The uncertainty about the direction interest rates will move in 2023 means defined benefit pension plan sponsors should be reconsidering their asset allocation strategies, says Ben Ukonga, principal at Mercer.
“I don’t think anybody knows when, or if, interest rates will come down. If [inflation] comes down, the Bank of Canada’s likely to stop increasing rates. But will it start decreasing them?”
In 2022, many central banks of major economies raised interest rates in an effort to reduce the rate of inflation. In Canada, rates rose from 0.25 per cent to 4.25 per cent. According to Ukonga, some observers expect inflation and interest rates to fall together because of the harmful effect higher interest rates have on the economy.
However, he isn’t convinced, noting the Bank of Canada’s monetary policy mandate is to keep inflation low, stable and predictable — not to avoid recessions. “Dealing with inflation is the priority. But how high they have to push [the interest rate], I can’t predict.”
This uncertainty about whether interest rates will rise or fall in the short term puts DB plan sponsors in a difficult position, he says. According to his team’s latest research, most plans have benefited from the recent hikes, which have caused liabilities to fall. As a result, the median solvency ratio of Canadian DB plan in Mercer’s database rose 10 per cent during 2022.
If interest rates continue to remain high, liabilities will continue to fall, but may not fall faster than asset values, says Ukonga. “In a high interest environment, the economy tends to slow. If interest rates keep going up, equities and fixed income values will, likely, go down.”
On the other hand, if interest rates fall, he expects most DB plan sponsors will see solvency ratios decrease. “In Canada, most plans aren’t fully hedged to interest rate movements — if rates decrease, liabilities will, likely, increase at a faster rate than the pension portfolio.”
Despite the uncertainty, Ukonga says DB plan sponsors can take proactive steps suited to either scenario. For those in positive solvency territory that are seeking to lock in current solvency ratios, more options are open to them than those in deficit positions. “There isn’t a magic solution for everyone – it’s different for every plan.”
DB plan sponsors with a typical balanced portfolio — comprised of 60 per cent equities and 40 per cent universe bonds — may wish to consider increasing the overall allocation to long duration bonds to better match liabilities, says Ukonga.
Annuitization may hold some appeal for DB plan sponsors in the current climate, he adds. “Buying annuities makes more sense as it costs less now that interest rates are higher. . . . For the most part, we believe annuities are attractive in this environment.”