By Joel Kranc

Markets have been on a wild rollercoaster seeing the Dow lose more than 1,000 points one day and back up in positive territory the next. Inflation remains high as well, and there is more and more chatter that a “soft economic landing” is less likely, leading to greater recession fears.

Still, a Mercer report on the state of Defined Benefit (DB) plans’ financial positions in the second quarter of 2022 shows an improvement in funding. The Mercer Pension Health Pulse, a measure that tracks the median solvency ratio of the DV pension plans in Mercer’s pension database, increased from 108% as of March 31, 2022, to 109% as of June 30, 2022.

“This quarter, and especially after the invasion of Ukraine by Russia, the world has entered a new world of volatility and uncertainty,” notes Ben Ukonga, Principal and leader of Mercer’s Wealth Business in Calgary. “But year-to-date, even though equity markets have gone down, and fixed income have also gone down due to [higher] rates, ironically, the financial position of most DB plans has improved due to the increase in interest rates.”

He explains that the liabilities of pension plans are based on interest rates. As liabilities and interest rates are going in opposite directions, the higher the interest rates are the lower liabilities are because a DB plan can discount future cash flows at a higher rate. Therefore, the higher interest rates has the effect of lowering the present value of future payments and therefore a lower obligation.

Said another way, similar to the first quarter, investment returns were negative for most DB plans in Q2 of 2022, and bond yields continued to increase. Yields, across all different durations, increased between 80 and 100 basis points during the second quarter, and have increased between 160 and 230 basis points since the beginning of the year. The increasing bond yields reduced plan liabilities, and the reduction in plan liabilities more than offset the reduction in plan assets leading to continued improvements in the financial positions of most plans.

Of the plans in Mercer’s pension database, at the end of the second quarter, 73% are estimated to be in a surplus position on a solvency basis, 16% of plans are estimated to have solvency ratios between 90% and 100%, 5% have solvency ratios between 80% and 90%, and 6% have solvency ratios less than 80%.

The war in Ukraine continues to be a major risk factor for investors as it creates continued volatility in the markets, especially as it is difficult to predict how long and how far it will go. “The war has also exacerbated the supply chain issues that existed before it,” says Ukonga. “Russia and Ukraine are both large agricultural exporters and, especially in the developing world, have experienced and are experiencing food shortages. We continue to believe appropriate governance and risk management systems are essential for the proper management of any DB plan. And plan sponsors and administrators need to frequently review and stress test these systems to ensure they will hold up if extreme market events occur,” Ukonga stresses.

He adds that plans should have well-documented systems that can withstand shocks (especially in an uncertain environment). Strategies will vary depending on the DB plans and their risk tolerance. The strategies and formal documents need to be living documents and not just kept on a shelf, he adds. The long-term nature of pension plans will also dictate the long-term strategies that may be needed.

Plan sponsors will also need to understand how high inflation will affect the plans they sponsor and their workforces. From the erosion of purchasing power for non-indexed DB pensions to the increase in the cost of indexed DB pensions. From higher salary demands from employees, which increase the ultimate costs of final average DB plans, to demands for benefit rate increases from members of flat benefit rate DB plans.

“The possibility of a recession arising from the global central banks’ efforts to battle inflation has dominated the narrative over the quarter.” says Venelina Arduini, principal at Mercer Canada. “We believe that markets will likely remain volatile for the foreseeable future. In this environment, we advise against second-guessing momentum and repositioning portfolios as events unfold. Investors with high liquidity needs should maintain sufficient buffers in portfolios and manage asset transitions carefully.”