Many pension fund CIOs around the world are waiting for central banks to raise interest rates, but research has shown that these increases may actually make their liabilities worse, not better.
The key is the effect any short-term rate increase has on the longer term, according to consulting firm Redington, as it is not a given that they will both travel in the same way.
“A rise in the base rate is not a guarantee that the value of pension fund liabilities will fall,” said Nick Lewis, an investment consultant at the firm. “Liabilities are very long dated so the key factor is not today’s short-term interest rates as dictated by [a central bank] but long term interest rates that already allow for the base rate to be increased over time.”
“A rise in the base rate is not a guarantee that the value of pension fund liabilities will fall,” said Nick Lewis, Redington. Sometimes, an increase in short-term rates actually leads to long-term rates falling as the market begins pricing the next rate cut cycle into long-term rates. Lewis said this had already happened twice in the UK during the periods 1999 to 2000 and 2003 to 2004.
Lewis showed that when short and long-term rates both rise, liabilities fall significantly; when short-term rates rise and long-term rates remain static, there is a much smaller cut to liabilities; and when long-term rates fall even by a smaller margin than that at which short-term rates are increased, liabilities are pushed up rather than reduced.
Additionally, investors should consider how rates move against what the market is expecting, Lewis said, as on several occasions during the economic recovery markets have incorrectly priced in higher rates that have not materialised.
Lewis warned pension funds not to rely on central bank action to try and curb their liabilities, but to take action themselves.
“Base rates will rise at some point but this may not have a material impact on your liabilities—it is the long-term rates that matter,” he concluded. “An increase in short-term rates will not necessarily lead to an increase in long-term rates, which have a greater effect on liability values.”
To read Lewis’s research in full, visit the Redington blog.
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