As 2017 draws to a close, we turn our attention to the new year. As usual, there’s a lot happening in the Canadian pension environment. Below are four pension trends to watch for in 2018.
1. Canada Pension Plan/Quebec Pension Plan reform
The Canada Pension Plan enhancements will be phased in from Jan. 1, 2019, and the Quebec government has tabled legislation that would make similar changes to the Quebec Pension Plan.
The changes will increase the target benefit payable under these programs, from 25 per cent to 33.3 per cent of employment earnings, and will increase the maximum earnings recognized for determining benefits and contributions by 14 per cent. Both employee and employer contributions will increase in order to pay for these additional benefits. Once fully phased in, each of employee and employer contributions will increase by approximately 0.8 per cent to 1.33 per cent of employment earnings, depending on an individual’s salary.
In 2018, employers will need to decide whether to adjust their retirement savings plans or other employee reward programs to reflect the increased costs and higher projected retirement income resulting from the expansion of the CPP and QPP. And, if they decide to do so, they have to determine which option is best. For example, employers may want to reduce the defined benefit accrual formula and/or decrease the defined contribution formula in their plans to offset the additional benefits and contributions under the enhancements. Alternatively, they can reduce other reward programs. Ideally, any changes to an employer’s plans would take effect by 2019 in order to be aligned with the CPP and QPP changes.
2. Retirement readiness and decumulation
With the continued move from defined benefit to defined contribution pensions in the private sector, more employees will have the majority of their retirement savings in a defined contribution plan. When originally designing these plans, many employers focused on the cost and competitiveness of annual contributions, but now that these plans are becoming more mature, employers are beginning to shift their focus to retirement readiness and decumulation.
For example, employees in a defined contribution plan may not have sufficient savings to retire at the date they had planned. And for employees who do retire, it’s often not clear how to convert their account balances into periodic retirement income that has to last for the rest of their lives.
The trend of an increased focus on retirement readiness and decumulation will continue into 2018. More employers will measure the retirement readiness of their defined contribution plan membership and some will even provide members with the tools to measure and monitor their own retirement readiness. We can also expect an increase in communication to these plan members that encourages them to maximize the benefit they derive from their pension. Education of members who are close to retirement will have a heavier focus on the options available to them and some of the risks they’ll face during the post-retirement decumulation phase. Some employers may also revisit their plan design, perhaps for the first time in many years, to better align it with employers’ retirement objectives, especially in light of the upcoming CPP and QPP changes.
3. Defined benefit funding reform
In 2016, Quebec eliminated the requirement for private sector defined benefit plans to be funded on a solvency basis. Ontario has recently announced changes to its funding rules — expected to come into effect in 2018 — which will only require funding when a plan’s solvency ratio falls below 85 per cent. And other provinces, such as Nova Scotia, are reviewing their funding rules. The goal of these funding reforms is to mitigate the large and volatile contributions that have been caused by the requirement to fully fund a plan’s solvency liabilities.
In the future, pension funding will largely be driven by a plan’s going-concern valuation instead of the solvency valuation. During 2018, employers affected by these reforms will need to adapt their pension’s financial management strategies to reflect the changes.
For example, an employer whose ultimate objective is to reduce risk by settling all defined benefit obligations may now have the luxury of additional time to implement its de-risking strategy. However, in order to accumulate sufficient assets to settle its pension obligations, the employer may need to establish a funding strategy that targets higher pension contributions than the minimum required under the new funding rules. For other employers, the new funding rules may mean that their plan’s costs and risks will now be manageable, in which case they’ll be able to sponsor a sustainable plan over the long term.
4. Interest rates
In recent years, Canadian interest rates have decreased to nearly record lows, resulting in ballooning pension liabilities and deficits, which have caused financial challenges for many plan sponsors.
For a number of years, the pension industry has been anticipating an increase in long-term interest rates, which would relieve the financial pressures on pension plans. However, these stakeholders have been repeatedly disappointed.
In 2017, many in the industry expected the dream of increasing long-term interest rates to finally gaining traction. The U.S. Federal Reserve raised its benchmark interest rate three times this year and the Bank of Canada raised the overnight rate twice during the third quarter of 2017. However, these rates are short term, and so increases don’t necessarily translate immediately into long-term rate rises.
For example, at the end of November, long-term rates were lower than they were at the beginning of 2017. The increases in the U.S. Federal Reserve and Bank of Canada rates have resulted in a flattening of the yield curve (a narrowing of the difference between long- and short-term interest rates), but this has generally not reduced pension plan liabilities, which are long term in nature.
In 2018, we’ll be watching the bond markets carefully with the hope that the 2017 increases in short-term rates were the beginning of a trend that will ultimately lead to significant boosts in long-term rates. Whether or not we’re witnessing the beginning of a trend remains to be seen.