Pension plan funding declines in Q2

It was a difficult few months in the second quarter of 2012 for Canadian pension plans, according to reports released today by both Mercer and Towers Watson. Mercer’s Pension Health Index stands at 77% as of June 30, down 5% over the quarter. And Towers Watson’s DB Pension Index fell 1.4%.

Plummeting bond yields and weak equity markets in May, combined with low long-term interest rates, are to blame for the poor performance. And while stock markets may have started 2012 on a positive note, negative investment returns in Q2 brought plans right back to where they had started.

“After a punishing 2011, pension plans were making a slow but steady recovery in the first four months of 2012,” said Manuel Monteiro, a partner in Mercer’s financial strategy group. “However, plummeting bond yields and weak equity markets in May more than reversed the gains in the first four months of the year. Despite June being a mildly positive month, most plans are now roughly back to where they started [at the beginning of] the year.”

The decline in the second quarter marks a continuation of disappointing stock performance over the past five years. The S&P/TSX Index is down by 0.7% per annum over the last five years, and this period of poor results has been a major contributor to deteriorating pension funded ratios. It’s also causing many plan sponsors to consider new investment approaches, such as greater use of alternative investments, de-risking strategies and use of derivatives.

“Companies need to measure the risks they face and develop comprehensive strategies to take some risk off the table,” said Monteiro.

According to Monteiro, while many plan sponsors will find it too expensive to take significant risk mitigation action in the short term, mapping out a longer-term strategy will allow sponsors to act decisively as de-risking opportunities arise. A comprehensive risk management strategy could involve changes to plan design, investment strategy and funding policy, as well as risk transfer opportunities such as annuity buyouts, annuity buy-ins and longevity insurance.

“Recent developments like General Motors’ plan to purchase $26 billion of annuities in the U.S. could change the insurance market landscape in Canada over the next few years, making risk transfer strategies possible even for some of the largest corporate plans in Canada,” he said.

“The solutions currently being explored and implemented are wide-ranging—from investment strategy shifts to plan design changes, to a complete sell-off of the risk. But the catalyst for change in all cases is the desire to reduce financial risk,” said Ian Markham, Canadian retirement innovation leader with Towers Watson.

Particularly challenging for pension plan sponsors is the dual effect of the fear and uncertainty currently pervading financial markets. Not only does risk aversion cause instability in stock prices, but, for the most part, the “safe” money is shifting to bonds, keeping interest rates low and inflating pension liabilities and costs.

“With interest rates seemingly stuck at such low levels, DB plan sponsors have by necessity started to assess more critically the investment tools they’ve historically used to boost returns and reduce risk,” said David Service, director of investment consulting with Towers Watson. “Led by some of the larger, more sophisticated plans, Canadian pension funds are accelerating a trend toward alternative assets such as real estate, private equity and infrastructure.”

As the markets evolve, some plan sponsors are also starting to explore ways of using traditional tools in non-traditional ways. For example, alternative approaches to equities market investing can help sponsors boost returns while at the same time reducing volatility.

“Some pension fund sponsors are putting shiny new tools in the toolbox,” said Service. “Others are simply sharpening the tools they already have. There are many ways to manage risk, and plan sponsors would be wise to explore them all.”