Whether Tuesday August 10 2004 will emerge as a turning point for economic history – and the global pension industry - is an issue for debate. What is clear is that the day saw the Federal Open Market Committee of the US central bank raise its benchmark interest rate by a quarter of a percent to 1.25%. The decision ended a sustained period of historic low interest rates in the world’s driving economy.
The Fed statement noted that inflation had been “somewhat elevated” – a far cry from all the talk not so long ago of deflation. So, it seems we could be now in a rising interest rate and inflation environment at the global scale.
Indeed, according to a recent survey by Merrill Lynch, fully 90% of respondents are convinced that global short-term interest rates will be higher a year from now.
But what does it all mean for pension scheme liabilities?
All the attention at the time of the Fed’s rate rise, naturally, was on the impact of the decision on the macro economy. Considering the current high profile of pension deficits, surprisingly little focus was initially given to the effect the decision could have on pension funds.
But what now appears to be emerging into the mainstream is the idea that it is not just asset prices that affect pension scheme funding – discount rates, defined as the interest rate used in determining the present value of future cash flows, have their part to play as well. And of course discount rates are based on bond yields.
“Although the fall in equity values has been most often credited as causing the under-funded position of many pension funds, the fall in bond yields (and the greater use of market-related discount rates for liabilities) has been at least as important,” says the International Monetary Fund, in its ‘Global Financial Stability’ report.
“Given the typically long duration of pension fund liabilities, changes in yields (and thus discount rates) have a major impact on the calculated value of liabilities.” The fund says there the impact of discount rates is “significant, and often underappreciated”.
The IMF is calling for the issuance of more longer-dated securities to help schemes match their liabilities. Sources within the transition management industry say they are observing large pension fund flows into the longer-dated end.
In essence, the lower the discount rate, the higher the liability. Standard & Poor’s asserts that, as a rule of thumb, each 10 basis-point change in the discount rate leads to a one percent change in projected benefit obligations. “If we assume a typical duration of 14 years for plan liabilities, the increase in liabilities attributable to a 50 basis point rate decrease is approximately seven percent,” says James Moore of Pimco.
At least one observer reckons the changed interest-rate picture is good for retirement systems. “Higher discount rates in all major retirement markets except for Brazil led to a tentative improvement in the funded status of global pension plans during the second quarter of 2004,” says consulting firm Towers Perrin.
It says: “The higher discount rates – which lead to lower defined benefit pension liabilities – offset poor investment returns which were only marginally positive in most markets due to global equity nervousness caused by continuing geopolitical instability.”
The UK has seen its main interest rate rise four times in the last eight months, with Towers Perrin arguing that pension plan equity returns have been positive as a result: 2.2% for domestic equity and 1.61% for international equity.
“Overall, the UK benchmark portfolios’ return was 0.85% and the UK benchmark plan improved by three percent on the second quarter. However, the UK benchmark plan is still only at 60% of its value on January 1 2000.”
“The road back to fully funded pension plans will be long without real growth in sponsor contributions,” says Nigel Bateman, principal in Towers Perrin’s Global Consulting Group.
“The fluctuating returns of equities and fixed income investments should also act as a reminder to both trustees and the company sponsors to ensure they are confident their plan’s asset allocation strategy meets their short and long-term financing needs."
Of course, the interest rate and inflation picture is going to have to change significantly if the industry is ever to haul itself out of what the OECD has estimated is a global pension shortfall of one trillion dollars. “The emergence of astonishingly large pension funding gaps has been a source of major concerns for financial policymakers in 2003,” says OECD secretary general Donald Johnston, perhaps stating the obvious.
So whether or not we have turned the corner on liabilities is an open question, but a more ‘normalised’ interest-rate environment absolutely has to happen.