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The Federal Reserve Board’s recent interest rate boost doesn’t directly affect corporate pension plan funding, but plan sponsors may want to begin taking action.
The Fed’s .25 percent increase to the federal funds rate directly affects short term interest rates, but not the long-term, high quality corporate bond rates that pension plans are sensitive to. In fact, long-term rates have dropped from about 4.25 percent to around 4.1 percent since the Fed began raising short-term rates in December 2015.
Long-term rates sometimes move in tandem with short-term rates and sponsors should continue to monitor them, John Lowell, pension consultant for October Three in Atlanta, told Bloomberg BNA March 16. Sponsors would be wise to construct models measuring the consequences to their plan’s funding in anticipation of long-term rates rising by as much as 75 basis points (.75 percent), Lowell said.
The bump in rates has the “psychological effect of making people expect that interest rates will keep rising,” but it’s impossible to know whether rates will continue to do so, and if they do, by how much, Evan Inglis, a pension actuary in Vienna, Va., told Bloomberg BNA on March 17.
Rather than trying to anticipate when long-term rates will peak, plan sponsors should gradually move their plan asset portfolio into longer-term corporate bonds so they don’t miss out on the higher yields these investments offer, Inglis said.
Matt McDaniel, a partner in Mercer’s retirement practice in Philadelphia, agreed with Inglis. Sponsors that don’t want to be in the “interest rate guessing game” can use the Fed’s latest rate hike to spur them to employ de-risking strategies to replace their plan’s stock investments with long-term bonds as interest rates rise and the plan’s funding level improves, he told Bloomberg BNA March 16.
Plan advisers agree that a rise in interest rates is generally good for plans because plan liabilities decline as interest rates rise. However, rising rates can ultimately erode the value of plan assets by reducing both stock and bond prices.
There's also the question of whether the Fed's interest rate moves amount to a trend. Despite the fact that Federal Reserve Chairwoman Janet Yellen said she expects the Federal Open Market Committee to raise rates several more times this year, the fact that the bond market yield curve is not steeper shows that the market is skeptical, Inglis said. “We've seen rates go up before,” only to “fool the market” by coming back down, said Inglis, who was speaking on behalf of the American Academy of Actuaries.
Many economists don’t believe that economic growth will return to past levels anytime soon. This means the potential for inflation and rising interest rates may be overstated, Inglis said.
Even if inflation pressures are mounting, the Fed’s action in boosting rates could actually serve to bring long-term rates down. That’s because bond investors may see the Fed’s action as an effective measure to hold inflation in check, he said.
Given all the uncertainty, it’s understandable that plan sponsors may be confused about what action to take, if any.
Lowell said he would advise sponsors to model the effects of potential interest rate changes, which should include an analysis of the cost of borrowing and raising capital.
Lowell said he expects to see some some large insurers encouraging plans to transfer pension risks through annuity purchases and plan terminations. “As rates trend upwards, insurers have more reason to believe that this will be the time that many plans try to terminate and these insurers will want their fair share of this business,” he said.
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