Inflation – It’s Not All Bad News for Defined Benefit Pension Plan Sponsors
There’s definitely no hiding from higher inflation these days – it’s everywhere from the gas station, to the grocery store, to the rent bill. According to the most recent information from Stats Canada, the annual inflation rate in Canada was 6.8% in April, and I don’t see any signs of it slowing down soon.
There are lots of theories on how long this will last, how bad will it get and how we will get ourselves out of this mess [see ‘further reading’ section at end], but today I’m going to focus on some of the potential implications of high inflation for defined benefit pension plans.
I always like to get bad news out of the way first.
As we’ve seen so far in 2022, high inflation is causing increased volatility in the financial markets, and this increased volatility is resulting in a greater degree of unpredictability in the funded status of DB pension plans. Financial markets and CFOs really don’t like uncertainty.
As Dean mentioned recently, equity markets are struggling so far in 2022, reacting to higher inflation, higher interest rates and other negative news. We’ve also seen dramatic increases in interest rates – both at the short end with the various central banks raising rates, as well as at the long end of the yield curve.
My view is that this higher level of volatility in investment returns will continue for the foreseeable future as we deal not only with higher inflation but with other related maters such as supply-chain bottlenecks, higher energy costs, and the transition from pandemic to endemic. Plan sponsors can either choose to ride out this volatility like they have several times in the past, or perhaps now is a good time to revisit the pension plan’s investment strategy with a view to reduce investment risk.
More directly related to inflation, some DB pension plans provide for automatic indexing in retirement, and for those plans their monthly pension promises will be going up faster than expected for at least a little while, which is bad news for those plan sponsors. In the private sector, very few pension plans have automatic indexing; however, those plans will not be totally off the hook as pensioners will increasingly start asking for ad-hoc increases to their pensions – which may be hard to ignore if the pension plan is currently in a surplus position.
The biggest good news for DB pension plan sponsors is the significant rise in long-term interest rates. This has the effect of dramatically reducing the solvency and accounting liabilities for many DB pension plans. I’ve talked to a number of clients recently who were expecting very bad news after hearing all the doom and gloom in the financial markets, but were pleasantly surprised to hear that their pension plan’s solvency ratio had actually increased thus far in 2022 – their liabilities are dropping faster than their investment portfolio. So far at least…
For active employees who are still earning DB pension benefits linked to their salaries, we have not yet seen higher inflation directly translate to higher salary increases across the board in Canada. So, this is also good news for pension plan sponsors, at least for now.
On the flip side, we have seen higher average wages in Canada over the past couple of years due to the lower wage employees becoming unemployed or under-employed during the pandemic. This automatically resulted in higher Canada/Quebec Pension Plan benefit and contribution thresholds which are tied to average wages. This is generally good news for DB pension plans that are integrated with C/QPP as a larger share of an employee’s pension will come from the government-sponsored pension plan and less from the employer-sponsored pension plan. It’s also good news from the employee’s point of view as a larger share of their benefits will come from a highly-secure and fully-indexed pension plan. [Side note: For those nearing retirement, if you have the means, you should seriously consider deferring your C/QPP pension until age 70.]
Interestingly, the long-term breakeven inflation rate that is implied by the difference in the yields between nominal and inflation-linked bonds, is currently just under 2% in Canada. This seems to imply that the financial markets are expecting the Bank of Canada and other central banks to be successful relatively quickly in bringing inflation back under control. Time will tell.
On a related note, over the past 40+ years we’ve been trained to think that inflation of 2% per year is the correct answer, but is that really the case and how aggressive do we have to be in our efforts to get back there as quickly as possible? Of course hyperinflation is very bad and destabilizing, but what about inflation of 5%-10% per year? Some experts think that moderate inflation isn’t as bad as we’ve been led to believe, as research has often shown that there is no strong evidence of actual economic harm outside of true hyperinflation [see ‘further reading’ section at end]. So, perhaps we should just keep calm and carry on.
My prediction, albeit with a high degree of uncertainty, is that inflation will get back under 4% by the end of 2023 and in the following years slowly return to the 1% to 3% range targeted by the Bank of Canada, but it will be a bumpy ride with higher than normal volatility in the stock and bond markets in the meantime.
The precise implications of high inflation over the short, medium and long term on a particular DB pension plan is complex and multifaceted. Plan sponsors are encouraged to regularly check-in with their actuary to get an up-to-date snapshot of the health of their pension plan, and to revisit their funding and investment policies. It may also be prudent to run some scenarios to better understand the implications of high/low inflation, interest rates and investment returns.
For Further Reading
For those interested, and with access to a subscription to The Economist, here are some link to recent articles on inflation: