Low rates may reduce asset returns and lower discount rates, hiking liabilities.
Lower interest rates may be great if you’re tapping the bond market. Not so much if you’re trying to fund a corporate pension plan.
Returns on assets fall. William Warlick at Fitch Ratings said the sudden dive in interest rates in July and August—10-year Treasuries fell below 2%, and by early September yielded about 1.5%—potentially creates a “double whammy.”
The first whammy is that yields remaining low for an extended period will eventually reduce returns on pension funds’ fixed-income portfolios, which have been growing as pension-fund managers shifted away from riskier equities.
Liabilities grow. As the return on assets shrinks, pension-fund liabilities are likely to increase, also potentially widening plan funding gaps. When treasury and high-grade corporate bond yields fall, plan administrators’ discount rates fall along with them, so a given set of future cash flows related to plan-participant liabilities is discounted back at a lower interest rate. That’s the second whammy.
“That means the present value of the liabilities is higher and the pension’s funded status could worsen,” Warlick said. “So the pension fund could either have a deficiency of asset returns or higher liabilities than expected.”
Good behavior lowers risk. Fortunately, lower tax rates and persistently solid investment returns have enabled most companies with large pension plans to significantly improve their funded status. The 150 companies Fitch reviews saw their median funded status improve to 85% from 81% between 2014 and 2018.
The problem: “We could be entering an environment where, despite a recent period of voluntary contributions, required contribution could go up,” Mr. Warlick said.
NeuGroup and BNY Mellon are hosting a Pensions & Benefit Roundtable in New York on October 2 for treasurers with oversight of pensions. If you would like to participate, please contact Chris Riordan at [email protected].