Negative interest rates are back in the news, currently accounting for 11 per cent of global outstanding debt. Even a long time hold-out like the Bank of England has recently thrown in the towel by issuing a negative yielding bond for the first time in its history.
Seen as extraordinary and unconventional on their introduction in 2014, negative rates have since become ordinary and conventional, as the global economy remains haunted by the spectre of secular stagnation – even well before the current crisis.
Of course, unusual times demand unusual measures. But that does not mean they will all work. Despite its formidable arsenal, the Fed has been powerless to force creditworthy households and enterprises to borrow, nor to create profitable ventures for capital to invest in. A research paper by PIMCO shows that negative rates, on balance, do more harm than good. For pension plans, their side effects are too obvious to ignore, especially in Europe.
Those plans that are regulated under the Solvency II regime are enjoined to hold a certain amount of ‘risk-free’ assets in their portfolio as a safety measure. Typically, such regulation has been used by governments in the past as part of ‘financial repression’, which keeps rates near zero and makes the cost of mounting public debt more manageable.
At the other extreme, those plans that have healthy funding ratios need to de-risk their pension portfolios via safe haven assets, even if that means paying their issuers for the privilege of lending them their money.
Either way, negative rates mark the latest phase in the long drawn-out downward trend that started in the 1980s. They have proved the Achilles heel of DB plans, holding more than half the retirement assets in the developed world.
The reason is that, in the investment universe, interest rate risk carries no reward — only a double whammy. Falling rates mean lower cash flows, as plans typically rely on bonds to fund regular payouts to their retirees. To cover the resulting shortfall, they have to invest even more.
Falling rates also inflate the present value of plans’ future liabilities, as calculated under prevailing pension regulations. As a rule of thumb, a 1 per cent fall in rates delivers a 20 per cent rise in pension liabilities and a 10 per cent fall in the funding ratio — a measure of a plan’s ability to meet its future commitments.
In a typical pension portfolio, a lower discount rate tends to be net negative: its positive effect on equity assets is more than offset by its negative impact on liabilities.
No wonder the Dutch government has just decided to reform its occupational pension sector by heralding a dramatic shift towards defined contribution plans where interest rates can no longer determine pension affordability. The details are yet to be worked out. But the message is not lost on regulators in other pension jurisdictions.
The harsh truth is that low rates have made it ruinously expensive for plan sponsors to honour their pension promise.
I wrote more about this subject in yesterday’s Financial Times (9th July 2020). The link for the subscribers is here.