The U.S. 30-year Treasury Bond recently posted a significant milestone. In Barron’s February 24th issue, it was reported that “Yields on long-term U.S. Treasury bonds fell to the lowest level in the history of the republic, under 1.90%.” As of this writing, rates have dropped even further. Here are our initial reactions to three questions pension plan sponsors may be asking.
What does this mean for actuarial valuations?
The decline in bond yields has driven average pension discount rates down 40 – 50 basis points since the beginning of 2020 (estimated based on regular and above median AA pension discount curves averaged across several corporate U.S. pension plans measured on an accounting (mark-to-market) basis), resulting in increases in pension liabilities. Pension discount rates are based on high quality corporate bonds, and although credit spreads have widened by a small amount during the current “flight to safety,” they have only offset a small portion of the drop in risk-free yields.
To the extent that the interest rate risk has not been hedged by holding bonds with similar characteristics to plan liabilities, plan sponsors should expect increases in unfunded liabilities on both a Pension Protection Act (PPA) funding valuation basis (not reflecting funding relief) and on a GAAP accounting basis.
What does this mean for liability-driven investing (LDI) strategies?
Investment performance for liability-driven strategies has been very strong during this decline in yields. As liabilities have spiked, so have the assets designed to hedge them. The Bloomberg Barclays Long Gov/Credit Index, a common LDI benchmark, has returned +8.3% YTD (as of market close 2/25/2020), far outpacing the low return of shorter duration bonds or the negative returns of most equity benchmarks. Therefore, plan sponsors that have already implemented LDI strategies may be significantly shielded from the hits to their balance sheet and to funded ratios.
Sponsors who have not implemented LDI strategies might be tempted to wait until interest rates rise a bit. However, there are several reasons it might not be a good idea to wait:
- Can rates go lower? Interest rates have hit all-time lows multiple times over the past decade, and rates in other developed nations have reached levels well below the current rates in the U.S. While no one knows how low they will go, it is possible that rates could continue to fall if global assets pour into U.S. fixed income investments, pushing prices higher and yields lower. (There are several reasons why this could continue, all beyond the scope of this post: stock market corrections, the impact of the coronavirus COVID-19 on global companies and markets, negative interest rates abroad that make U.S. fixed income relatively attractive, U.S. companies deploying idle cash in the search for yield, and so forth.) This would have consequences for pension liabilities measured on a mark-to-market basis.
- Convexity may cause liabilities to further outpace assets. As interest rates decline, durations – interest rate sensitivities – of assets and liabilities increase due to convexity. Therefore, a further drop in interest rates could have even greater consequences beyond the movement that we have seen recently.
- Perception of de-risking as advantageous. At times of high volatility and uncertainty in financial markets, stakeholders react favorably to any steps taken to reduce volatility and avoid further negative surprises.
So, we believe plan sponsors may do well to get past their initial hesitancy and look into de-risking, even at current interest levels.
What does this mean for pension risk transfer (PRT) strategies, including group annuity transactions?
Plan sponsors may be reluctant to pursue PRT strategies and group annuity buy-outs when interest rates are at or near all-time lows. However, as noted above, higher durations (i.e., higher interest rate sensitivity) brings greater balance sheet volatility. Plan sponsors may wish to minimize this source of volatility, notwithstanding the cost in absolute terms.
It is generally true that lower risk-free interest rates (absent an offsetting widening of credit spreads) result in lower effective group annuity purchase rates and higher buy-out premiums. For plans without LDI strategies in place, higher premiums may indeed force sponsors to postpone annuity purchases until rates climb higher (see comment above about interest rate predictions).
However, for plans that have hedged a substantial amount of interest rate risk, an annuity purchase may not be out of the question; both actuarial liabilities and group annuity premiums generally increase (decrease) when interest rates fall (rise). Said another way, the ratio of group annuity premiums to GAAP pension accounting liability – a standard metric for many plan sponsors – remains relatively stable in most interest rate environments.
For additional perspective on the market, register for our March 25 webinar on managing risk in an era of uncertainty. PIMCO market strategist Tony Crescenzi will join Buck’s investment team for a discussion on market trends and the implications for plan sponsors and the capital markets.