Defined benefit plans: opportunities to secure funding progress may only knock once

The unprecedented rise in Canadian interest rates has played a significant role in improving the financial health of defined benefit (DB) plans over the last two years. But with many central banks nearing the end of their tightening cycles, the notion that interest rates may be heading back down to more neutral levels has suddenly become a very real possibility. Supposing the funding paradigm in Canada shifts, how can DB plans manage their risk exposures to ensure they remain financially stable? 

Be aware of markets bearing gifts

Just four years ago—at a time when interest rates were significantly lower than they are today—the average funded status on a solvency basis for DB plans in Canada hovered at just 85%. But a dramatic run-up in interest rates, particularly over the last 18 to 24 months, has contributed to funding gains that have generously propelled that measure above 120%. 

That’s because rising rates tend to put significant downward pressure on pension liabilities, especially when they decline at a much faster rate than assets (as is the case for many pension funds today). Conversely, falling rates are likely to have an adverse effect on DB pension schemes. But why? As rates fall, liabilities typically rise, leading to a deterioration in overall pension health. Couple this with a scenario where liabilities rise faster than asset values and plan sponsors could very well see a reversal in some of the progress made over the last two years. So what’s the opportunity that’s become too costly to miss?  

In short, DB pension funds that have improved their financial position need to lock in the gains they’ve made during this historic rate cycle. By considering derisking and liability-driven investing (LDI) strategies, plan sponsors can better match the duration of assets and liabilities, mitigate downside risk, and ensure they’re able to meet their long-term commitments to pensioners as rates normalize. With regard to CFOs of corporate plans, this can also prevent them from going back into deficit, a situation that would require plans to be funded with additional contributions.

“As rates fall, liabilities typically rise, leading to a deterioration in overall pension health. Couple this with a scenario where liabilities rise faster than asset values and plan sponsors could very well see a reversal in some of the progress made over the last two years.”

Fast forward: an interest-rate backpedal may be in the cards

Weighing the prospects of a directional change in rates depends largely on the macro landscape and how it’s expected to evolve. Looking forward, global growth could continue to be challenged, prompting central bankers to come face to face with a precarious dilemma: Should they begin easing, even if inflation is significantly above target?  

Our base case is that central banks will in fact begin easing around mid-2024. While inflationary pressures remain above target, they’re clearly moving in the right direction. Outside the United States, a muted economic growth backdrop will also be an added incentive to begin normalizing.  As such, we’re calling on plan sponsors to begin thinking of ways of limiting any potential variations in funded status. After all, why not take action before the rates narrative changes even more drastically? 

Time for a shift in focus?

We’ve already established that the average DB plan in Canada is healthy. We’ve also laid out our expectations for rates to come down to more neutral levels in the foreseeable future. We can now proceed to take a hard look at how a typical Canadian DB plan is structured, analyze prevailing risk factors, and examine if any tweaks are warranted when it comes to the overall focus of plan sponsors and administrators.

Dissecting the average DB pension plan in Canada

Canada’s typical DB plan aims to strike a balance between growth, hedging, and diversification—with each of these components playing a unique role in the overall functioning of the plan. Based on our capital market assumptions and stress tests, the average asset mix implies an expected return over 5.22% and a 95.00% probability that losses relative to liabilities will be lower than 14.68%.

DB plans are focused on growth, hedging, and diversification of assets

Source: Pfaroe Moody's Analytics, as of December 31, 2023. VaR refers to value at risk, a statistic used to measure the level of risk exposure within a portfolio. The MSCI World Real Estate Index was discontinued as of November 1, 2023. Because of this, as of Q4 2023, the index for the real estate category has been substituted with the S&P Global Property Index. Consult our Pension Barometer for more details on the assumptions used for the calculations.

Outlining the prevalent risks to Canadian DB plans

While underfunded plans seek to reach their funding goals by maximizing returns, fully funded plans are more focused on preserving or improving their surplus over time. The tendency among the latter is to put a greater emphasis on risk reduction, concentrating on elements such as downside protection, diversification, and duration matching.

The average DB plan in Canada is exposed to a myriad of risks, and equity, interest rate, inflation (which will be explained later), credit, and property risks all need to be monitored to ensure they’re diversified away as much as possible. When it comes to two of the biggest risks—interest-rate and equity risk—a fall in interest rates can offset a DB pension plan’s surplus just as easily as a pullback in equity prices. 

Market movements can have a material impact on the average DB plan in Canada

The table below illustrates the impact certain market moves would have on the surplus status of the Average Defined Benefit Pension Plan in Canada. 

Source: Manulife Investment Management, as of December 31, 2023.

