Interest rates are key to deciding upon de-risking moves as they drive the liabilities, lump sums, the cost of annuities, the value of fixed income assets, and the cost of financing. Such transactions always seem to come down to interest rates.
Generally speaking, as interest rates increase, liabilities are driven lower – and the cost of lump sums and annuities decrease. So, other things remaining the same (which they never do, of course), firms tend to wait for rates to move higher if they are anticipating de-risking moves.
To recap recent history the 10-year treasury began 2016 at 2.24%, fell to a low of 1.37% in July, all before hitting 1.86% on Friday of last week.
For interest rate watchers, this seems like a “spike” in what is a historically low interest rate environment marked by negative rates internationally and Fed watching that looks like a vigil. But the last time we were north of 3% was at the end of 2013 and we’ve largely been in this range since 2011. The last time we were over 4%? Not since early 2008.
So, waiting for rates to rise has been a fool’s game for a long time. I should know, I’m the biggest one I know as I’ve been waiting, and waiting, and waiting. This has not been a winning strategy for most plan sponsors over the past decade or so, as we can see from the chronically underfunded plans.
Why? In a nutshell: actuarial assumptions and regulatory “breaks”. Actuaries tend to think very long term and assume that rates will “normalize” by the time a plan pays out its benefits. But plan sponsors looking to de-risk or terminate have a much different time horizon. Additionally, plan contributions are usually driven as low as possible as it is assumed plan sponsors want to put as little as possible into their plans. And regulatory bodies, like the U.S. congress repeatedly come up with legislation that reduces short term contributions thinking that rates will rise sooner than later. MAP-21 is an example.
This mismatch between time horizons, contributions and interest rate assumptions add up to pension plans that never quite get to the point of being fully funded, let alone fully funded on a termination basis.
However, that’s not the end of the story, because low rates also mean that financing has rarely been more attractive.
Another key factor is that the market value of fixed income securities are near all-time highs, and most pension portfolios have significant holdings. Which is a big reason why we’ve seen some of the largest de-risking transactions in history recently – both in the U.S. and abroad.
It appears there is reduced anticipation that rates are rising any time soon. And plans are pulling the trigger on buyouts and partial buyouts, no longer waiting for rates to increase and hoping to time the market.
But most importantly perhaps is that the cost of carrying pension debt, that is, the underfunded portion of a pension liability, is historically high with PBGC premiums shooting through the roof. Therefore, the cost of buying SPGAs and paying out lump sums, even at low interest rates, makes sense for many.
Especially because a shrinking pension plan is a de-risking pension plan.
These items need to be considered individually and in context with one another to develop plans that rationally anticipate the interest rate environment – and inform de-risking moves.