The BoC’s October rate hike puts DB plan indexation and long-term funding assumptions under the spotlight
The Bank of Canada’s decision to raise interest rates for the first time in three years has caused pension plan sponsors to take notice. While the October 28 decision to raise the overnight rate from 2.25 per cent to 2.50 per cent may have been anticipated, the inflation outlook behind it carries real consequences for defined benefit plans with indexation exposure.
The question of how elevated inflation affects pension plan funding and indexation obligations is now front of mind. DB plans with automatic or conditional cost-of-living adjustments face growing pressure from retirees seeing their purchasing power erode – even if core measures have not yet caught up to headline figures.
Randall Bartlett, deputy chief economist at Desjardins Group, argued the risk varies across the pension landscape.
Inflation expectations forced the Bank’s hand
“Many Canadian plans have release valves that allow them to delink benefits for a short period of time because of high inflation. Or take other measures that allow them to minimize the risk of the funded status of the plan during periods of elevated inflation,” he said. “It’s something that every individual plan leadership is going to need to contend with differently.”
He suggests those provisions will be tested sooner than some sponsors may have expected. While markets generally priced in the rate hike before October’s meeting, Desjardins projects another hike in December. Bartlett himself also doesn’t rule out a third hike.
“The increase in inflation expectations as well as businesses saying quite clearly that a larger share of them plan to pass more of their higher input costs on to consumers over the next year really pushed the market pricing toward a hike. And I think was really the straw that broke the camel's back in terms of putting the bank clearly in hiking territory as well,” said Bartlett.
For plan sponsors managing long-duration liabilities, the near-term rate path matters less than what’s embedded in the long end of the curve, Bartlett suggests. He noted that markets are currently pricing in another three to four hikes by each of the Bank of Canada, the Fed, and the ECB. While Desjardins thinks that’s too aggressive as the firm expects perhaps one more from the Fed and one from the ECB before both start to ease, if those extra hikes never materialize, rate expectations should come off and pull longer-term yields down with them.
Bartlett also cautioned that would be a tailwind for liability valuations, even as the term premium on longer-term bonds stays elevated.
“The real question for us now is not whether or not there’s going to be an additional hike, but whether or not there will be one more after that and whether because of this additional global demand for capital, we’re actually seeing that the neutral rate is starting to move higher in Canada,” he added. He put the potential new neutral rate at 3 per cent, up from the Bank’s current estimate of 2.75 per cent.
A new benchmark for underlying inflation
Whether the tightening cycle extends beyond October hinges on how fast cost pressures filter into core prices, Bartlett noted, adding the Bank’s traditional preferred measures - CPI trim and CPI median - still show no pass-through from higher energy prices, but the governor has moved away from those gauges. The MPR and the governor’s opening remarks pointed instead to total CPI excluding food and energy as the Bank’s new benchmark for underlying inflation.
The shift matters because the inflationary effects of tariffs on Canadian imports, a weaker dollar, and elevated energy costs haven’t landed in consumer prices yet but Bartlett underscored it’s only a matter of time until they will.
“The Bank of Canada can’t really look at past inflation necessarily as an indicator of future inflation. The possibility of another rate hike after that isn’t our baseline call, but certainly that’s where the balance of risks is starting to tilt at this point,” he said.
Even with the Bank tightening at the short end, Desjardins expects longer-term yields to fall. Bartlett said the market has overshot in pricing three to four additional hikes from major central banks, and as those expectations unwind, the long end should come down with them.
There’s also a notable disconnect between how different actors are reading the inflation picture. Consumer and business surveys show rising expectations — and that’s what’s driving central bank action — but bond markets haven’t flinched, he said.
“Markets are not particularly fazed about inflation at this point in the sense that we don’t see market-based measures of inflation expectations having moved at all, actually, through all of this,” Bartlett said.
What has pushed longer-term yields higher is a combination of rate hike expectations and a growing term premium fuelled by a global surge in long-dated bond issuance. Once the first of those drivers fades, Desjardins expects the yield curve to flatten from here.
“The bank is still expecting core inflation to be elevated next year. Certainly, higher than where we are currently in our projection,” Bartlett added.
“But the bank is hanging its hat on stronger underlying inflation going forward because of these supply shocks related to the trade war, conflict with Iran, and the weaker Canadian dollar that we've seen so far.”
Pension plans adjust to hawkish world
Still, Bartlett believes the Canadian economy can likely absorb another 25-basis-point increase without a significant slowdown, and Desjardins’ ongoing work on the neutral rate suggests it may sit closer to 3 per cent than the current 2.75 per cent, meaning there could be room for a further hike beyond that before monetary policy becomes actively restrictive.
While Bartlett deferred on the specifics of how additional hikes affect plan liabilities, he expects most Canadian plans have already begun hedging against the interest rate risk that a more hawkish regime entail. Plan sponsors who built discount rate assumptions during the prolonged hold at 2.25 per cent earlier in 2026 now face a different era.
“The world has moved more hawkish, especially in North America,” Bartlett added. “I'm sure the sophisticated investors at Canadian pension plans have been listening closely and taking that into account and making their decisions.”
To that end, according to Bartlett, bond markets aren’t pricing in elevated long-term inflation. What’s driven longer-term yields higher is a combination of short-rate expectations and a rising term premium from a global surge in bond issuance.
“As rate hike expectations come off, we are expecting longer-term bond yields to come down and for the yield curve to flatten somewhat from here," said Bartlett.
