Increased leverage due to a lower interest rate environment and demographic shifts is driving the investment stakes higher for some Canadian pension plans. The average leverage of the six largest funds in Canada rose to 24% from 19% since 2009, according to a recent report by Moody’s. The combined assets of the plans represented C$1.4 trillion ($1.1 trillion) in assets as of 2016.
“As in many other countries, Canadian defined benefit pension plans are facing adverse demographic shifts thanks in part to an aging baby boomer population,” Jason Mercer, assistant vice president of Moody’s, said in a statement. “The active-to-retired ratio, a measure of the relative proportion of contributing members to retirees collecting benefits, has fallen for all six pension managers in the past 10 years as growth in retirees outpaces contributors.”
The pressure to pay higher benefits with lower contributions, in part, has forced the plans to become more reliant on investment income, according to the report.
Further, funds that increase leverage and illiquid assets in order to generate returns high enough to ease funding pressures from aging demographics and low interest rates also increase the pension fund’s asset risk in the event of a market correction. Increasing leverage involves higher risks for pension managers since leverage magnifies losses as well as gains.
“Weaker net cash flows make funds more dependent on market performance to maintain current funding levels,” added Mercer. “But low interest rates hinder the funds ability to make returns strong enough to offset the net cash flow pressures.”
Canadian public pension funds are generally considered to be of high credit quality, given their strong stability and predictability of future cash flows, predictable national and provincial legal systems, highly-rated sponsors and strong coverage of obligations by high quality liquid assets, according to Moody’s. However, high leverage and less-liquid investments raises risk for the pension funds.
“Should a prolonged decline in investment values materialize, higher interest costs and lower liquidity would further strain fund cash flows,” said the report. “This could result in cuts to retiree benefits and/or increases to contribution rates from employees, and employers would commensurately reduce liabilities and/or bolster pension plan asset positions.”