The solvency position of Canadian pension plans rose in the second quarter of 2015. The Mercer Pension Health Index stands at 100% on June 26th, up from 94% at March 31st. The rise in the funded status was driven by rising interest rates. Long-term interest rates rose by 50 basis points in the quarter, pushing pension liabilities for most pension plans down by between 5% and 8%. However, asset returns were poor in the second quarter due to sputtering equity markets, and the negative impact of rising interest rates on bond portfolios.

“Pension plans remain exposed to significant risk, particularly the possibility of an equity market downturn or another drop in interest rates.” said Manuel Monteiro, leader of Mercer’s Financial Strategy Group. “With funded positions being relatively healthy, it is an opportune time for plan sponsors to adjust their pension risk exposure to their desired level. For many, this means reducing their risk exposure by increasing fixed income allocations or by offloading portions of their liabilities to an insurance company through an annuity transaction.”

After successive record-breaking years in 2013 and 2014, the annuity market has been remarkably slow in the first half of 2015. Plan sponsors interested in an annuity transaction should position themselves to take advantage of attractive pricing with insurers likely to narrow profit margins in the second half of 2015 to meet their ambitious targets.

“Equity markets had mixed but relatively subdued performance during the second quarter. Both the US and EAFE equity markets experienced decent returns of close to 2% in local currencies for the quarter (up to June 25). Due to the strengthening of the Canadian dollar relative to the US dollar, US equity market returns ended close to flat in Canadian dollar terms. Canadian equities lagged with a return of 0.6% for the quarter (up to June 25) led downward by negative performance in a number of sectors including Energy, Materials, Industrials, Utilities and Information Technology. And emerging markets equity exposure provided a similarly flat return (measured in Canadian dollar terms) over the same period,” said David Zanutto, Partner in Mercer’s Investments business.

David Zanutto continued, “Canadian long term yields did see a significant increase this Spring, resulting from a variety of factors including higher oil prices, rising yields in the US due in part to the anticipation of upcoming Fed rate increases, and a new, albeit cautious optimism about the Canadian economy. After reduced consumer spending brought on by the tough winter, and a lower Canadian dollar, demand for Canadian goods and services is expected to finally increase from both sides of the border.”

A typical balanced pension portfolio had about -1% return in the second quarter of 2015. Other results for the quarter measured to June 25th:

Long-term Government of Canada bond yields ended the second quarter at 2.4 per cent, up 50 basis points from March 31st.

For the quarter, the best performing S&P/TSX sectors were Health Care (+12 per cent), Telecom Services and Consumer Discretionary (both +3 per cent). The worst performing sectors were Industrials (-8 per cent), Utilities (-5 per cent) and Information Technology (-4 per cent).

Small cap stocks (S&P/TSX SmallCap Index) returned 3 per cent, outperforming large cap stocks (S&P/TSX 60 Index) which returned 1 per cent during the quarter.

Value stocks outperformed growth stocks as measured by the S&P Canada BMI Value and Growth indices. The indices returned 1 per cent and 0 per cent in the second quarter, respectively.

The S&P 500 Index returned 0 per cent for the quarter in Canadian dollar terms. International equities, as measured by the MSCI EAFE (CAD) index, generated a return of 2 per cent for the quarter.

Emerging markets, as measured by the MSCI Emerging Markets (CAD) index, returned 0 per cent in the second quarter.

The FTSE TMX Canada Universe Bond Index returned -3 per cent in the second quarter, while the FTSE TMX Canada Long Term Overall Bond Index returned -6 per cent. At the end of the quarter, the yield on the FTSE TMX Canada Universe Index was 2.1 per cent as compared to 3.2 per cent for the Long Bond Index.

The chart below compares the distribution of the estimated solvency ratios of Mercer clients (covering 600 plans) at January 1, 2015 and June 30, 2015:

While there are outliers on either side, almost 75% of Canadian pension plans are between 80 and 100 per cent funded on a solvency basis at the end of the second quarter of 2015.

Mercer Pension Health Index

The Mercer Pension Health Index tracks the funded status of a hypothetical defined benefit pension plan.

The Mercer Pension Health Index shows the ratio of assets to liabilities for a model pension plan. The ratio has been arbitrarily set to 100 % at the beginning of the period. The new Pension Health Index assumes contributions equal to current service cost plus solvency deficit payments, and no plan improvements.

The Mercer Pension Health Index assumes that valuations are filed annually on a calendar year basis and that the deficit revealed in each valuation is funded on a monthly basis over the subsequent five years.

Assets: Passive portfolio with asset mix of: Asset mix: 42.5% DEX Universe Bond Total Return Index; 25% S&P/TSX Composite; 15% S&P 500 (CAD); 15% MSCI EAFE (CAD); 2.5% DEX 91 day T-Bills.

Liabilities: 50 % active members, 50 % retired members. 60% of benefits for active members assumed to be settled through commuted values based on the Canadian Institute of Actuaries transfer value standards without the one-month lag, and the remaining 40 % assumed to be settled through an annuity purchase. Benefits for retired members assumed to be settled through an annuity purchase. Annuity prices determined based on the CIA guidance for the medium duration illustrative block. Results will vary by pension plan.

Source: Mercer