What are DB pension plans doing to maintain financial health during volatile economic times?
Despite the overall improvement of the financial health of DB pension plans over 2023, a lot of risk remains in the market as it is unclear whether interest rates that apply to DB plans will stabilize in 2024, according to Jared Mickall, principal and leader of Mercer’s Wealth Practice in Winnipeg, MB.
The recent equity market bull run was a positive contributor to the financial health of DB plans over 2023. In the fourth quarter, plans saw positive asset returns, but these returns were not enough to offset plans’ increased DB liabilities, which resulted in an overall weakening of solvency ratios, according to the Mercer Pension Health Pulse (MPHP).
“We have started to see interest rates that apply to DB pension plans decline over 2023 and this should result in an increase in DB liabilities. However, it's unclear whether interest rates that apply to DB plans will stabilize in 2024; we can even look to the last three months of 2023 just to just to indicate how difficult it is to predict interest rates because of how much they came down over the fourth quarter,” Mickall said.
Over recent years, the industry has seen three general categories: de-risking pension plans, re-risking pension plans and transferring risk within pension plans.
According to Mickall, many plans have considered asset classes that behave in a manner similar to the liabilities, for example the use of longer-term fixed income asset classes such as long-term bonds. Meanwhile. because interest rates were very low for a very long time, others started to seek alternative asset classes, which started to see increases in asset allocation into things like real estate infrastructure funds. Finally, others started to transfer risk away from the traditional pension plan to an insurance company, typically through a group annuity policy group, annuity buy in or group annuity buyouts.
Mickall believes there will likely be a continuation of further exploration into all three of these categories. In terms of investment strategy in 2024, Mickall also expects to see the continuation of the role of sustainable investment beliefs as an ever-growing consideration for pension plans. He suggests that plan sponsors be on the lookout for more sustainable investment beliefs.
“It's not just about general equities, fixed income, real estate and infrastructure; it’s specifically about what we are investing in, who these companies are and how they are contributing to society at large, which is either being driven by plans, sponsors of the cells or by regulators and in many cases members,” Mickall said.
With regards to interest and inflation rates, Canadian inflation came down over 2023 and is approaching the upper end of the Bank of Canada’s inflation-control target of 3 percent. General views are that inflation will continue to decline in 2024 and reach the policy target of 2 percent in 2025.
In 2023, the Bank of Canada increased the overnight rate to 5.00 percent from 4.25 percent, which was a continuation of increases that commenced in 2022, to mitigate inflation and to balance against the risk of a recession. However, DB pension plan benefits are accumulated and paid over periods that are significantly longer than the overnight rate, so interest rates continue to pose a significant risk for many DB pension plans, according to the MPHP.
Meanwhile, Canadian debt markets experienced positive performance as yields declined significantly over the quarter due to interest rate and inflation expectations. The yield curve remained inverted, but rates declined across the curve. Long-term fixed income saw the greatest pricing gains with its higher sensitivity to interest rate changes, recovering from losses from previous quarters.
“Heightened geopolitical risk, inflation volatility, diverging global policies and transition risks all point to greater market instability, dispersion, and dislocation. These conditions are ripe for dynamic alpha generation.” said Venelina Arduini, principal at Mercer Canada. “Investors should engage with experienced partners and explore dynamic mandates. Agile managers across public and private asset classes can capitalize on opportunities created by these dispersions and risks.”
