07/03/2013 05:20 EDT | Updated 09/02/2013 05:12 EDT

Canadian pension plans boosted by rising interest rates

Canadian pension plans are continuing to improve as interest rates rise, according to a pair of surveys on the state of defined-benefit pension plans released Wednesday.

Defined-benefit pension plans have been struggling in the past few years, as returns have failed to grow as quickly as the amount of money they owe to pensioners.

According to a poll of 275 pension funds across Canada in both the public and private sector conducted by the consulting firm Aon Hewitt, the average fund has assets totalling just 77 per cent of what it owes.

But this may be starting to change as interest rates finally begin to creep upward.

Bonds make up about 40% of portfolio

Mercer Consulting says its Pension Health Index, which is based on what it considers a "model" pension fund, rose to 94 per cent of liabilities in the second quarter of this year. That means the fund would have 94 cents in assets for every dollar it owes to pensioners. At the beginning of the year, the index was at 82 per cent.

"The financial position of pension plans improved in June despite the recent pullback in equity markets," said Manuel Monteiro, a partner at Mercer’s Financial Strategy Group in a press release. "This was mainly driven by the significant increase in long-term bond yields over the last two weeks."

Most pension funds have a significant proportion of assets — usually 40 per cent — invested in bonds, which are more stable than equities and can be relied upon for a steady return on investment. Mercer's "model" fund has a 42.5 per cent weighting in bonds.

When interest rates rise, so does the value of the fund's bond portfolio. However, low interest rates have meant these bond investments have not been able to keep up with rising liabilities.

Small rise can reduce liabilities

The increase in the interest paid on a long-term bond might not seem that significant — the yield on a 30-year Canadian bond has risen 70 basis points, or 0.7 percentage points so far this year. However, Monteiro says a rise of one percentage point in the long-term interest rate can reduce pension liabilities by 10 to 15 per cent.

The Aon Hewitt survey showed that defined-benefit pension plans increased their solvency, or ability to pay out pension benefits, by three percentage points.

The boost was again mainly due to long-term interest rates rising, which has boosted the bond holdings of most pension funds and offset the decline in equity markets, which were down in the second quarter.

Aon, which gathers data from a large sample of Canadian pension plans, says 95 per cent of plans are still not fully funded, and those that are have only covered 77 per cent of liabilities.