Falling bond yields pose long-term risk to Canadian pension funds

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Canadian pension plans have shrugged off most of the impact of stock market turmoil following the Brexit vote, but problems with falling bond yields are poised to have a bigger and longer-lasting impact.

A new report on pension plan solvency by consulting firm Aon Hewitt shows pension plans saw their funding dip in late June following the Brexit vote, but made up part of the loss as stock markets recovered late last week.

Pension plans had a median solvency level of 85.4 per cent as of June 30, an increase from 83.1 per cent at the end of March. While solvency levels initially slumped by 1.7 percentage points in the two days after the Brexit vote, they recovered substantially as stock markets rallied.

But Aon Hewitt said falling bond yields are the bigger worry on the horizon for pension funds, which are required to measure the size of their funding obligation using long-term bond yields. As yields drop, the size of the pension liability increases.

Ian Struthers, Aon Hewitt's investment consulting practice director, said bond yields have not reversed course the way share prices did late last week.

"We believe the continued decline in bond yields, which is likely only to be aggravated in a post-Brexit world, highlights a longer-term challenge for pensions, and represents a risk factor that plan sponsors need to have a position on and address," he said in a statement.

Aon Hewitt credits the latest drop in yields to a rally in government bonds caused by investors fleeing to safe asset categories following the Brexit vote, which drove up bond prices and drove down yields as a result. Between June 23 and June 29, for example, the yield on Government of Canada benchmark 10-year bonds fell by 0.18 percentage points.

The Brexit turmoil, however, "only aggravated" a far longer-term decline in yields, Aon Hewitt said. From the start of 2014 to the end of June this year, for example, the yield on Canadian benchmark 10-year bonds has fallen by more than 1.6 percentage points.

Companies are not required to immediately fund shortfalls in their pension plans, but they must contribute cash if shortfalls persist over the long term.

A "continuing, deep low-yield environment" means pension plans are going to have trouble making their target returns, Mr. Struthers said. That means companies need to continue looking for ways to "de-risk" their pension plans through other investment strategies.

"It's difficult to see on the horizon anything other than heightened volatility in stocks and suppressed fixed-income yields," he said. "In this environment, active and informed risk and volatility management – including diversification, smart hedging and other de-risking strategies – should be on the minds of all pension plan sponsors."