2022 is a new year and all of us at FSRA wish you and your loved ones peace and happiness and health and prosperity in all your endeavours.
The start of 2022 sees continuation of an inflationary trend arising mainly from Covid-related global supply chain disruptions amid the context of recent stimulative fiscal and monetary policies. Monthly year-over-year CPI increases during much of 2021 exceeded the Bank of Canada’s target inflation range of 1 to 3%. October, November, and December increases were 4.7%, 4.7% and 4.8% respectively. While the Bank of Canada and other central banks expect the increases in inflation to be transitory, it is not clear whether the recent increases are a prelude to a period of sustained inflation. In this context, prudent pension plan administrators will want to consider the impact of inflation on their pension plans (e.g., investments, liabilities and funding) and, if warranted, take appropriate action.
Impact of inflation on your pension plan funding positions
Higher inflation would generally be expected to lead to an increase in the long-term government bond yields. This would mean an increase in solvency discount rates which, in turn, would decrease plans’ solvency liabilities. The expected impact of inflation on plans’ future investment returns, and the corresponding going-concern discount rates, is not as obvious. Higher inflation also impacts plans’ benefit obligations to the extent a plan provides earnings-based benefits or ad hoc or contractual inflation protection. Have you, as a plan administrator, considered:
- The impact of inflation on your plan’s funded position on both a going-concern and solvency basis?
- Whether the existing strategic asset allocation remains valid?
- If there is an opportunity for strategic de-risking through the purchase of annuities or adopting liability-driven investment strategies?
Stress testing the impact of various scenarios of sustained and transitionary increases in inflation, can provide plan administrators and sponsors with a better understanding of the potential financial impact of higher inflation. For example, consider:
- What are the future fluctuations in funding costs under various inflation scenarios?
- What is the probability of delivering on the benefits or the range of possible outcomes with the current funding/investment strategy?
- What are the corresponding mitigation strategies?
Impact of inflation on the pension plan sponsors
Inflation is such an important factor in the economy that it affects virtually every type of business in some way, both on the demand and the supply side. Plan sponsors might want to consider how inflation may impact their businesses and cashflows, including any direct effects on the company’s total compensation package (e.g., higher wage demands and associated pensions and benefits obligations). For example, the new yearly maximum pensionable earnings in 2022 is $64,900, compared to $61,600 in 2021, reflecting an increase in average Canadian industrial wages of 5.4%. The 5.4% increase is the largest percentage change since 1992. Together with continued implementation of the enhanced Canadian Pension Plan (CPP), the maximum employer and employee contributions to CPP for 2022 will be $3,499.80 each, an increase of 10.5% over 2021. There may also be implications on employer and member contributions to the pension plan, particularly if your pension plan benefits and contributions are integrated with the CPP. Have you, as a plan administrator, considered and tested the continued validity of your current funding strategy under various evolving economic environments?
Impact of inflation on plan members
Inflation could also have an impact on whether the plan continues to meet its objectives. For example, benefit adequacy or, for defined contribution (DC) plans, inflation could affect the suitability of existing investment options and strategies. Have you, as a plan administrator, considered:
- Assessing the validity of these concerns in the context of your plan?
- Communicating the impact of inflation to your plan members, including any planned adjustments, if deemed appropriate (e.g., changing the investment options under a DC plan)?
- How sustained inflation might impact inflation assumptions imbedded in plan member tools and information, such as retirement income projections?
While making predictions is hard, preparing for possibilities in case of negative implications is the right thing to do. Plan administrators will want to understand and get ahead of inflationary impacts on their plans to be in a position to make informed choices.