Regulators and supervisors need to “act promptly” to shore up pension funds and life insurers under pressure from sustained low interest rates, according to the International Monetary Fund (IMF), which pointed to the need in Europe for a common framework for risk assessment and enhanced transparency.
It said a prolonged period of low interest rates posed a threat to the solvency of many life insurance companies and pension funds, identifying this as one of many mounting medium-term risks to global financial stability as a result of potential negative feedback loops.
“Low interest rates add to the legacy challenges facing many insurance companies and pension funds, along with those from ageing populations and low or volatile asset returns,” it said in its 2016 global financial stability report today.
“Heightened concern over these important long-term saving and investment institutions could encourage even greater saving, adding to financial and economic stagnation pressures,” it added.
It called for “a more potent and balanced policy mix” to deliver economic growth and financial stability, setting out recommendations with respect to banks but also life insurers and pension funds.
The viability of business models of many life insurance companies and pension funds are being “eroded” from sustained low interest rates, threatening solvency over the medium term, said the IMF.
For pension funds, this is because low interest rates are exacerbating funding gaps via the mechanism of discount rates used to calculate pension liabilities, reflecting falling interest rates and low asset returns.
The IMF cited figures for US and UK pension funds, putting the average funding gap at around 30%.
The IMF said that “adverse dynamics” in many pension plans triggered by the low interest rate environment could lead to “a vicious, self-fulfilling cycle” by driving rates even lower.
It sees this as a possibility because of a shift toward liability-driven investment (LDI) strategies among pension funds – notably in the US, it said – which “could substantially increase demand for duration in riskier assets, such as corporate debt and emerging market economy debt, as well as in safe haven sovereign bonds, particularly US Treasuries”.
It added: “The more firms that shift their asset allocations toward such assets, the more the yields on these assets decline, reinforcing funding gaps and thus generating additional demand for bonds in a potentially negative spiral.”
The IMF recommended “prompt regulatory enhancements” to tackle the risks to pension fund and life insurers and associated potential for negative spillover effects.
These measures, according to the IMF, include “identifying medium-term insolvency risks and funding gaps, while enhancing the reform agenda to strengthen standards for internal models and capital frameworks and improve transparency”.
For pension funds in Europe, regulations should be strengthened to ensure a common framework for risk assessment and enhanced transparency, according to the IMF.
This has strong echoes of a contested recommendation from the European Insurance and Occupational Pensions Authority (EIOPA), which many in the European pensions industry fear will pave the way for solvency requirements for pension funds.
The IMF did not reference EIOPA. On its recommendation for a common framework, it said this “means valuing assets and liabilities on a market-consistent basis to facilitate standardised reporting and risk analyses, such as stress testing”.
It added: “Greater consistency would boost transparency, including by ensuring regular public disclosure of balance sheet metrics and risk analyses.”