This paper explains why the environment for DB plans has drastically changed, making 2023 an inflection point for many sponsors. It also presents the case for why now is an opportune time for many plan sponsors to revisit their pension strategies.
Not long ago, industry-wide discussions were held about the potential impact on pension solvency of negative nominal interest rates, as seen in other developed markets around the world. The focus of many sponsors was to manage their plan’s deficit through a combination of generally low expected returns going forward while trying to keep contribution levels reasonable. To help plans sponsors navigate the lower return environment, a number of jurisdictions across Canada replaced what had been a more volatile funding regime driven by solvency regulations with a more stable going concern basis with additional margins.
Then the pandemic arrived. Its early days created serious market volatility, even forcing some regulators to make adjustments to protect benefit security. Developed economies experienced a significant paradigm shift when non-essential workers were directed to work from home for a prolonged period of time, creating a permanent change going forward for many companies. Supply chain disruptions, impact of COVID excess monetary supply and geopolitical conflicts eventually pushed inflation to levels not seen in the last 30+ years and that quickly became the major cause of concern for central banks around the world.
This backdrop has caused a significant transformation in the Canadian yield curve over the last 3 years as shown below. The entire interest rate yield curve moved up with the shorter end moving higher than the long maturity, suggesting that central banks pronounced corrective actions are expected to be relaxed at some point.
2023 inflection point is driven by the 3-year funded status bull market
The last decade has seen good overall portfolio returns and significant plan contributions have been made but with little improvement to show in funded status, with the exception of the last 3 years. The graphic below shows that we are in a 3-year funded status bull market due to:
- Great equity returns in 2020 and 2021;
- A greater reduction in liabilities than plan assets, as of 2022, most plans are not fully hedged to movements in interest rates; and
- Impact of improved group annuity pricing
Tracking of median solvency ratio for DB plans registered in Ontario
The significant improvement in funded status has transformed the conversation we are having with many plan sponsors. We went from building strategies to eliminate deficit to discussing strategies to potentially leverage the existing and future surplus growth while protecting the downside risks.
What else makes 2023 an inflection point?
In addition to the improvement in overall funded status, several other factors contribute to making 2023 an inflection point year:
- The relative pricing of group annuities in Canada has seen changes. As shown below, the spread offered by insurers when compared to the long-term risk-free rates shows an implicit yield that has increased by approximately 40-50 bps since 2019 compared to its historical level. The group annuity spread is now more in line with a portfolio consisting of high-quality corporate bonds (similar to the accounting discount rate) versus the spread previously embedded in the FTSE long-term index. This change has implications on LDI portfolios since the liability hurdle rate (minimum rate required by the portfolio to keep-up with the inactives’ liability) has increased by the same 40-50 bps. The increase in spread in annuity pricing results is ~5% lower solvency liability for members in payment. Has your LDI portfolio been keeping track with the liabilities? While protecting against interest rate fluctuations, your bonds may not protect against the passage of time and be a drag on your funded status.
- The relationship between Government of Canada bond yields and equity risk premium has changed significantly over the recent past. In an interest rate environment where yields were very low, equity risk premiums were more attractive given the significant gap between the expected return profile. Other asset classes, such as alternatives and/or real assets were also looking more attractive from a yield perspective. Now that interest rates have risen, the risk return trade-off between fixed income and equities has changed, especially for sponsors considering excess return LDI strategies whereby the target return on the fixed income portfolio is 50 to 100 bps in excess of liability growth.
- Investment solutions that were, for years, accessible to large and complex institutional investors have become much more accessible for pension plans. Whether it is an exposure to real assets, alternative asset classes, a bond fund with extra-long duration or other illiquid asset classes, pension plans never had as many investment tools to manage the risks and return of their pension plan assets.
- In addition, dynamic asset allocations (glidepaths) that were established using only one set of triggers (solvency funded status for example) should now be revisited to account for changes to funding regimes. Finally, the discount rate on a going concern basis no longer needs to reflect the dynamic nature of the investment policy as per recent changes to Canadian Institute of Actuaries Standards of Practice.
- Other circumstances have contributed to making 2023 an inflection point year. The adoption of Bill C-228, the Pension Protection Act, potentially impacts pension risk transfer strategy. The Bill also raises the question on the appropriateness of the future level of PBGF coverage and premiums.
- Views on observed and expected inflation are influencing strategies for plans sensitive to it.
- Lastly, the impact of an aging population on the maturity of plan liabilities is accelerating. The proportion of liabilities attributable to inactive participants is rising, and consequently risk management or risk transfer views are evolving accordingly.
The path forward
A defined benefit pension financing strategy is a plan of action to help a sponsor or pension committee achieve its long-term objectives by optimizing the interaction between plan design, investment, funding and risk transfer actions, as shown below.
WTW Financing Strategy Framework
The toolbox associated with each of the levers shown above has never been so garnished. Given the significant changes described above, a strategy review may lead your organization to the adoption of a very different financing strategy than what was initially established.
In our next publication, we will provide insights for sponsors considering pension risk transfer transactions or pension plan wind-ups. More specifically, key considerations to determine the optimal trajectory.
Conclusion
2023 should be seen by pension plan sponsors as a turning point marked by an ability to make changes given healthy funded status for most sponsors. As funded status has not recently been so high, we have great conviction that now is the time to revisit the pension strategy and to take action to unlock value for all stakeholders.
