Since the financial crisis of 2008, a disturbing number of Canadian defined-benefit pension plans have been underfunded and in a deficit situation. This means their expected liabilities for the next 20 to 30 years — the benefits they have to pay out to their members — exceed the expected amount of future assets.

In very simple terms, the assets of a pension plan include the current amount of money in the plan, the expected future contributions by active members and the expected investment returns on that total amount of money.

Actuaries are the professionals who make these calculations. (They are an exciting bunch, much like accountants but without that quirky sense of humour.) They make long-term assumptions about interest rates and investment returns and then customize these valuations for each pension plan, based on factors such as the ratio of active to retired plan members and average member age, to help determine an accurate estimate of the future assets and liabilities.

When the rate of return used in the long-term projections is low, the calculation of assets is decreased significantly. This has been a problem since 2008, exacerbated by several years of low actual returns on investment portfolios.

And, inconveniently, pension plan members continue to get older, despite the strain that puts on their pension plans.

At the beginning of 2013, only six per cent of Canadian pension plans were fully funded, according to the pension health index maintained by Mercer, the large pension, investment and human resources consulting firm.

The good news? By Dec. 31, 2013, the number of public and private pension plans deemed by Mercer to be fully funded had jumped to almost 40 per cent. The underfunded pensions are also in much better shape than a year ago, with only six per cent now less than 80 per cent funded, versus 60 per cent at the end of 2012. That was a pretty scary number.

The overall rating at year-end is that pension plans stand at 106 per cent of the required funding at Dec. 31, their best level since June 2001. The funding estimate was just 82 per cent at the beginning of 2013.

So, what happened?

There are two main factors. The actuaries are now using a higher long-term interest rate assumption, as a result of rates rising in the second half of 2013. As I mentioned earlier, the assumed future rate of return on all the money invested in pension plans makes a huge difference to the estimate of future assets.

As well, we have had another good year of stock market returns, with the S&P/TSX Composite index up 9.5 per cent and the S&P 500 in the U.S. up 29.6 per cent over the last 12 months.

Most pension plans also invest in bonds, international stocks, private equity and infrastructure investments. With the exception of bonds, all of these sectors had good returns in 2013.

So, when actual returns exceed a cautious assumption, and the long-term assumption becomes more optimistic, the health index improves dramatically.

Plan sponsors — the companies and governments who are on the hook for any of these unfunded liabilities — will likely remain cautious after more than 10 years of pressure on their balance sheets. The trend away from defined-benefit plans to defined-contribution plans will likely continue.

The defined-benefit (DB) plan promises pension calculated as a certain percentage of a person’s final average salary, times the number of years as a member of the plan. If the plan has a deficit, it’s up to the employer to make up the shortfall.

In a defined-contribution (DC) plan, the company agrees to match employee deposits each year based on a formula, but the ultimate pension available depends on the investment returns in the plan. The plan member could end up with more or less pension than with a DB plan, but the employer has put a cap on their share.

If you are in a pension, make sure you are clear on the type of plan and obtain an accurate estimate of your future benefits.

If you’re not a member of a pension plan, then remember you have to provide for yourself, through vehicles such as RRSPs, TFSAs, rental real estate and other investments. Don’t leave it too late, or you’ll have your own personal pension deficit.

Source: Winnipeg Free Press