Finally, some good news for benefit plans – they’re at their healthiest levels in over a decade, according to pension consulting firm Mercer. This is also good news for companies who saw their pension funding status plummet after the subprime mortgage crisis in 2008. The improvements come as a result of higher bond yields, which push interest rates higher – great for savers, if not so much for those trying to score a mortgage.
Bull Market, Rising Interest Rates Help Pensions
A whopping 40 per cent of defined benefit pension plans reached fully funded status at the end of last year, according to Mercer. This is a huge improvement from the beginning of 2013, when only six per cent of plans were fully funded.
2013 was a banner year for defined benefit pension plans, which reached their healthiest funding levels in 12 years. While the markets have seen plenty of ups and downs over the last decade, 2013 represented a return to stability. Pension plans benefited immensely from favourable market conditions – stock markets and long-term interest rates rose, while the Loonie weakened.
Understanding Pension Plan Funding Status
Canada is very strict when it comes to funding status – any shortfall must be made up by companies through larger contributions. In traditional defined benefit pension plans, employers bear all the investment risk.
Similar to workers saving towards retirement, pension plans invest in a combination of equity (stocks), fixed income (bonds) and cash. 2013 was a stellar year in the stock markets in North America – the TSX was up nine per cent, while the Dow was up an astounding 26 per cent. Improving equity returns mean fewer contributions by employers.
Rising Yields and Better Pensions
Despite the overnight lending rate staying put at one per cent, we saw a significant improvement in the bond market last year. Previously pension plans were hurt by falling bond yields, which decreased the discount rate applied to future payments, while increasing their liabilities.
The trend was reversed in 2013, which saw long-term Government of Canada bond yields reach 3.2 per cent by year-end, up from 2.3 per cent at the beginning 2013. To put this into perspective, a one per cent increase in long-term interest rates would decrease pension liabilities between 10 per cent and 15 per cent.
Are Defined Benefit Pension Plans Here to Stay?
You’d think companies would breathe and sigh of relief and reconsider shifting away from defined benefit to defined contribution – in fact, the opposite is true. The return to fully funded status represents an opportunity for companies to reexamine their pension plans.
When funding status improves, it’s a lot less costly for employers to de-risk. According to pension experts, this is an ideal time to consider de-risking strategies, such as switching to defined contribution or closing defined benefit plans to new hires.
Factors Driving Rates Up
The Fed’s recent decision to ease up on quantitative easing (QE) is one of the key factors that could drive rates up in 2014. Ben Bernanke’s decision to taper will eventually be felt in Canada. This could result in higher Government of Canada bond yields in 2014 – good news for defined benefit pension plans, but bad news for anyone renewing a fixed rate products. We already saw Government of Canada bond yields edge up this past summer on fears the Fed would ease up on QE, so it will be interesting to see what’s in store for 2014.