Despite Fed’s rate hike, Canada’s pension plans still face low bond returns

The U.S. Federal Reserve’s recent 25-basis-point rate hike—the first one since the 2008 meltdown—won’t affect the funded status of Canadian defined benefit pension plans, experts argue. But, they note, the uptick in this short-term rate might encourage these investors to drop some of their American allocations and buy more global assets.

Still a low-yield environment

Changes to long-term interest rates—rather short-term interest rate moves—are the key factor that affects the funded status of Canadian defined benefit pension plans.

“What’s really critical for [them] is the rates on long-term Canadian bonds because pension liabilities are very sensitive to these long-term interest rates,” explains Gavin Benjamin, a senior consultant and actuary with Towers Watson’s retirement practice.

An uptick in the American rate can have a knock-on effect on long-term interest rates both within and outside the U.S. under certain circumstances. But because the Canadian economy is facing challenges due to sliding commodity prices and because the Bank of Canada recently lowered the overnight rate, it’s unlikely that the Fed’s move will affect Canadian long-term interest rates, Benjamin explains.

“Therefore, one would expect that the impact on the funded status of Canadian pension plans would be minimal, if any,” he says.

Stephen Lingard, portfolio manager at Franklin Templeton Solutions, agrees. “Canadian pension funds are underfunded in the order of 10% and do require higher long-term interest rates to improve that funding.”

So, despite the Fed’s move, Canadian pension plans are are still operating in a low-yield environment. “Nobody knows for sure how long-term bond yields are going to move, but there’s a general sense that they’ll likely remain low at least in the short term,” Benjamin predicts.

Impact on American assets

Still, the Fed’s move might have a positive impact on Canadian plans’ American assets.

If the rate hike causes the U.S. dollar to appreciate compared to the loonie, the unhedged American investments of Canadian pension plans would increase in value and bring higher returns, Benjamin explains.

But history has shown that the U.S. dollar’s behaviour is counterintuitive in these situations, notes Lingard. “About two-thirds of the time, at least over the last 40 years, as the Fed begins to raise interest rates, the U.S. dollar starts to fall.”

However, Lingard says this isn’t bad news for Canadian pension plans—rather, it’s an opportunity for them to reduce their allocations to American assets and buy more foreign ones.