Why pension plan sponsors can't get complacent

Majority have recovered from market crash but expert tells WP that major risks linger

Why pension plan sponsors can't get complacent

Canadian pension plans have been urged to avoid complacency despite recovering from the “gut-wrenching” decline during last year’s Q1.

Mercer reported that, during the fourth quarter, funded positions of DB plans continued to recoup their losses, primarily driven by equity markets and aided by slightly higher bond yields.

The Mercer Pension Health Index (MPHI), which represents the solvency ratio of a hypothetical defined benefit (DB) pension plan, increased from 107% at the end of September to 114% at the end of December, and is up 2% from the beginning of 2020. The median solvency ratio of the pension plans of Mercer clients was at 96% on December 31, up from 93% on September 30, but lower from 98% at the beginning of the year. 

Ben Ukonga, Principal in Mercer’s Financial Strategy Group, told WP that most plans are back at, or close to, pre-pandemic level and remain well-funded by historical standards, even with liabilities measured at today’s ultra-low interest rates.

He said: “The bulk of the reason for the change is the equity markets. But then it was also aided a little bit by interest rates inching up slightly higher and then also by the change in commuted value standards and how lump sums payable from pension funds are calculated; that also had a slight impact on improving the positions.”

Ukonga is cautiously optimistic about the year ahead, with the rollout of the COVID-19 vaccines now under way, and the anticipated re-opening of the global economy expected at some stage. However, he warned that significant risks linger, including the pace at which the pandemic subsides, significant increase in debt levels, persistent low interest rates and geo-political tensions.      

He said: “Things are looking good and there’s cause for optimism but plan sponsors can't be complacent. The risks are how quickly do global markets recover from the pandemic. Vaccines are being rolled out, but how successful and fast is it [going to be] and, therefore, how fast will the ultimate recovery be and how much longer will we be locked down?

“Also, because of the pandemic, debt levels have increased significantly and will need to be dealt with, so that will have an impact on interest rates going forward. Then, it’s a case of how businesses and governments deal with the post-COVID economy and how quickly things recover.”

Ukonga added that many well-funded closed and frozen plans have very little upside reward for taking on significant risk, and that it may be prudent to take risk off the table through increased allocations to defensive assets, better matching of plan investments to plan liabilities, annuity transactions, wind-ups or even merging into jointly-sponsored pension plans if possible. 

“This is a good time to actually look at your pension plan,” he added. “Are you being appropriately compensated for the risk you've taken on? If your DB plan is closed to new entrants, should you still be taking on a lot of significant equity risk because for closed DB plans, there's limited upside gain.

“The key message is don't be complacent. Use this opportunity, that you've recovered, to really look at your pension plan, how the pension plans assets are invested and then make a conscious decision [about whether] the investments are appropriate for your risk tolerance and pension plan obligations.”

Open plans and plans with long time horizons also face a more difficult challenge. Given the persistent low yields on fixed income investments, they must remain significantly invested in growth assets in order to remain affordable. However, large allocations to growth assets come with exposure to the volatility of the markets. Ukonga believes that realistic contribution rates, risk-sharing design features, broad diversification across asset classes and geographies, and selecting the right investment managers will become even more important going forward. 

Overall, though, he expects pension plans will feel quietly confident that 2021 will result in a better year.

He said: “I would say we are cautiously optimistic but at the beginning of 2020, we were alsol cautiously optimistic. Having said that, with the rollout of the vaccine, it's a fair assumption to say that the end of the pandemic is in sight.

“With the reopening of the economy, one would assume that the market should do well. In 2021, interest rates will remain low. However, even with the persistent low interest rates, many pension plans are well funded, so with markets doing well, pension plans should do well.”