The interest-rate hedge ratio explained

In short, the interest-rate hedge ratio is the percentage of interest-rate risk that’s hedged (the higher the ratio, the lower the interest-rate risk). The robust health of Canadian DB plans, coupled with a relatively modest interest-rate hedge ratio of 49.6%, suggests plan sponsors have significant leeway to derisk their portfolios in the current environment. Expectations for falling interest rates set the stage for plan sponsors to reduce their interest-rate risk and secure their progress with LDI strategies.

As a rule of thumb, the healthier a DB plan, the closer its interest-rate hedge ratio (which essentially gauges the plan’s interest-rate exposure) should be to 100%. But selecting a target interest-rate hedge ratio isn’t as straightforward as it seems and requires a careful assessment of the plan on different fronts. 

From a general point of view, plan sponsors should aim for a higher target ratio if taking on more interest-rate risk isn’t worth their while. This could be because of an unwillingness to put a fully funded plan at risk, or because potential return benefits simply don’t outweigh incremental risks taken. Interest-rate expectations and the degree of mismatch between assets and liabilities are some other key considerations to look at. 

“The robust health of Canadian DB plans, coupled with a relatively modest interest-rate hedge ratio of 49.6%, suggests plan sponsors have significant leeway to derisk their portfolios in the current environment.”

Revisiting plan goals to limit variations in funded status

With inflation still above target, interest rates set to reverse course, and pension plans in good financial standing overall, now may be the time for Canadian pension sponsors to think about the following:  

• Increasing allocations to real assets
• Transitioning to an LDI approach for plans that haven’t already
• Increasing fixed-income allocations 

Increasing allocations to real assets

DB plans are particularly susceptible to inflation, regardless of whether or not they offer benefits directly linked to the Consumer Price Index. Unlike equity risks, inflation is an unrewarded risk that should be diversified away as much as possible. Because we may potentially see a resurgence in demand (if central banks ease before inflation gets back down to target), we need to be cognizant of the negative consequences that inflation can have on the financial stability of DB plans. 

Traditionally, real return bonds have been a reliable way to hedge inflation in Canada. However, the recent decision by Canadian policymakers to cease all new issuances of these instruments means plan sponsors need to explore other avenues for hedging their plans against inflationary pressures. Over the past 20 years, real assets such as real estate and infrastructure have outperformed traditional asset classes like equities and fixed income while providing a good hedge against inflation (specifically in rising inflation regimes). This, coupled with their enhanced return potential and diversification benefits, has turned real asset allocations into table stakes for pension schemes. Investing across real estate, infrastructure, timber, and farmland are all examples of ways to enhance the average DB plan in Canada. 

Revisiting LDI strategies

Any failure to meet obligations to pensioners not only presents a risk to the typical DB plan, but it presents a risk to all pension plans. This is the whole premise behind LDI, a holistic approach that can be applied to both a plan’s assets and liabilities to help ensure all obligations are met in full and on time. Through the matching of assets and liabilities LDI strategies are focused less on beating a market benchmark and more on securing funded progress.

The following scenario illustrates the expected impact of this asset mix change. Portfolio A is representative of the typical DB plan in Canada while Portfolio D represents a portfolio that’s positioned for our expected macro outcomes.

Should there be any change in interest rates or the shape of the yield curve, Portfolio D  should help preserve the financial stability of the average pension plan. By incorporating an LDI strategy instead of a traditional fixed-income approach, asset performance can better match that of pension liabilities. This, coupled with an increasing allocation to fixed income and a diversified portfolio of real assets, should have the overall effect of improving a plan’s focus on liability hedging assets versus return-seeking assets.

As can be seen, the plan’s risk/reward profile becomes increasingly attractive with each individual enhancement. The recommendations put forth should therefore result in a reduction in the volatility of excess returns over liabilities, as well as a modest improvement to expected return. For instance, the expected return potential of a diversified portfolio of real assets tends to be higher than that of other asset classes, bridging the gap in returns after adding to fixed-income allocations. Last, in our analysis within fixed income, the LDI strategy has a 33% allocation to corporate bonds for better liability hedging, an allocation that’s higher than that of the combined FTSE Universe Index and FTSE Long Index used in the current base case portfolio.  

What does this imply going forward?

The window of opportunity for securing funded gains is narrowing and plan sponsors are surely beginning to realize that some form of derisking is needed.

An LDI solution can fit the bill, as it helps protect the financial health of DB pension plans by better matching the risk exposures of assets to liabilities (particularly when it comes to limiting the impact of rate decreases). As mentioned above, allocations to private real assets can also help, as this asset class will likely play a role in hedging inflation risk, diversifying sources of return, and maintaining a strong return profile.

But what if rates ultimately remain unchanged or even increase? Regardless of what’s in store for the economy, plan sponsors can still take comfort in knowing their LDI component will effectively match assets and liabilities, protecting whatever funding progress they’ve made to date. That being said, don’t pass up on the opportunity to secure funding gains—capitalize!