Falling Bond Yields ‘Warning Sign’ for Canadian DB Plan Sponsors

The solvency positions of Canadian defined benefit pension plans declined slightly during the third quarter due to declining bond yields and stalling asset returns amid global economic uncertainty, according to professional services firm Aon’s most recent Median Solvency Ratio survey.

Aon said that although the overall solvency remains relatively high for the defined benefit plans, the decline in yields and dimming economic outlook should be taken as a “warning sign” for pension plan sponsors.

“Bond yields continued to fall in the third quarter, and the risk that equity returns are going to follow them is becoming more and more clear,” Erwan Pirou, CIO for Aon’s Delegated Investment Solutions in Canada, said in a release. “Economic uncertainty seems to have set into financial markets, which means we don’t foresee a sustainable rebound in yields anytime soon.”

Pirou said that the falling bond yields are increasing plan liabilities at the same time that the return horizon for equities is looking “murky.”

According to Aon’s research, plan sponsors are increasingly turning to alternative investments in search of yield and diversification.

“And that makes sense,” said Pirou, “but it might not go far enough. Plan sponsors need to consider every means to take risk off the table, including hedging strategies. Time might be running out.”

Aon’s median solvency ratio measures the financial health of a defined benefit plan by comparing total assets to total pension liabilities on a solvency basis. The analysis takes into account the index performance of various asset classes, as well as the applicable interest rates to value liabilities on a solvency basis.

The solvency ratio declined to 98.6% during the third quarter, from 99.3% at the end of the second quarter. A majority of the plans are in a solvency shortfall that figure rose to 52% as of Sept. 30, up two-tenths of a percentage point since the end of the second quarter.

Continuing their decline from the previous two quarters, Canadian 10-year yields were down eight basis points, and Canada long-bond yields were down 11 basis points during the third quarter. Because lower yields increase pension plan liabilities, this movement adversely impacted plan solvency.

The survey also found that pension assets returned 2.2% during the quarter, compared with a 2.7% return the previous quarter.

In Canadian dollar terms, most equity indices had “weak returns,” as the Canadian S&P/TSX composite rose 3.1%, while the US S&P 500 gained 3.6%, and the global MSCI World and international MSCI EAFE indices increased 2.3% and 0.3% respectively. And the MSCI Emerging Markets index declined 2.3% during the third quarter. Real asset returns had strong returns due to investors seeking diversification from equity exposures as global real estate rose 5.6% in Canadian dollar terms, while global infrastructure increased 4.4%.

“Plan sponsors might not be pursuing de-risking strategies aggressively enough; if they aren’t, now is the time for a rethink,” said William da Silva, Aon’s Canadian Practice Director, Retirement Solutions. “Strong solvency over the past few years has given Canadian pension plans a huge window of opportunity to lock down an end-game strategy, but that window seems to be closing.”