Interest rates: What’s the risk to your plan?

As interest rates rise, they have the effect of lowering the pension plan’s liabilities; the opposite is true as interest rates decline. Plan sponsors thought they got some relief (on a solvency basis) in the first quarter 2011, as interest rates started to increase based on the belief that the global economy was on the path to recovery. With the continued issues in Greece, and to a lesser extent Portugal and Spain, and with continued economic weakness in the U.S. and the U.K., interest rates are once again declining. Investors are reducing risk in investment portfolios, seeking the safety of long government bonds.

The natural question is whether bond yields are expensive at their present levels. Towers Watson’s Global Investment Committee does not think so. Despite yields being at very low levels, we still think that nominal government bonds are broadly fair value.

To further explore this, we derive a set of one-year interest rates for each of the next few years.

Our analysis shows that a more “normal” interest rate environment is expected within the next four or five years in the U.S., U.K. and Euroland. Canada might reach normalization a bit earlier.

The path to normalization implies above-trend growth, the reduction of economic slack and much higher employment levels in developed economies over the next few years. On balance, we believe that major developed economy nominal bond markets offer a reasonable premium over cash rates for the next three to five years.

The main risks to this view are higher inflation and inflation expectations. Our base case inflation outlook is a gradual return to central bank targets. That being said, the balance of risk is to the upside, given the possibility of policy errors and further commodity price increases. As economies normalize, the monetary stimulus in place since 2008 will have to be withdrawn.

The exit strategy is likely to be more difficult than normal given the starting point of low policy rates and significant “money printing.” This increases the risks and impacts of policy mistakes. While policy errors could push inflation undesirably higher (or lower), central bank preferences for inflation rather than deflation skew inflation risks to the upside.

Based on the above, we recommend a neutral position on portfolio risk as the major asset classes are broadly fairly priced as noted in the table below:

Economic uncertainty has risen as the trade-off between global growth and inflation has become more evenly balanced and as the world tightens policy in aggregate. While we recommend being neutrally positioned across major asset classes, dynamic investors may take advantage of relative value between countries and within asset classes.

So what does this all mean for pension plan sponsors?

In hindsight, the first quarter of 2011 represented an opportunity for plan sponsors wishing to de-risk, by increasing the allocation to bonds and/or lengthening duration for a portion of their investment portfolio. It is becoming increasingly important to have a roadmap, a journey plan that lays out actions that might be taken under certain circumstances. This could include, but is not limited to, reducing the allocation to equities as the plan’s funded position improves or increasing the allocation to bonds as certain interest rate levels are triggered.

The action taken and its timing will be subject to each plan’s financial position and that of its sponsor. Key considerations are the impact on contributions, pension expense and disount rate.

What is clear is that a plan is needed so that opporunities to de-risk (if desired) are not missed as interest rates normalize over the next three to five years.