How Rising Rates Can Affect Pension Plans

The Fed raised rates and the market absorbed it without a problem. That seems to be the consensus after the Federal Reserve Open Market Committee’s announcement on March 15 that it raised the federal funds rate 0.25% to a range between 0.75% and 1%. This was only the third time since the global financial crisis that rates were hiked and the first increase this year, but it was a well-managed event that did not have the dramatic effect on long-term rates that would have been expected only a few years ago.

After the announcement, long treasuries rates were down about 10 basis points, yet this move was counter to what many expected. However, the move aligned with what many bond experts were saying about Fed rate hikes for some time now: Any move the Fed makes will not quickly impact the long end of the curve.

As an added surprise, the Fed said it would not raise rates four times this year, as was widely predicted. Instead, many expected a more hawkish tone about the number of hikes in any future tightening cycle. To many, this indicated that Fed policymakers will be less hawkish on monetary policy in the near future.

But this also raises the question: If rising Fed rates aren’t the “fix” that companies are hoping for, what does this mean for plan sponsors’ pension plans?

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“While the Fed’s move made the news, it was by no means unexpected, so it had no significant impact on the yield curve. It was already priced in by the market,” according to Jay Love, US Director of Strategic Research at Mercer. In contrast, Love said that when Trump won the election unexpectedly, bond rates rose 100 basis points.

For pension funds, Love said that rising rates are a net positive for funds since they can generate a better expected return, and in the corporate world, a rate increase could amplify the impact on a how companies value their liabilities. For pension funds, rising rates and a modest increase in inflation helps pension funds, Love said.

This opinion was shared by Bob Collie, Russell Investement’s chief research strategist, Americas Institutional, who added that “as far as pension plan funded status goes, all of the excitement and interest in interest rate movements becomes something of a non-story. It matters a lot, obviously, to a lot of other investors, but for pension plans, what matters is the middle and longer end of the yield curve.”

“As a result, it’s not the Fed rate or the one-year treasury yield that really matters, though both assets and liabilities are more closely tied to longer-duration instruments. The one-year and longer-duration treasuries are related, but they’re not the same. Long-term yields are affected by a wider range of supply-demand pressures, not just by expectations about the Fed. So, even though loose monetary policy meant the one-year rate remained low and stable from 2009 through mid-2015, the 10-year rate moved significantly up and down several times during that same period.”

Based on events seen at the end of 2015, Collie noted that the market priced in rate increases that were more gradual. This is why the one-year and 10-year yields were projected to be essentially equal by the end of 2020. “But while future expected rate increases remained essentially unchanged, the market expected that monetary policy will be very different in five years’ time. Now, this does not imply anything like as big a change in the longer-term outlook. However, history supports this view: when the Fed has raised rates in the past, longer-term yields have been much less impacted than short-term,” Collie said.

Rate Increases Alone Do Not Dramatically Impact Funds

As the general rule, bond rate increases can improve a plan’s funding status and lowers their required annual cash infusions from sponsors. This happens because rate increases mean that long-term bonds often come under pressure since the underlying value of existing bonds decreases as new bonds are issued that carry higher interest rates.

But pension plans are complex, so while a rate hike could improve corporate bond yields that will have a positive impact on liabilities, it is no general panacea to a plan’s other financing issues, including its unfunded liabilities. For instance, in 2013, corporate bond rates rose about 100 basis points and this helped boost yields for defined benefit sponsors, but this alone did not significantly improve portfolio returns of DB plans.

According to a report from Strategic Insight “interest rates have remained too low for too long and now must normalize more quickly given the wide gap to traverse from ¾-1% to 3.5%.

“Normalization requires adopting a systematic program similar to 2004’s cycle, instead of an arbitrary mantra of ‘data dependency.’ We expect to reach equilibrium sooner at a level more consistent with the long-run average than generally assumed. The window of opportunity for a slow methodical program is closing with a wide gap to the Taylor Rule’s indicated Fed Funds Rate, already exceeding 2.8%,” according to Strategic Insight. (The Taylor Rule is used by central banks to make estimates of ideal short-term interest rates when an actual inflation rate does not match the expected inflation rate.)

For funds with exposure to corporate bonds, rising rates accompanied by a stronger macro economy that raises corporate revenues have a direct impact on corporate bond rates. A calculation by Alan Glickstein, a senior retirement consultant at Towers Watson, found that for every 100 basis point move on the corporate bond rate, pension liabilities fluctuate 15%.

By Chuck Epstein

Corporate pension plans’ funded ratio dipped to 81.5% for February, from 81.6% for January, according to Milliman. The funded ratio, based on the 100 largest defined benefit pension plans of US public companies, had been rising in the previous five months, and is up about 3% over the past 12 months. It dipped in February as a result of a drop in the discount rate to 3.89%, from 4% for January, according to the Seattle actuarial firm.

Investment gains of 1.74% in February helped counter the negative effect from discount rates somewhat. “While February’s strong investment gains helped soften the blow dealt by the discount rate decline, all eyes are on interest rates right now,” said Zorast Wadia, a Milliman consulting actuary.

If the Federal Reserve goes through with a series of interest rate hikes this year, it would benefit corporate pension plan funded ratios. Milliman anticipates that if interest rates touch 4.39% by the end of this year, and 4.99% at the end of 2018, accompanied by annual investment gains of 11.2%, the funded ratio would climb to 91% by year end, and 104% by the end of 2018.

On the other hand, if discount rates were to drop to 3.39% at the end of 2017, and 2.79% by year end 2018, and investment gains were a less robust 3.2% for each year, Milliman sees the funded ratio declining to 75 % by the end of 2017. In this scenario, it could even go down to 69% by the end of 2018.

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In contrast, Wilshire Consulting reports that the funded ratio for US corporate pension plans edged up 0.2% for February, to 83.4%. It is also up about 7% over the year. The Wilshire report is based on the corporate pension plans of S&P 500 companies.

According to the Santa Monica, Calif., investment advisory firm, asset values were up 1.9% for February, outpacing a 1.6% rise in liability values, causing the corporate pension plan funded ratio to go up.

Although both the Milliman corporate funded ratio and the Wilshire corporate funded ratio were based on a drop in discount rates for February, in the Wilshire model, the asset value rise offset the impact of the rise in liability values. In the Milliman model, the impact of the dip in the discount rate was stronger than the impact of investment gains, causing the Milliman corporate funded ratio to drop for February.

Ned McGuire, a member of the Pension Risk Solutions Group of Wilshire Consulting, noted, “This month’s increase was primarily driven by the continued post-election increase in equity markets, lifting the Wilshire 5000 Total Market Index 3.7% during February.”

McGuire expects that if interest rates rise further this year, the liability value of defined benefit corporate pension plans will decline. He expects that if investment returns continue to rise as well, corporate funded ratios will also rise this year.

By Poonkulali Thangavelu