The FINANCIAL -- Defined benefit pension plans’ solvency in Canada improved slightly
in 2012 thanks to company contributions and a strong equity market,
according to Aon Hewitt, the global human resource solutions business of
The median pension solvency funded ratio – or the ratio of the market value of plan assets to liabilities — is approximately 1 percent higher this year than at the start of 2012.
According to Aon Hewitt, opposing factors had an overall positive impact on the financial status of defined benefit pension plans this year. On the one hand, interest rates continued their decline pushing up the value of liabilities of pension plans. The discount rate used to calculate the liabilities to be settled by annuity purchases in case of a plan termination went down from 3.31percent at the beginning of the year to 2.96 percent at the end of 2012.
As WebWire said, equities performed well, with Emerging Markets leading the pack at 16.0 percent, followed by International Equities (15.3 percent), US Equities (13.4 percent) and Canadian Equities (7.2 percent). Pension plans invested in alternative asset classes such as Global Real Estate and Infrastructure were rewarded with returns of 25.8 percent and 11.7 percent respectively. Finally, most plan sponsors had to contribute towards their deficits due to minimum solvency funding requirements.
The combination of all these factors led to a slight rise in Aon Hewitt’s median solvency funded ratio of a large sample of pension plans from 68 percent at the end of 2011 to 69 percent at the end of 2012. About 97 percent of pension plans in that sample had a solvency deficiency as at December 31, 2012. The solvency funded ratio measures the financial health of a defined benefit pension plan by comparing the amount of assets to total pension liabilities in the event of a plan termination.
“There are mainly three ways that plan sponsors will see themselves out of this solvency conundrum,” said Thomas Ault, an associate partner in Aon Hewitt’s Retirement Consulting practice. "Through an increase in interest rates, favorable equity and alternative markets returns, or through higher employer contributions. We had two out of three this year.”
The following graph depicts the movement of assets, liabilities and funded ratios for this median pension plan since January 1, 2010
The graph shows that assets have only increased by 20 percent over the three-year period since January 1, 2010 while liabilities, driven by a continuous drop in long term interest rates, have increased by 50 percent over the same period.
In addition to the performance of the typical plan, Aon Hewitt has also tracked the performance of a plan that has employed a few simple de-risking strategies since January 1, 2011, such as: Increased investment in bonds from 40 percent to 60 percent of the portfolio. Investment in long bonds instead of universe bonds to better match liabilities.
The de-risked plan experienced a 79 percent solvency ratio as at December 31, 2012 as opposed to 69 percent for the median plan.
According to Aon Hewitt, there was, again, downward pressure on yields in 2012, and it is likely to continue in 2013. “The demand on long bonds by pension funds and insurance companies to better hedge their liabilities, foreign investors looking for a safe haven and the level of public debt are all contributing factors to this trend,” said André Choquet, a senior consultant in Aon Hewitt’s Investment Consulting Practice. "Plan sponsors may want to review not only their investment policy but their benefit design and funding policies if they believe we’re in this low rate environment for the long haul"
Aon Hewitt believes the following trends are likely to continue in 2013:
Mega risk transfer deals: 2012 saw two large scale North American annuity buy-outs with GM and Verizon settling $26 billion and $7.5 billion of their retiree liabilities respectively both with the same insurer, Prudential. Some plan sponsors that believe low interest rates are here to stay may opt to remove pension risk from their balance sheet as it negatively affects their stock price. Canadian insurers hope to see the first $1 billion buy-in or buy-out deal this year.
Diversification out of equities: Plan sponsors who do not envision an early exit from their defined benefit plans, may opt to continue diversifying the growth component of their pension fund into alternatives and hedge funds mainly to reduce market risk while preserving their return expectation. Many alternative asset classes are now available to smaller investors through pooled funds.
Delegation of responsibilities: Some sponsors concerned about the level of oversight and governance needed to effectively manage their defined benefit plans especially as they approach their endgame may choose to delegate some or most of their responsibilities to a third party who will then implement a de‑risking and an eventual annuity settlement strategy.