The quarterly pension plan solvency ratio survey by Aon Hewitt, which assesses the financial health of pension plans by measuring their market value of assets over liabilities, found the median solvency ratio not only fell for the third quarter in a row, but dropped below 90 per cent for the first time since September 2013.
On March 30, the median solvency funded ratio stood at 89 per cent. This represents a two percentage point decline from the previous quarter, and a six point drop from a year ago. Only 18 per cent of surveyed plans were more than fully funded at the end of Q1, roughly equivalent to the previous quarter, but down significantly year-over-year.
The key drivers of lower solvency were declining long-term interest rates and the corresponding decrease in discount rates used to value plan liabilities. Following significant volatility in 2014, interest rates fell dramatically in the first quarter, as 10-year bond yields dropped by about 40 basis points. Countering the difficult rate environment was the performance of U.S. equities (9.3 per cent) and global equities (11.4 per cent), and ,to a lesser extent, Canadian equities (two per cent).
By historical standards, overall plan solvency remains strong, and well above the recent low-water mark of 66 per cent set in 2012. As well, plan sponsors who took advantage of their relatively robust positions by adopting de-risking strategies, such as delegating investment oversight and decision-making to an outsourced chief investment officer (OCIO), bucked the downward trend and saw solvency increase for the second quarter in a row.
“Falling interest rates are adversely affecting the health of traditional DB plans, but we are seeing a clear picture emerge of the benefits of taking a different course and adopting de-risking strategies,” said William da Silva, senior partner with Aon Hewitt’s retirement practice. “The evidence of the past few quarters shows that stronger risk management can help Canadian pension plans weather the storm of market and interest rate volatility, and enable them to better meet their obligations over the long term. In fact, while the financial health of surveyed plans decreased overall during Q1 2015, the median solvency ratio of those clients who have delegated execution of their risk management strategy to us increased by 1.4 percentage points.”
Traditional DB plans typically have a 60/40 equity-bond mix. Plans that have adopted de-risking strategies seek broader diversification through allocations to asset classes like hedge funds, real estate and infrastructure.
These assets produce stable returns over time and have lower correlation to equity markets. Hedge funds target low-volatility, absolute returns, and have had a very low correlation to traditional equity classes. Global REITs and infrastructure assets, meanwhile, have offered excellent returns (13.5 per cent and 10.5 per cent, respectively, in Q1 2015) and additional diversification.
“Gaining exposure to non-traditional asset classes can effectively mitigate risk and achieve portfolio diversification beyond bonds and equities,” said Ian Struthers, a partner with Aon Hewitt’s investment consulting practice. “Combining this with a strong governance process that dynamically reassess risk is very powerful. We have seen plans materially outperform by taking advantage of gains in value, to manage asset allocations and shift from return-seeking assets to interest rate hedging strategies. They protect their gains. There are different options
for implementation, from following a clear investment policy to adopting an OCIO model.”
The solvency funded ratio measures the financial health of a defined benefit plan by comparing total assets to total pension liabilities in the event of plan termination.
Aon Hewitt’s median solvency ratio is developed using a database of 449 pension plans from the public, semi-public and private sectors and from most Canadian provinces. Each plan’s characteristics and data are used to project their solvency ratio on a monthly basis. These projections take into account the increase in financial indices for various asset classes, as well as the applicable interest rates to value liabilities on a solvency basis.