Complacency is threatening well-funded Canadian DB plans: experts

Each month at BPM, we offer a slate of articles and content pieces that go deep on a particular topic. This month, we're focusing on defined benefit (DB) plans and what plan sponsors need to know. 

Canadian defined benefit (DB) pension plans are in their strongest financial position in decades. According to a recent FSRA report, the median solvency ratios have climbed up to 127 per cent, a record high, while DB plan surpluses are widespread.

Despite this, however, two pension specialists believe the good times carry a risk of their own and plan sponsors may not see it coming.

When plan sponsors become complacent

“Equity markets have been in a generally sort of upward trend since the global financial crisis with a few exceptions of relatively short, short-term pullbacks, for example, in 2020 and 2022," said Gavin Benjamin, partner in retirement consulting at TELUS Health. "So, when plan assets have generally performed well for an extended period, it becomes easy to assume that this experience is normal and repeatable, which can result in complacency."

Dany Lemay, managing director and investment leader at WTW in Montreal, sees a trade-off that many sponsors have not fully reckoned with. He emphasized how the tools to hedge interest rate risk have improved dramatically, something that was rare 20 or 30 years ago is now standard practice. But neutralizing one risk can quietly amplify another, he said.

When a plan locks in its liability hedge, the performance pressure shifts entirely to the growth portfolio, and Lemay questions whether sponsors are scrutinizing that side of the balance sheet with the same rigour. He pointed to passive index strategies as a particular blind spot for plan sponsors, noting how it’s often low cost and benchmark-aligned, but still carries concentrated exposures by country, sector, and currency that many committees overlook.

"Nothing’s risk free,” said Lemay. “You might be feeling good about yourself because you're protected from an interest rate perspective and they're moving in line with liabilities, but you might be underestimating what's the risk in the remaining of your portfolio, whether it's equity, real assets, or other type of asset classes," he said, adding longevity risk, by contrast, registers as a slower-moving concern, one that's present but unlikely to deliver the kind of sudden shock that interest rates or equity drawdowns can.

"The longevity risk is something that’s typically gradual and will not impact you from one day to the next," he said.

Do interest rates ultimately matter for pensions?

Meanwhile, Benjamin emphasized that while the Bank of Canada's overnight rate dominates headlines, it should be noted that it’s a short-term rate and pension liabilities are long-term obligations that will pay out over decades. What actually moves the needle on DB plan financials is the long end of the yield curve, and those rates don’t always track the central bank's policy moves, he said.

He argues that sponsors need to understand precisely how exposed their funded position is to shifts in long-term rates, rather than taking comfort from the direction of monetary policy.

"It's always important for pension plan sponsors to understand the sensitivity of their funded status to changes in long-term interest rates because it's very difficult to predict how interest rates will change over time," he said, adding where that sensitivity creates a problem for the plan's long-term sustainability, sponsors should not wait.

"The plan sponsor should consider what actions they can be taking to reduce the interest rate risk," he added.

How Canadian DB plans are managing risk

Lemay points to a structural shift in how Canadian DB plans manage risk. Before the global financial crisis, the degree to which plan assets moved in step with liabilities as interest rates shifted sat at roughly 5 to 15 per cent. Today, he said, most plans are above 50 per cent and some approach full hedging.

According to Lemay, the growth side of the portfolio has also changed. Plans still hold significant allocations to return-seeking assets, but those allocations now stretch across global equities, real assets, alternative credit, and other non-traditional strategies in ways that were uncommon two decades ago. While he doesn’t claim any of this makes plans invincible, he argues the foundation is materially stronger.

"It's not like there’s a silver bullet that plan sponsors need to do right now, but if they properly diversify over time and maintain good level of liquidity, they should be in good position to go through whatever storm is coming our way," he said.

The real anxiety, in his view, has moved away from funded status altogether. For most plan members, the pension is no longer the worry. It’s whether their employer survives the current trade and tariff environment.

"What's ultimately the biggest risk is that your employer goes bankrupt. And if that happens in a time where the plan is underfunded, obviously there's ramifications," he said.

Lemay acknowledged the small number of plans he works with that are slightly underfunded got there by design. Those sponsors pulled back on risk-taking roughly a decade ago, accepting modestly higher contributions in exchange for a more predictable funding path. He’s seen no appetite among them to chase returns by re-risking portfolios to close the gap.

He believes the broader picture, however, is that the vast majority of Canadian DB plans are either in surplus or close to fully funded, a fundamentally different landscape from the post-financial-crisis years, when funded ratios in the 50 to 70 per cent range created acute pressure across the system.

What happens to a DB plan that’s underfunded?

While Benjamin underscores that an underfunded plan is never beyond repair, getting the plan back to full funding forces sponsors into a difficult calculation. Sponsors can either inject cash through contributions or lean into return-seeking assets to outpace liabilities.

In practice, those levers pull in opposite directions, but it also introduces more volatility and the real chance that the funding gap widens instead, Benjamin noted.

"On the one hand, there's some merit in saying we're going to invest in more return-seeking assets such as equities, which can potentially, if they perform well, reduce or eliminate a planned deficit. But on the other hand, investing in more return-seeking assets generally comes with more risk, which means more volatility and the risk that the funded position could deteriorate further," he said. "Finding that balance or the sweet spot that works best for a particular circumstance is what many plan sponsors grapple with.”

The question of what to do with surplus has also become a notable topic when it comes to governance decisions facing plan sponsors. To that end, Benjamin identifies several options – maintaining the surplus as a buffer, using it to reduce contributions, improving benefits, or reducing plan risk. But he also cautioned against treating any of them casually.

"There's always a tendency when things are good, such as the current environment where DB pension plans are well funded, to assume that the current conditions are sustainable and won't change over time," Benjamin said. "It's important to avoid the temptation for complacency."