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Erosion of Canadian pension plans to halt in 2013: Mercer survey

Investment managers are predicting positive funding growth for pension plans in 2013, but most feel interest rates – which are critical to the health of pension plans – will change little in the coming year.

Funding forecasts unveiled Thursday by pension consulting firm Mercer show pension plans may not face further erosion of their funding this year after years of growing shortfalls. But they are also unlikely to see significant improvement.

According to the Mercer survey, 33 per cent of investment managers predict long-term interest rates will be largely unchanged in 2013, varying up or down by 0.25 of a percentage point or less, while 51 per cent predict rates could rise between 0.25 and 0.75 of a percentage point. Only 9 per cent forecast a significant drop in rates, and just 7 per cent thought there would be a large increase in rates.

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Brendan O'Brien, a principal in Mercer's investment consulting business, said higher rates "would be good news for pension plans."

Pension funds have been hugely affected by low interest rates because they must calculate the value of their pension liability using current interest rate levels.

Yields on 10-year bonds are currently about 2 per cent, far lower than the 8 to 9 per cent level they sat at 20 years ago. A rule of thumb in the pension sector is that every percentage point decline in interest rates boosts the liability for providing pensions by 10 per cent to 15 per cent.

Mr. O'Brien warned, however, that interest rate forecasts have been notoriously wrong, noting the Bloomberg monthly survey of economists has consistently predicted interest rates will rise since 2002. He said interest rates in Canada hovered around 3 per cent for 20 years from the mid-1930s to the mid-1950s, while Japanese interest rates have been below 2 per cent for the past 14 years.

"If we see Canadian rates staying lower for a long period of time, it wouldn't be unprecedented," he said during a Mercer pension forum in Toronto on Thursday.

Mr. O'Brien said he "wouldn't recommend" that companies rely on interest rates going up to solve their pension funding issues.

A key factor influencing interest rates is inflation, with rates rising as inflation grows. The Mercer survey showed fund managers are forecasting an inflation rate of 1.9 per cent in 2013, a steep increase from 0.8 per cent in 2012.

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In other areas, fund managers predicted Canadian gross domestic product would grow by 2 per cent in 2013, which would match growth in 2012, while global GDP would grow by 3 per cent, slightly down by 3.3 per cent in 2012. The S&P/TSX composite index was forecast to climb 5.6 per cent, which is less than the 7 per cent growth in 2012.

A small majority of fund managers expected longer bond yields to increase modestly from currently levels in 2013, although Manuel Monteiro, a partner in Mercer's financial strategy group, said none of the increases would be enough to restore most defined-benefit pension plans to fully funded status.

He said companies will likely need to increase their cash contributions to their pension plans in coming years or look at alternatives, like using letters of credit to defer payments.

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