Hot on the heels of a Watson Wyatt report that said pension funding ratios were at their highest in five years comes a Mercer release revealing that the Mercer Pension Health Index is no better funded than it was a year ago.
In fact, funding ratios ended the year with a 2% net loss. “The main reason we didn’t have a good fourth quarter is from an asset/liability perspective,” says Peter Muldowney, business leader for Mercer’s investment consulting business in Canada.
He says a prime cause for the poor performance is the turmoil in the equity markets. “We’re investing in capital markets with a lot of uncertainty,” he explains. “I’m sure a lot of it has to do with the markets being jittery and with uncertainty surrounding sub-prime.”
Stephen Bonnar, a principal at Towers Perrin, says his company’s findings are similar to Mercer’s. Towers Perrin’s index saw a net loss of 0.2% and a benchmark return of 2%, as opposed to Mercer’s return of 1.7%. “So that’s quite close,” says Bonnar. “When you factor everything in, our numbers and Mercer’s numbers are consistent. Both of them assume no contribution. Watson Wyatt may have assumed a typical contribution.”
According to Ian Markham, director of pension innovation at Watson Wyatt, the company does assume a typical contribution. “When we have a deficit [in our calculation] we put money in,” he says. “I have a feeling Mercer concentrates more on what investment markets do to pension funds.”
“The difference is embarrassing,” says Muldowney, adding that the gap between the results is “very unusual.”
Other factors also contribute to the varied results. Besides Watson Wyatt’s accounting for plan top-ups, Mercer has a different makeup of U.S. and international equity in its assumed portfolio. Watson Wyatt uses 12% in the S&P 500 and 12% in EAFE, while Mercer has 15% in each.
Also, Mercer bases its valuations on solvency, while Watson Wyatt concentrates on pension accounting. “We don’t base this on what would happen if a company wound up,” says Markham. “What our numbers look like is what would be reported to shareholders.”
Markham points out that solvency is based on Canadian funds, while the company’s accounting takes corporate bonds into account. “Canada funds perform quite differently from the bonds that form the basis of pension accounting numbers,” he explains.
There are other, subtle differences between how Mercer and Watson Wyatt operate, but the bottom line is that it’s very difficult to compare the findings of the two companies.
Fortunately for confused advisors, the disparity between findings isn’t the norm. Paul Forestell, retirement professional leader at Mercer, says it’s the first time ever that there’s been such a difference between the two reports. While they’re never exactly the same, usually if one’s reporting low numbers, the other follows suit and vice-versa.
This year, Canada’s credit crisis has resulted in a wider gap between corporate and government bonds, and that’s how you get, for the most part, the different results.
With these reports offering different takes on pension ratios, clients might have a few questions about what to believe. But Bonnar downplays the variations between the results. He says these numbers matter only for clients who participate in a defined benefit pension plan. And out of those clients, the results are relevant to those whose company is in financial trouble.
“They’re only at risk if the company goes under when the pension plan is underwater as well,” he explains. “And it doesn’t mean they’ll get zero cents on the dollar. They might get 90 cents, which is not very good, but it’s not the end of the world.”
For employers that are financially secure, such as the Government of Canada, lower-funded ratios just mean that the plan sponsor needs to top up the plan.
Markham agrees. “It doesn’t matter if a company is well below 100% funded as long as the plan sponsor stays in business,” he says. “If they stay in business and the plan is 50% funded, if the people can deal with emotional stress as they wait for that 50% to come up to 100%, they’ll still get their pension.”
From Muldowney’s perspective, lower-funded ratios shouldn’t have a significant effect on how a plan sponsor operates. “If they have a schedule that they’ve been putting in, and they thought that now might look like a good opportunity to start trimming back, the fourth-quarter results meant that it might just be the same business as usual in terms of keeping money topping in.”
But an underfunded plan could make shareholders nervous. Markham says that “the lower the funded ratio, the bigger the expense will be and the bigger hit to the bottom line.”
“What advisors can take from this is that for plan sponsors it’s going to be an odd year,” adds Forestell. “Companies are saying that their funded position improved, but cash requirements are going up. That’s the confusing part.”
Despite the confusion and conflicting reports, there is some reason to be concerned about the future health of plans, especially if the market turmoil continues. Fortunately, economists are predicting that the uncertainty should subside in the latter half of 2008.
Mercer’s own research found that investment managers expect a 6% return by the end of the year, but Muldowney acknowledges things could change, and they may already have done so. “This info was relatively recent,” says Muldowney. “But with this whole sub-prime thing, one month seems like a very long time. If I surveyed managers a week ago, I might have had a more conservative view, particularly in respect to interest rates.”
Bonnar doesn’t want to predict how next year’s report will look, but he says a lot of it depends on discount rates, if the Bank of Canada can keep inflation under control and how the sub-prime mess will play out.
He says Government of Canada bond yields fell slightly in the last half of the year, but because there’s not much concern over credit quality, they didn’t drop enough to cause panic. While that’s good news, it’s still not time to relax. “No one is concerned that the Government of Canada may go under, but who knows what bad stuff might exist on bank financial statements.”
Next year’s results also depend on discount rate cuts. Bonnar says he expects the U.S. Federal Reserve to cut rates, but he’s not sure what the Bank of Canada will do, especially because current governor David Dodge will hand over the bank’s reigns on January 31 to Mark Carney.
“I don’t know what’s going to happen at the long end of the bond market,” he says. “But if I’m a bond market participant in the U.S., I’m going to be nervous that cutting discount rates will lead to higher inflation and higher yields on my bonds. It’s easier to see that. It’s unclear what will happen in Canada.”
Filed by Bryan Borzykowski , Advisor.ca bryan.borzykowski@advisor.rogers.com.