Since the financial crisis of 2008, a disturbing number of Canadian defined benefit pension plans have been underfunded and in a deficit situation. This means that their expected liabilities for the next 20 to 30 years - the benefits they have to pay out to their members - exceed the expected amount of future assets.
In very simple terms, the assets of a pension plan include the current amount of money in the plan, the expected future contributions by active members, and the expected investment returns on that total amount of money.
Actuaries are the professionals that make these calculations. (They are an exciting bunch, much like accountants but without that quirky sense of humor.) They make long-term assumptions about interest rates and investment returns, and then customize these valuations for each pension plan, based on factors like the ratio of active to retired plan members and average member age, to help determine an accurate estimate of the future assets and liabilities.
When the rate of return used in the long term projections is low, the calculation of assets is decreased significantly. This has been a problem since 2008, exacerbated by several years of low actual returns on investment portfolios.
And, inconveniently, pension plan members continue to get older, despite the strain that puts on their pension plans.
At the beginning of 2013, only 6% of Canadian pension plans were fully funded, according to the pension health index maintained by Mercer, the large pension, investment and HR consulting firm.
The good news? By December 31, 2013, the number of public and private pension plans deemed by Mercer to be fully funded had jumped to almost 40%.
The underfunded pensions are also in much better shape than a year ago, with only 6% now less than 80% funded, versus 60% at the end of 2012. That was a pretty scary number.
The overall rating at year-end is that pension plans stand at 106% of the required funding at December 31, their best level since June, 2001. The funding estimate was just 82% at the beginning of 2013.
So, what happened?
There are two main factors. The actuaries are now using a higher long term interest rate assumption, as a result of rates rising in the second half of 2013. As I mentioned earlier, the assumed future rate of return on all the money invested in pension plans makes a huge difference to the estimate of future assets.
As well, we have had another good year of stock market returns, with the S&P/TSX Composite index up 9.5% and the S&P 500 in the US up 29.6% over the last 12 months.
Most pension plans also invest in bonds, international stocks, private equity and infrastructure investments. With the exception of bonds, all of these sectors had good returns in 2013.
So, when actual returns exceed a cautious assumption, and the long-term assumption becomes more optimistic, the health index improves dramatically.
Plan sponsors - the companies and governments who are on the hook for any of these unfunded liabilities - will likely remain cautious, after more than 10 years of pressure on their balance sheets. The trend away from defined benefit plans to defined contribution plans will likely continue.
The defined benefit (DB) plan promises pension calculated as a certain percentage of a person’s final average salary, times the number of years as a member of the plan. If the plan has a deficit, it’s up to the employer to make up the shortfall.
In a defined contribution (DC) plan, the company agrees to match employee deposits each year based on a formula, but the ultimate pension available depends on the investment returns in the plan. The plan member could end up with more or less pension than with a DB plan, but the employer has put a cap on their share.
If you are in a pension, make sure you are clear on the type of plan and obtain an accurate estimate of your future benefits.
If you’re not a member of a pension plan, then remember you have to provide for yourself, through vehicles like RRSP, TFSA, rental real estate and other investments. Don’t leave it too late, or you’ll have your own personal pension deficit.
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Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.
Please consult legal, tax and investment experts for advice on your unique situation.
David Christianson, BA, CFP, R.F.P., TEP, is a financial planner and advisor with Christianson Wealth Advisors, a Vice President with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.