All eyes are on the Federal Reserve to see whether chair Janet Yellen and her colleagues will continue a gradual tightening of monetary policy. Recent rhetoric from members of the Federal Open Market Committee has convinced us that the U.S. is prepared for some degree of interest rate normalization. In the current environment of plunging markets and negative interest rates at the European Central Bank, the Swiss National Bank and the Bank of Japan, however, rate hikes are no longer a guarantee.
So, what does this mean from a pension fund perspective? In the short term, interest rate changes may not have a significant impact on plans. Two years out, however, its imperative we get back to rate normalization to stabilize plan valuations.
Given how low rates have been for nearly a decade, any rise will be helpful to most pension plans. At State Street Global Markets, we recently gathered asset and liability data from more than 2,000 pension plans globally, simulated yield curve shifts and then modeled changes in the assets and liabilities. We calibrated possible scenarios using yield curve shapes experienced during previous rate hike periods. As a result, we discovered, the change in funding ratios under a rise-and-flattening scenario is largely positive for our sample as the reduction in liabilities exceeds the depreciation in plan assets. The median plan experienced a 10 percent improvement in funding ratio, even in a fairly conservative scenario of hikes and curve flattening combined with a depreciating equity market.
When we test for how funds would be affected should there be more rate hikes over the next two years or if rates go negative, the outcome changes. In the worst-case scenario in which short-term rates fall into negative territory and the long end of the curve sinks the median U.S. corporate defined benefit plan in our sample would experience a 10 percent decrease in funding ratio.
With rate normalization comes some element of risk and volatility. Although theres no one-size-fits-all approach to managing interest rate risk because of the unique asset and liability structure of each pension plan, there are some general strategies that can be used to manage the impact of rate normalization:
Asset allocation. Plans can strategically reallocate portfolios to protect against downside risk over the long term without necessarily increasing liability-matched assets.
Liability matching. Plans can increase the proportion of liability-matched assets to neutralize some of the volatility that is expected to come with rate normalization.
Derivatives. There are several products, including options, over-the-counter swaps and, more recently, exchange-traded deliverable swap futures, that can help a plan manage risk.
Pension plans should be prepared for the best- and worst-case scenarios of rate normalization. Even if the Fed continues to raise rates, fund managers will need to be prepared to manage potential risks. Although the current market environment is volatile and uncertain, for the sake of pension plan performance, we hope that the Fed normalizes rates within two years.
Peter Weiner is head of transition management, Americas, and head of global sales at State Street Global Markets in Boston.
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