The Billion-Dollar Question

Everybody loves cheap money, right? Well, if you’re a borrower, you’ve definitely benefited from actions taken by the Federal Reserve to keep interest rates at record lows.

But not everyone is thrilled with this wave of cheap money. Sponsors of defined benefit plans, in particular, have dealt with surging plan liabilities due to low interest rates.

As you can see from the chart, there has been a steady downward slide in the interest rates used to determine plan liabilities on corporate pension plans.

The Principal Financial Group, April 15 2013, Accounting Discount Rates based on yield curve of pension plans with services by Principal Life Insurance Company between January 2008 through January 2013

The Principal Financial Group, April 15 2013, Accounting Discount Rates based on yield curve of pension plans with services by Principal Life Insurance Company between January 2008 through January 2013

In fact, despite the fact that employers contributed more than $45 billion to their pension plans in 2012, pension deficits still increased by a whopping 17% to $295.2 billion by the end of 2012[1]

This begs the billion-dollar question: When will interest rates go back up?

Unfortunately, considering all of the factors that can affect interest rates—Federal Reserve policy, economic conditions and inflation, to name a few—their movement is impossible to predict.

So what’s a sponsor of a DB plan to do? Keep these considerations in mind:

  • Rates may stay low for an extended period of time. This is especially important to plan sponsors who are waiting until interest rates rise before employing a risk management strategy, including the purchase of long-duration bonds.
  • Once rates do start to rise, they’ll likely do so at a slow, steady rate.  A gradual increase in rates would temper the market losses associated with bond funds.
  • The funding relief afforded to plan sponsors by the Moving Ahead for Progress in the 21st Century Act (MAP-21) legislation will, once expired, have an impact on most plans. Minimum funding requirements have been artificially lowered for most plans compared to what they’ll be under the full Pension Protection Action legislative impact.  Plan sponsors should be considering steps to take now to plan for increased contribution levels.
  • Don’t try to time the market. After a careful analysis of their options and evaluation of their risk tolerance, plan sponsors should consider a strategy that best allows them to be comfortable in a variety of market conditions.

My suggestion is to determine your strategy now. For example, a dynamic asset allocation strategy,  could help you take advantage of changes in both interest rates and equity market performance. So even though you can’t know when interest rates will begin to rise, you’ll feel prepared for the day it happens.

 

In addition to blogging here, I also tweet regularly about DB topics of interest. Click to follow me on Twitter- @scottruba.

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Affiliation Disclosures

Asset allocation/diversification does not guarantee a profit or protect against a loss. Use of DAA and/or any glide path does not guarantee improvement in plan funding status nor the timing of any improvement.

While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

Insurance products and plan administrative services are provided by Principal Life Insurance Company a member of the Principal Financial Group® (The Principal®), Des Moines, IA 50392.

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[1] “Analysis: Pension Deficits Rise Again,” Employee Benefit News, April 23, 2013