Defined Benefit Pension Plans Stuck in the Doldrums according to the Second Quarter Results for 2012
No improvement in solvency funded ratio since the last quarter
TORONTO, July 5, 2012 /CNW/ - Negative equity returns and a decrease in interest rates were the main reasons for the deterioration of the financial status of pension plans in the second quarter of 2012, according to Aon Hewitt, the global human resource solutions business of Aon plc (NYSE:AON). The median solvency funded ratio of a large sample of pension plans has decreased from 69% at the end of March 2012 to 66% at the end of June 2012. This is a further decline of funding positions relative to the start of 2012—despite significant cash contributions being made to pension plans—leaving many plan sponsors lost for what they can do to resolve their pension funding crisis.
About 97% of pension plans in this sample had a solvency deficiency as at that date. The solvency funded ratio measures the financial health of a defined benefit pension plan by comparing the amount of assets to total pension liabilities in the event of a plan termination.
We can see that assets have only increased by 12% over the 2 1/2 year period since January 1, 2010 - despite significant contributions being made over the period. A typical pension fund earned an average annual return of 4.9% over this period, caused by disappointing equity markets performance: 2.3% for the Canadian stock exchange, 9.4% (in Canadian dollars) for U.S. equities and -1.6% (in Canadian dollars) for international equities.
While asset returns have remained low, it is the 46% increase in liabilities that has caused much of the current solvency crisis. This has been mainly caused by the significant drop in long term interest rates over the period. "A 1% drop in long term interest rates will increase liabilities by about 18% for a typical pension plan" says Thomas Ault, an Associate Partner and actuary with Aon Hewitt in Vancouver "which is why the decline in interest rates since the start of 2010 has had such a dramatic effect on solvency liabilities".
Impact of de-risking
Aon Hewitt has tracked the performance of a plan that employed a few simple de-risking strategies since January 1, 2011 namely:
- Increased investment in bonds from 40 per cent to 60 per cent of portfolio
- Investment in long bonds instead of universe bonds to better match liabilities.
The de-risked plan would have experienced a 75% solvency ratio as at June 30, 2012 as opposed to 66% for the median plan.
Will interest rates ever go up?
There is a lot of pressure on interest rates to stay low, according to André Choquet, an investment consultant and actuary with Aon Hewitt in Toronto. "Given the size of the Canadian long bond market ($266 billion) compared to the Canadian DB pension plan market ($976 billion), no wonder yields stay low with such a strong demand for long bonds. Add to this the demand for Canadian bonds by foreign investors and the stage is set for plan sponsors having to make up deficits with contributions in the future unless a Danish solution is adopted".
In Denmark the government has tackled the low yield problem by allowing sponsors to raise the discount rate used to calculate the liabilities of pension plans. The decision sent yields on longer-maturity bonds soaring as the industry's need to buy up debt assets to match pension obligations was reduced.
"In the face of continuing low interest rates plan sponsors are considering many options for their funding challenges," says Ault. "Their choice depends on whether they are in it for the long or short haul."
Those sponsors who are in it for the long haul are considering:
- Interest rate hedge path to gradually increase the allocation towards long term bonds as interest rates increase or as time goes by
- Solvency relief offered by provincial regulators where available
- Letters of credit to avoid making cash solvency contributions in the hope that interest rates will rise at one point in the future and erase funding deficits
For those sponsors who have a more limited time horizon to solve their pension deficit crisis, historically the only option has been to make significant cash contributions to settle the unfunded portion. However, increasingly over the last few months, we are seeing traction and creativity in the products provided by insurance companies to help plan sponsors avoid such significant contributions.
"The recent transaction in the US that saw up to $26 Billion worth of retiree liabilities being transferred from General Motors to Prudential Financial may open the door to similar transactions in the future" adds Choquet. "But just like the long bond market, the annuity market in Canada has limited capacity so first movers will have an edge".
About Aon Hewitt
Aon Hewitt is the global leader in human resources solutions. The company partners with organizations to solve their most complex benefits, talent and related financial challenges, and improve business performance. Aon Hewitt designs, implements, communicates, and administers a wide range of human capital, retirement, investment management, health care, compensation and talent management strategies. With more than 29,000 professionals in 90 countries, Aon Hewitt makes the world a better place to work for clients and their employees. For more information on Aon Hewitt, please visit www.aonhewitt.com.
Aon plc (NYSE: AON) is the leading global provider of risk management, insurance and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 61,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative and effective risk and people solutions and through industry-leading global resources and technical expertise. Aon has been named repeatedly as the world's best broker, best insurance intermediary, reinsurance intermediary, captives manager and best employee benefits consulting firm by multiple industry sources. Visit www.aon.com for more information on Aon and www.aon.com/manchesterunited to learn about Aon's global partnership and shirt sponsorship with Manchester United.
Image with caption: "Aon Hewitt Survey of Median Solvency Ratio 2010-2012 (CNW Group/AON Hewitt)". Image available at: http://photos.newswire.ca/images/download/20120705_C6320_PHOTO_EN_15977.jpgFor further information:
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