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Pension barometer

The Canadian bond market rallied significantly in the final quarter of 2023, pushing the broad Canadian bond indexes into positive territory for the calendar year. The catalysts for the bond rally included inflation continuing its downtrend — the year-over-year inflation rate fell to its lowest level since June — and softer economic data, most notably in the labour market. These developments boosted investor expectations that the Bank of Canada (BoC) was finished with its series of short-term interest rate increases and have now turned its focus to when the BoC will cut rates, starting in 2024. This view was confirmed when the Bank held rates steady at its two interest-rate policy meetings during the quarter.

As the bond market began pricing in rate cuts by the Bank of Canada for some time in 2024, bond yields declined sharply across the board, boosting bond prices. Sector performance in the fourth quarter was uniformly positive, with provincial government and investment-grade corporate bonds delivering the strongest returns, while federal government and high yield corporate bonds lagged somewhat.

Canada’s stock market produced a robust gain in the fourth quarter to finish 2023 with a double-digit return. Slowing inflation fueled optimism that the Bank of Canada and other major central banks could begin cutting interest rates as soon as the first half of 2024. In addition, GDP growth appeared set to remain in positive territory in the fourth quarter following a contraction in the previous three months, raising expectations that the economy would experience a “soft landing.” Notably, the market’s advance occurred without the participation of energy stocks thanks to impressive gains for gold miners and financials. The rally helped the S&P/TSX Composite Index move out of its longstanding trading range and close the year near an 18-month high.

The world equity markets performed very well in the fourth quarter, as the worries that had weighed on sentiment earlier in the year rapidly dissipated. The U.S. Federal Reserve indicated it was likely on track to begin cutting rates in 2024 given the rapid deceleration in inflation. Other central banks were expected to follow suit, removing a headwind that had pressured investor sentiment for almost two years. At the same time, global growth remained in positive territory. This raised hopes that the economy could achieve a “soft landing” despite the protracted period of central bank tightening, which in turn would support corporate earnings. While nearly all major market segments and geographies finished with gains, mega-cap U.S. technology stocks continued to be an important source of leadership.

Canada yield curve

Source: Bank of Canada, Manulife Investment Management, as of December 31, 2023. 

For the fourth quarter of 2023, the average funded status moderated to 123.1% from 124.7% in the previous quarter. Although the assets generated a healthy return over the quarter, the growth in liabilities outpaced that of the assets with the sharp fall in yields over the quarter – resulting a funded status that is less healthy than the previous quarter. However, the current average funded status is significantly higher than what it was in December 2020. 

Funded status of the average defined benefit pension plan in Canada

Source: PFaroe Moody’s Analytics 2023, as of December 21, 2023. 

The average asset mix represents a combination of growth, hedging, and diversifying assets – each playing a unique role in the functioning of the pension portfolio. The average asset mix below implies an interest rate hedge ratio of 49.6%, relative to the interest rate exposure of the average liabilities.² Based on Manulife’s Capital Market Assumptions, the average asset mix implies an expected return of 5.22%. Based on Manulife’s modelling and stress testing, there is a 95% probability that losses relative to liabilities will be less than 14.68%.  

Equity risk represents a large component of risk exposure for defined benefit pension plans. Hence, a drastic downward move in Equity prices has the potential to reduce a big portion of the surplus for the average defined benefit pension plan in Canada. A decrease in interest rates also has the potential to negatively impact the surplus for the average defined benefit pension plan, as it would lead to an increase in present value of liabilities – as it did in the fourth quarter of 2023.

The table below illustrates the impact certain market moves would have on the surplus status of the Average Defined Benefit Pension Plan in Canada. 

Sources of relative risk for the average defined benefit pension plan

The chart below illustrates sources of relative risk for the average DB pension plan. As shown in the chart – a fair amount or risk is diversified away, and along with significant equity risk, the average plan also has exposure to interest rate risk, credit risk, and property risk.

Source: PFaroe Moody’s Analytics 2023, as of December 31, 2023. VaR refers to value at risk.

Solvency funded ratio

The chart below illustrates the Solvency Funded Ratio of the average defined benefit pension plan across various scenarios, ranging from best case to worst case, forecasted all the way out to 2033. Based on our scenario analysis, the median forecasted Solvency Funded Ratio for the Average Defined Benefit Pension Plan in December 2024 is 123.0%, and in December 2033 is 117.5%.  

Source: Manulife Investment Management, as of December 31, 2023. 

In Canada, the economy has shown significant signs of slowdown and we anticipate a moderate economic contraction in the first half of 2024.  Facing elevated interest rates, households have started to pullback. Pent-up demand and excess savings aren’t likely to underpin growth in 2024 and the mortgage refinancing schedule may hinder many people’s budget. Core inflation has been relatively more sticky than in the U.S but the BoC is likely to place more emphasis on supply/demand imbalances, trying to avoid a hard landing.  In the equity market, Canadian financial firms have seen relative strength. However, these companies could see weaker demand for loans due to a slower housing market and broadly fewer demand for credit.

Technical recessions or not, we believe 2024 will be a much more challenging year for economic growth globally compared with 2023. That economic hardship won't be felt equally across income groups or countries, with the United States more likely to withstand the tightening in the system relative to many other major economies as the country’s domestic focus, strong employment profile, and relative consumer health should all provide support.

Conversely, countries that are heavily exposed to international trade and constrained by their ability to borrow are likely to face significant headwinds during the first half of the year, with gradual improvement as central banks begin easing financial conditions. While no cycles are equal, this environment prescribes late-cycle investing strategies, especially in the first half of the year. That said, for many economies, it's often darkest before dawn, and sometime in 2024, it will be time to think about the beginning of the next cycle. Jumping too prematurely on this eventual rebound, however, is dangerous, as troubled waters are still yet to be crossed.

For Central banks, the fight against inflation continues as they reluctantly move past peak rates. Inflation eased significantly in 2023, but 2024 will likely show that the last leg of the inflation battle is more difficult, not just because year-over-year price growth will struggle to return to the pre-COVID norm, but because central banks will, ultimately begin easing before inflation definitively returns to target as they are forced to relent in the face of weaker growth, risking a reemergence of inflationary pressure.

Financial markets and their impacts on the pension industry are fast moving, and there's no one-size-fits-all approach. Our liability-driven investments and multi-asset solutions teams are here to help simplify markets and build strategies that work for you. Get in touch with us today to learn about how we can support your goals.