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

Investment consultants at Mercer, Rocaton, and Towers Watson share their views with aiCIO readers on the short and long-term impacts of the Federal Reserve’s second bout of bond purchases (QE2) for US pension funds and for the economy as a whole.

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.

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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.



To contact the <em>aiCIO</em> editor of this story: Paula Vasan at <a href='mailto:pvasan@assetinternational.com'>pvasan@assetinternational.com</a>; 646-308-2742

Strategic Insight on the Fed’s Quantitative Easing: Tricky News for Bond Fund Investors

Loren Fox, senior research analyst at Strategic Insight, says the Fed's attempt to use quantitative easing to boost the US economy will exacerbate concerns regarding bond mutual fund investors.

The Federal Reserve’s recent news that it would use quantitative easing to bolster the slow-moving economy highlights – and will probably exacerbate – some concerns regarding bond mutual fund investors. Faced with a lethargic recovery, the Federal Reserve has responded with rock-bottom interest rates. This situation has created two closely related trends, both of which have sparked a flood of money into bonds and bond mutual funds.

First, as is common in a low-rate environment, bond mutual funds have logged impressive gains; the average investor in bond funds enjoyed 9.6% gains through the first 10 months of the year, following 18.6% gains for 2009. Such performance has drawn risk-averse investors into the general bond sector as a substitute for more-volatile equity funds. The second trend is that investors seeking current income have eschewed deposit accounts and money-market funds that are carrying near-zero yields; instead, they’ve shifted their money into higher-yielding short- and intermediate-term bond funds. Thus, bond funds have been seen as attractive alternatives to deposit accounts and money funds for income investors, and alternatives to equity funds for growth investors.

Although the rush to bond funds has been a global phenomenon, with over 60% of fund inflows in Europe and Asia going to bond funds, it has been most pronounced in the US. Over the first 10 months of the year, inflows into bond mutual funds (including ETFs) accounted for 80% of bond and stock fund inflows, according to Strategic Insight’s Simfund databases. To put this in perspective: until 2009 stock and bond fund flows together had never before topped $300 billion in one year, but in 2009 bond fund flows alone reached a record $400 billion, and this year bond funds will likely surpass $300 billion in flows.

Similar trends are buoying the bond market itself. This year is on pace to see around $6.5 trillion in bond issuance, according to data from the Securities Industry and Financial Markets Association. That would be the third-highest dollar value of issuance in history, close behind the $6.7 trillion issued in 2009 and also in 2003.

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For much of this year, industry participants have worried that the flight to bonds has been overdone, and bond funds threatened to reach bubble proportions. Some fund management companies and broker-dealers have been trying to educate the public and at least push investors to diversify their bond holdings away from short- and intermediate-term bond mutual funds. Of particular concern is the many bond fund newcomers who don’t understand the risks inherent in bonds and view short- and intermediate-term bond funds as simply higher-yielding money market funds or alternatives to cash. These investors may be in for nasty surprises when interest rates eventually start to rise, causing bond values to fall.

Now, the Federal Reserve has essentially announced that it is seeking an ultra-low rate environment at least until June. Whatever else it may do, the quantitative easing will only reinforces the trends that have been driving massive flows of capital into bond funds, and extend these trends through the first half of 2011 (and possibly beyond). The ravenous demand for bond funds will continue for a while.

The downside is that this all may bring greater numbers of relatively inexperienced investors into bond funds, setting them up for disappointment when the economy strengthens and rates start to creep upward. The investment industry will certainly make more efforts to educate investors about bond fund risks. But given the history of investing, we expect that eventually many bond fund holders will face an unpleasant reckoning. When that – and the start of rate hikes—will come is anyone’s guess.

Strategic Insight, an Asset International company, is a leading research firm for the mutual fund and wealth management industry, providing clients with in-depth studies, consultation, and electronic decision support systems. Strategic Insight assists over 250 firms worldwide, including the largest U.S. mutual fund companies. Visit us at www.SIonline.com.



To contact the <em>aiCIO</em> editor of this story: Paula Vasan at <a href='mailto:pvasan@assetinternational.com'>pvasan@assetinternational.com</a>; 646-308-2742

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