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Normandin Beaudry

Financial Position of Pension Plans

LinkedIn

There, in black and white

Bulletin NB Vol. 11 N. 11, October 2008

The situation that has been plaguing financial markets for some time is very troubling. What impact will it have on the financial position of pension plans?

The low level of interest rates and the stock market setbacks in the third quarter of 2008 will, in all likelihood, have a major impact on the financial position of pension plans.

Hurt by the U.S. real estate crisis, global stock markets began their plunge around the end of summer 2007. Certain events changed the U.S. financial landscape, including the government takeover of mortgage lenders Freddie Mac and Fannie Mae, the buyout of Bear Stearns and Merrill Lynch and the bankruptcy of Lehman Brothers, to name a few now famous examples. The relative immunity that the Canadian market had enjoyed up to the middle of 2008 ended abruptly with a sharp decline in the Energy and Materials sectors over the past few weeks. As a result of this context, the S&P/TSX Index fell 18% in the third quarter and the Materials and Energy sectors were down 34% and 27% respectively. The S&P/TSX Index took its biggest hit for 2008 in September when it slid 14% in a single month.

Table A below summarizes the returns for benchmark indexes for the third quarter of 2008 and since the start of 2008.

Table A - Market Performance for 2008

Asset Category Benchmark Index 3rd Quarter 2008 Jan. 1 to
Sept. 30, 2008
Short Term Securities DEX 91-day TB 0.8% 2.6%
Canadian Bonds DEX Univers -0.4% 1.8%
Canadian Equities S&P/TSX -18.2% -13.3%
U.S. Equities1 S&P 500 -4.7% -13.4%
International Equities1 MSCI EAEO -17.3% -24.1%
Global Equities1 MSCI World -11.8% -18.7%
Typical Pension Fund Combined Index2 -7.8% -9.0%

1 Returns converted into Canadian dollars.
2 Consists of: 2% in Short Term Securities, 38% in Canadian Bonds, 20% in Canadian Equities, 20% in U.S. Equities, 20% in International Equities.


 In addition, interest rates used to determine solvency liability fell slightly in 2008. The financial position of pension plans would most likely suffer should interest rates remain stable through the end of the year, because the actuarial liability would increase.

Impacts on the financial position of pension plans

Since the start of 2008, the rate of return for a typical pension fund has been around -9% following modest returns of around 1% for 2007. These returns are well below the long term assumptions set out in actuarial valuations. Sponsors of pension plans for which three-year actuarial valuation reports must be filed by December 31, 2008 could look into choosing a valuation date other than December 31.

Accounting expense

Poor returns could result in a significant increase in the accounting expense for the coming year, given the unamortized losses that will likely exceed the "10% corridor" for several organizations. This could significantly affect the statement of income and expenses. The only respite could come from an increase in the discount rate used to determine the actuarial liability on an accounting basis, which is determined by interest rates for high quality corporate bonds. Moreover, organizations that are subject to U.S. accounting standards must recognize in the financial statements the financial position of their pension plans, which may reduce shareholders' equity and have an impact on borrowing capacity if the plans are in an accounting deficit position.

Should the trend continue, the recent events that affected the stock markets and the low level of interest rates will contribute to the deterioration in the financial position of most pension plans at the close of 2008. This serves as a reminder that sound planning and risk management in a liability-driven investment context are critical for sponsors of defined benefit plans in order to mitigate risks associated with interest rate and market fluctuations.

 

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