QE2: A Consultant’s Take on What It Means for Pensions

Investors are undoubtedly anxious about whether the Federal Reserve’s second bout of bond purchases — dubbed QE2 — will be successful in stoking long-term inflation and borrowing to stimulate the economy. The commodities buying spree has raised alarm of an inflationary bubble as critics of QE2, both inside and outside the US, argue that this action could result in high inflation and low interest rates that would form asset bubbles as investors seek returns by fleeing into riskier asset classes. Others view the strategy as a necessary evil to avoid the tail risk of a double-dip recession.

In this vein, investment consultants at Mercer, Rocaton, and Towers Watson share their views with aiCIO readers on the short and long-term impacts of this program for US pension funds and for the economy as a whole.

Consultancy firm Mercer noted that if long-term interest rates move lower as a result of the Fed’s recent move, the funded status of US corporate defined benefit pension plans could deteriorate further. Companies, therefore, will continue to bear the burden of heightened funding pressures.

“We won’t know the full effect of the impact of QE2 on the US pension system, for some time,” said Jonathan Barry, partner in Mercer’s retirement, risk and finance group. “Our mantra is to have plan sponsors understand the risk they’re exposed to in the short and long-term,” he told aiCIO, noting that the Fed’s recent move is yet another factor in the laundry list of unknowns in regards to how it will impact a pension plan.

In the short-term, Barry claimed that lower rates on Treasury debt could push down yields on high-quality corporate bonds used to discount pension liabilities. However, if QE2 succeeds in its mission to stimulate economic growth, the move could have a long-term benefit to pensions. If inflation begins to creep upward as a result of the Fed’s actions, interest rates would be driven higher, potentially lowering liabilities. “But we don’t expect to see any real movement in less than 12 months,” he said.

Rocaton’s David Morton shared a pessimistic view of the Fed’s recent decision. “I don’t think it’s going to do much – the Fed shouldn’t have done this,” he said, noting that the decision by the Federal Reserve — seen as somewhat independent of the political process historically — has lost credibility by seeming to be pushed around by policymakers. “I think the Fed made this move because policymakers said ‘you have to do something.’” Morton indicated that jamming more liquidity into a system that already has a lot of liquidity isn’t going to help save the faltering economy if banks still aren’t lending and businesses aren’t investing. “Solve the root of the problem: fix the issues of the banks first and clean up their balance sheets to start lending money.”

Leo de Bever, CEO and CIO of AIMCo, recently shared a similar sentiment with blog Pension Pulse regarding the Fed’s policy: “Quantitative easing is all about giving banks enough of a cushion to absorb these losses. For Bernanke, keeping the system afloat takes precedence over everything else. Not sure he’s wrong but he’s solving one crisis by sowing the seeds of another.”

One of the biggest risks of QE2, from Morton’s perspective, is the potential loss of confidence in the US economy and its political system that has stemmed from the Fed’s action — perceived largely as a bad idea internationally. “Coming up with bad policies like this doesn’t do anyone any good. It’s not a disastrous idea, it’s just a bad one,” he said.

Having taken the position that quantitative easing has been a sensible monetary policy idea, Towers Watson’s view is slightly more optimistic, yet still cautious. “QE2 is being done in a thoughtful and highly communicative way, but we’ll see if it translates from the capital markets to the economy,” said the New York Investment Leader and a member of the firm’s Global Investment Committee, which develops the firm’s views on the economy and the markets. “For institutional investors, economic growth — GDP growth north of 3% — is what we need to reduce unemployment, and I think the Fed is trying to signal its intention pretty clearly so markets react in an orderly way, as real yields have fallen and equities have risen since Bernanke telegraphed QE2 this past August.” One of the biggest risks, he claims: currency and trade wars. He asserted that fears of runaway US inflation and a weak dollar may lead to retaliatory measures, already seen through sharp rhetoric from Brazil and China. “That continues to be a big question mark,” Morton said.