Goodbye 2022, Hello 2023: a brief review, and a look ahead
With the transition to a new year, it is time again to take stock of what happened to defined benefit pension plans last year and look ahead to what to expect in the year ahead.
What Happened in 2022
As 2022 has come to a close, financial market commentators have stopped calling the elevated rates of inflation ‘transitory’, and the more interesting question is when (hopefully not if) inflation will be brought to heel, and whether this can be achieved with a ‘soft landing’, or if the economy is headed into a recession.
Throughout much of the developed world, central banks dramatically increased their policy rates in 2022 as a means to curb higher inflation. In particular, the Bank of Canada increased its policy rate from 0.25% to 4.25% over the course of 2022, with another anticipated increase expected in their next meeting on January 25, 2023.
While the overnight rate increased 4.00% in 2022, long-term government bonds only increased by about 160 basis points from December 31, 2021 to December 31, 2022 – potentially suggesting that market participants have faith that the Bank of Canada will be successful in getting inflation under control in the near future.
While the considerable increase in interest rates (and bond-yields) have made investing in fixed income assets more attractive going forward, it has led to capital losses for those that held fixed income investments in 2022. Specifically, one of the worst performing asset classes in the past year has been long-term bonds which declined by about to 22% in 2022, followed closely by universe bonds which declined by close to 12% in 2022.
Equity investments did not fare much better in 2022. Here, the Canadian TSX Composite Index decreased about 6%, and the US S&P 500 Index was down about 12% in Canadian dollars in 2022.
In light of these investment returns, we would expect that unhedged pension plans could see their assets decline by around 10% in 2022.
However, with the considerable increase in interest rates that occurred in 2022, there has also been an increase in the commuted value and annuity purchase interest rates that are used to value the solvency liabilities for pension plans. In particular, the interest rate for annuity purchases has increased by just shy of 2% in 2022, and commuted value interest rates are also well over 1% higher than a year ago. With such a significant change in these rates, we expect that the solvency liabilities for pension plans have decreased substantially in 2022, and in some cases by up to 20%.
Thus, with respect to their solvency status, we expect that 2022 will have been a favourable year for unhedged pension plans (i.e. those that have not already adopted a ‘de-risked’ investment strategy), with plan sponsors experiencing an improvement in their solvency funded status by potentially as much as 10%.
However, with respect to their going-concern status, we expect 2022 will be a down year for most unhedged pension plans. In most cases, the interest rate assumption used for going-concern valuations tends to be a long-term assumption that is not ‘marked-to-market’ with the exact changes in interest rates. While plan sponsors may see a slight increase in their going-concern interest rate assumptions, it is likely that the decline in plan assets will be greater than the expected pick-up from the decline in the going-concern liabilities.
Nevertheless, many plans had a sufficient level of surplus on a going-concern basis at the beginning of 2022, and many are still expected to be in a surplus position at the end of 2022. Thus, the decline in the going-concern funded status may not impact their special payment requirements; and further, any potential increase in their going-concern interest rate assumption may decrease their current service cost contribution requirements.
As a result, we expect that the 2022 experience will be viewed as a net positive for the funding of most pension plans. For pension plans where the solvency position is the main driver of the funding requirements, the improved solvency position for unhedged pension plans may generate relief from special payment funding requirements. For pension plans where the going-concern basis is the main driver of the funding requirements, there will be a more delicate balance between the deterioration in the funded status and its potential impact on the special payment contribution requirements, and the potential impact of an increase in the going-concern interest rate assumption which may decrease the current service cost contribution requirements.
Accounting Position at December 31, 2022
In addition, the yields on high-quality corporate bonds increased by close to 2.00% from December 31, 2021 to December 31, 2022. Thus, plan sponsors with a December 31st financial statement measurement date, and who use these high-quality corporate bond yields to develop their discount rate assumption for the benefit obligations used in their financial statements, should see that their benefit obligations for their pension and other post-retirement benefit plans decrease by 20% or more at December 31st.
While this will make the financials look quite favourable in 2022, plan sponsors should not expect to see such dramatic increases in interest rates in future years. Further, if interest rates decline, then these gains could be reversed in future year financial statements.
Looking Forward in 2023
Here is a list of items we will be watching for in 2023:
Bill C-228: As noted in a previous blog, Bill C-228 is a federal bill which proposed to amend the Bankruptcy and Insolvency Act, the Companies’ Creditors Arrangement Act, and the Pension Benefits Standards Act, 1985 to provide super-priority to pensions in the event of plan insolvency, and aims to ensure that a plan sponsor prioritize paying pensions before paying the claims of other creditors. This bill has progressed through the House of Commons and is now making its way through the Senate. As noted in my previous blog, this bill could lead to various unintended consequences. In particular, sponsors of defined benefit pension plans may see an increase in their borrowing costs, or experience greater restrictions on their borrowing, which may in turn lead them to respond by first ‘de-risking’ their investment strategy, and ultimately lead to them winding-up and terminating their plans.
De-risking: Irrespective of Bill C-228, we continue to see plan sponsors increase their desire to ‘de-risk’ their investment strategy and/or formally wind-up their plans. This is especially true for plan sponsors who previously decided to transition away from providing a defined benefit pension to their employees, but still have closed and/or frozen defined benefit pension plans.
As a reminder, the decision to de-risk/wind-up is never straightforward, and today there are numerous alternatives to winding-up – such as transferring to a jointly sponsored pension plan like CAAT or obtaining a discharge via an annuity purchase buy-out. As such, we would encourage plan sponsors to discuss these options with their consultant prior to making a decision.
Ontario Target Benefit Pension Plan Framework: In its 2022 Budget, the Ontario government acknowledged that Specified Ontario Multi-Employer Pension Plans have been operating under temporary regulations that will expire in 2024 unless replaced by a permanent framework. The Ontario government said that it would consult will affected stakeholders on proposed regulations before implementing a permanent target benefit framework in 2023. Developments on this initiative will be of particular interest to trustees, employers, and members involved in multi-employer pension plans. Further, it will be interesting to see if this new framework will open the door for more innovation in the pension industry and expand the use of target benefit pension plans beyond the sphere of multi-employer pension plans.
Real Return Bonds Discontinued: In late 2022, the federal government announced it would cease issuing real return bonds. This decision will have significant implications for pension plans with indexed liabilities, as real return bonds provide an ideal inflation-linked hedge, and also provide a benchmark for the ‘break-even inflation rate’ implicit in the yields in government bonds. A couple of consequences of this decision could be that the pricing for indexing annuities could increase, and that there will eventually be a need to revise the commuted value standards for inflation-linked pensions. I wish to note that there have been a number of market participants who have expressed their disappointment with this decision and have requested that the federal government reconsider this decision. My hope is that the federal government would reverse this decision, and resume issuing real return bonds, irrespective of the fact that real return bonds are a negligible amount of the federal government’s total bond issuance.
Surplus: We continue to see the emergence of surplus in some pension plans. This is an acute issue for plan sponsors that are looking to wind-up their plan in the near future, as they may wish to consider various strategies on how to utilize the surplus (such as benefit improvements and contribution holidays), or potentially even reconsider their decision to wind-up their plan.
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As a reminder, we encourage plan sponsors to continuously monitor their plans, and to contemplate their long-term strategy for providing pension benefits. At a minimum, this includes periodic reviews of their investment and funding policies. As we begin a new year, now may be as good a time as any to review the design of your company’s pension plan(s) to ensure that they continue to meet the needs of the organization and its employees.
All the best to you in 2023!