Thursday, October 2, 2014

Trouble Brewing at Canada's Private DB Plans?

Janet McFarland of the Globe and Mail reports, Funding for Canadian pension plans weakens in third quarter:
Canadian pension plans saw their funding worsen in the third quarter this year as a result of falling long-term interest rates, after recording strong improvements over the past two years.

A survey of 275 pension plans by consulting firm Aon Hewitt shows the average solvency of plans fell to 91.1 per cent as of Sept. 26 from 96 per cent at the end of June.

The decline marks the first downturn in funding for defined benefit (DB) pension plans since June, 2012, eroding two years of improvements in funding as interest rates climbed.

“Canadian DB plans have strung together a nice run of winning quarters, but as we have been saying for some time now, market volatility continues to present significant risks,” Aon Hewitt senior partner William da Silva said in a statement.

Aon Hewitt said decent stock market returns and contributions from employers helped to offset some of the decline in the third quarter, and said some pension plans have implemented “de-risking” strategies to make them less sensitive to interest rate movements and did not suffer as much.

Mr. da Silva said pension plans are still in much better health than they were a few years ago, but said more plans should be implementing de-risking strategies, which include shifting more investments into categories that are not as sensitive to interest rate movements.

“Now that we have seen plan solvency decline for the first time in over a year and a half, hopefully this will serve as a wake-up call to all plan sponsors to consider their funding and investment strategies with risk management as their key objective,” he said.

The survey found 23 per cent of pension plans were more than 100 per cent funded at the end of the third quarter, a decline from 37 per cent above full funding at the end of June. Pension funds are more than 100 per cent funded when they have a surplus of assets compared with their pension liabilities.

Aon Hewitt also warned in its report Tuesday that pension funds are facing a further hit in 2015 when they will have to account for new Canadian mortality tables released earlier this year, showing average lifespans have climbed further.

The firm said that if those tables had been applied in the third quarter this year, the average funding of pension plans would have fallen more sharply to 86.9 per cent instead of 91.1 per cent.

Ian Struthers, a partner in Aon Hewitt’s investment consulting practice, said a correction in stock markets this winter coupled with the impact of the new mortality tables would create “a perfect storm of lower returns and increasing liabilities, erasing the tremendous gains many plans have experienced over the last 18 months or so.”
Indeed, the perfect storm for all pensions is a massive correction in stocks and lower interest rates. And keep in mind, the decline in rates has a much bigger impact on pension deficits than the correction in asset values because interest rates drive pension deficits. If rates stay low or decline further, it will have a significant impact on pensions and insurance companies (in finance parlance, the duration of liabilities is a lot bigger than the duration of assets, so a drop in rates will disproportionately impact pension deficits, even if asset values rise).

Add to this the change in the new mortality tables, reflecting the fact that people are living longer (longevity risk), and you begin to understand that things are a lot more fragile than meets the eye at Canada's private defined-benefit (DB) plans:
The pension-consulting firm, Aon Hewitt, has found that the solvency of Canadian defined benefit pension plans fell in the most recent three months.

“Decent equity market returns and pension plan contributions helped offset some of the declines, but overall plan solvency ratio dropped in the third quarter by more than four percentage points from the second quarter – the first decline in plan solvency since June 2012,” said the report issued this week.

Aon Hewitt said that the “decrease in discount rates used to value plan liabilities,” was the main driver for the drop in solvency ratios during the quarter. While the decrease had a positive impact on fixed-income assets, it had a “negative impact on transfer values and the cost of purchasing annuities,” it said.

Of the more than 275 pension plans included in its survey, Aon found their median solvency funded ratio – defined as the market value of plan assets over plan liabilities — stood at 91.1% at Sept. 26, 2014. In contrast, the comparable ratio was 96% at the end of June. In April 2014, the ratio was 96.8% — the peak for the year. But as a sign of how far things have improved over the medium term, the solvency ratio was 88% in September 2013.

“Now that we have seen plan solvency decline for the first time in over a year and a half, hopefully this will serve as a wake-up call to all plan sponsors to consider their funding and investment strategies with risk management as their key objective,” said William da Silva, senior partner, retirement practice, at Aon Hewitt.

As for the future, da Silva said that “market volatility continues to present significant risks and plan sponsors should be implementing or fine-tuning their de-risking strategies in order to stay current and optimized in the face of ever-changing capital market conditions.”

Indeed Aon Hewitt expects that the release, next year, of actuarial standards for solvency valuations will be a major negative for the solvency of pension funds. Those new standards, which will take into account the new mortality tables released earlier this year, “will have a real impact on the solvency liabilities of DB plans,” because mortality tables project longer life spans for Canadian pensioners.” If those standards were in effect today, Aon Hewitt estimates that the solvency ratio would be 86.9% compared with 91.1%.

The slide in solvency in the third quarter also meant a drop in the percentage of funds that are fully funded. At the end of September, about 23% of the surveyed plans were more than fully funded compared with 37% in the previous quarter and 15% in the third quarter of 2013.
After reading these articles, you might be wondering what is Mr. da Silva talking about when he says: “Now that we have seen plan solvency decline for the first time in over a year and a half, hopefully this will serve as a wake-up call to all plan sponsors to consider their funding and investment strategies with risk management as their key objective.”

I've discussed the race to de-risk pensions but if you ask me, the best way to ultimately de-risk pensions once and for all is to enhance the Canada Pension Plan (CPP) for all Canadians across the public and private sector. I've said it before and I'll say it again, in my ideal world, there aren't any private DB plans, only large, well-governed public plans managing the pension assets of all Canadians, regardless of whether they work in the public or private sector.

But the boneheads in Ottawa keep pandering to the financial services industry, which is why we haven't made any significant policy progress in terms of bolstering our retirement system. Even worse, there is a full frontal assault by the media which is spreading lies and misinformation on the CPPIB and Ontario's new supplemental pension (who owns the media?).

It's important to understand that while Canada's large public pensions are far from perfect, they are the pillars of what will ultimately be the way forward in terms of significantly improving our retirement system and eradicating pension poverty once and for all. There are excellent pension fund managers in the private sector but in my opinion they should be working on managing the pension pots of all Canadians, not just those of their company employees.

Finally, while Canada has problems, other countries are in much worse shape. For example, China's looming retirement crisis is something that should worry all of us as it will reinforce deflationary pressures hitting Europe and Japan right now. The demographic shift, longer life spans and ongoing jobs crisis are taking their toll on global retirement systems and threaten the long-term growth prospects of many countries.

Below, Bridgewater Associates founder Ray Dalio explains why he agrees with Fed chair Janet Yellen's decision to wait until the U.S. sees more inflation before raising interest rates. It was over ten years ago when Gordon Fyfe and I met Ray and I told him deflation is the ultimate endgame.

Now, if I can only convince Ray and the folks at Bridgewater to give me a cut of the enormous profits they made playing the deleveraging/ deflation theme over the last decade. Not bad for someone without a "track record." -:)

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