From an economic perspective, the last year has been quite tumultuous.
As central banks began raising rates to tame inflation, the loose monetary environment with policy rates held at historic lows evolved to a rapidly tightening one. In October 2021, the overnight rate was 0.25 per cent and the 10-year Canadian bond yield was 1.6 per cent.
At the same time, the fiscal policy was accommodating. It reflected the government’s intentions to stimulate the economy over the course of the coronavirus pandemic. The low interest rate environment supported strong stock market returns — the TSX returned 28 per cent and the S&P 500 returned 23 per cent for the year ending on Sept. 30, 2021.
Pension plans have long suffered in a chronic low interest rate environment. While funding rates were aided by strong stock market performance, persistently low interest rates kept most defined benefit plans in solvency deficit positions. According to the Financial Services Regulatory Authority of Ontario, the median Canadian pension plan solvency level sat below 85 per cent in June 2021, rising to 94 per cent in September 2021.
Towards the end of the 2021, governments and central banks began to grapple with the long-term hangover associated with persistent low interest rates combined with government stimulus payments. Inflation was rising (sitting at 4.8 per cent by the end of the year) and unemployment rates were falling (reaching six per cent).
Making matters worse, Russia invaded the Ukraine in February 2022. This military action increased inflationary pressures globally due to the disruptions it caused in the global petroleum and food markets. By mid-2022, inflation levels were running in excess of eight per cent.
In response to these alarming levels of inflation, central banks began sharply raising interest rates and committed to continued increases to combat runaway inflation levels.
Over the course of the first three quarters of 2022, the Canadian overnight rate rose to 1.5 per cent and the 10-year government bond yield increased to 3.2 per cent. The combination of these shocks caused global stock markets to crater. The TSX lost 11.1 per cent and the S&P 500 lost 17.2 per cent year to date, as of the end of Q3. Growth companies, in particular, were hit hard, with the Nasdaq falling 26 per cent in the same period.
Ironically, pension plans fared well during this simultaneous correction in both the stock and bond markets. The rapid increase in interest rates has catapulted most DB plans into a strong solvency surplus funding position as the impact of a rising discount rate lowered liabilities more than the declines to their investment portfolios. In fact, by March 2022, the median Canadian solvency position was at a healthy 112 per cent.
Central banks have a tendency to overreact and overshoot their targets. Looking forward, I expect the rapid and persistent interest rate increases to ultimately kick in stronger than intended and result in an economic slowdown. Inflation is already beginning to peak with a downturn in the stock market. Though employment levels have remained strong to date, initial layoff announcements are starting in certain sectors.
Here’s what I expect to see over the next year:
- As the economic slowdown deepens, central banks will begin cutting interest rates at some point. Falling interest rates will benefit fixed income portfolios. Longer duration fixed income portfolios will benefit more than short duration portfolios.
- Stocks, which have largely corrected already as a result of higher interest rates, can expect equity returns to be flat or deliver low single-digit returns. The one exception to this trend is European equities, which may experience further declines due to energy shortages and skyrocketing energy prices expected during the winter months.
In the face of these continued shifts, Canadian pension plans should take advantage of solvency improvements and consider taking some interest rate risk off the table. Frozen plans waiting for improving solvency levels to windup, convert or annuitize might wish to take those steps. In particular, it should be noted that annuitization costs have become more attractive as a result of higher interest rates.
Ongoing plans may benefit from lengthening the duration of their fixed income portfolios to match the duration of their liabilities. This would better protect their current solvency positions when interest rates ultimately retreat.