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Normandin Beaudry

Interest rates continue to fall... again

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There, in black and white

NB Bulletin Vol. 13 N. 13, November 2010

Interest rates on long-term maturities have fallen substantially since the start of 2010. Despite the fact that the Bank of Canada began adjusting its overnight rate, long-term interest rates, which influence the value of actuarial liabilities, reached levels similar to those attained at the height of the financial crisis of 2008. This trend intensified in the third quarter of 2010.

Low rates result in good returns on bond markets, but could have a less positive impact on the financial position of pension plans. Pension committees and pension plan sponsors should immediately prepare to assess the effects of low interest rates on the financial position of their pension plans at the end of 2010.

The bond market as at September 30, 2010

The table below presents total returns for various Canadian bond market indexes. The strong returns highlight the impact of low interest rates on bond performance.

Indexes3rdquarter
2010
Year to date
(as at sept. 30, 2010)
Universe3.2%7.5%
Long Term5.6%13.9%
Real Return5.2%9.4%

Effects on actuarial valuation assumptions

Pension plans subject to solvency standards and required to file an actuarial valuation report as at December 31, 2010 will be hit hardest by these low interest rates. What will the impact be on the discount rate used for solvency valuations?

Since the end of 2009, the discount rate prescribed by the Canadian Institute of Actuaries for the solvency valuation of a pension plans actuarial liabilities decreased by around 0.5% for non-indexed pension plans and around 0.4% for indexed pension plans. The value of the liabilities of a non-indexed pension plan could increase by 5% to 10% in 2010. There will be less of an impact on indexed pension plans.

As regards to accounting valuations, the effect will be felt even more. Keep in mind that the discount rate for accounting valuations is based on high quality corporate bond yields which fell by approximately 0.75% in 2010.

Impact of market volatility on the financial position of pension plans

The other element that will impact the financial position of pension plans will be the equity performance for 2010. As previously mentioned, bond yields were very positive as at September 30, 2010. Returns on Canadian and Global equities have been around 7.5% and 1.0% respectively since the beginning of 2010.

A typical pension fund with 60% of the fund invested in equities and 40% invested in bonds, obtained a return between 5.0% and 7.5% as at September 30, if the bond portfolio is invested in Long-term or Universe bonds. With respect to risk management, long-term bonds definitely helped protect the financial position of pension plans.

Given the combined impact of returns on equities and low interest rates on the value of actuarial liabilities, pension committee members and sponsors can expect to observe a deterioration over the previous year in the financial position of their pension plan as at December 31, 2010. Unless the third quarter stock market trends continue, this situation will have an adverse effect on the solvency of most pension plans. The effects will be intensified for plans that already have an actuarial deficit.

In a context of low interest rates, long-term nominal bonds, which are more sensitive to changes in interest rates, performed best. Real return bonds, which provide protection against inflation increases, also generated strong yields owing to their long terms to maturity.

 

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