions against “dwelling [only] on one concept.” She says Kraft Heinz Canada has continued to “focus on overall financial wellness, while incorporating messaging on inflation and investing during volatile market environments” in its financial education for plan members.

Looking to the future

Going forward, Tremblay expects to speak with DC plan sponsors about reconsidering their plans’ design or contribution formula — even for just a short period of time — to help employees boost their retirement balances.

This moment should also prompt DC plan sponsors to start talking about inflation as part of their retirement savings education programs going forward and incorporating inflation-linked investments into their investment strategies, says Jenab.

“We’ve had such long periods of low inflation that people have really ignored inflation as one of the key risks to retirement savings. It’s really important to re-learn how and why inflation has to be incorporated into retirement planning and member communication.”

Read: Ontario DB pension plans return average 2.9% in Q4 2022: report

Even as inflation starts to ease, Malone says a key question remains: whether it will return to the Bank of Canada’s target of between one and three per cent or settle somewhere slightly north of that. Even a modest increase in headline inflation could present new challenges for all types of pension plan sponsors to achieve higher returns for members.

“Even if we move from two per cent to 2.5 per cent or 2.75 per cent, we’d need 60 or 75 basis points more in our returns to have real gains in our investments. It will be interesting to see, over the next five to 10 years, if inflation is sticky and, if it remains higher than what we’ve observed, [can] real returns continue to be high? If they [aren’t], it’s going to be tricky for 40-year-olds and 30-year-olds to get the same level of retirement savings at a later stage.”

Kelsey Rolfe is a Toronto-based freelance writer.