The prospect that negative interest rates could spread to the U.S. has gotten a lot of buzz lately, in part thanks to a widely quoted blog post, “Interest Rates: Naturally Negative?” by PIMCO’s global economic advisor, Joachim Fels. To be sure, PIMCO’s baseline forecast does not anticipate negative U.S. yields over the cyclical horizon. Nonetheless, Joachim’s thoughts remind us that a number of factors may be putting downward pressure on Treasury bond yields.
Although lower rates will benefit many consumers and industries, falling rates are almost never good news for U.S. corporate defined benefit plans because their liabilities typically are marked-to-market based on bond yields. Lower yields jack up the present value of their liabilities.
But it is challenging to appreciate the extent to which further interest rate declines may hurt pensions. After all, defined benefit plan managers have rarely, if ever, faced initial conditions like the current ones.
50 is the new 100
A low interest rate environment can bring with it a degree of complacency. That is, plan sponsors may feel that their risk exposure is lessened going forward because there is just not as much room for rates to fall. However, it is crucial to recognize that (because of convexity effects) smaller declines in interest rates from today’s levels can cause as much pain as larger declines had in the past.
Figure 1 compares the interest rate sensitivity in dollar terms of a hypothetical liability stream in today’s market versus mid-2007 (the last time we faced, unbeknownst to us at the time, end-of-cycle dynamics). At today’s rates, a 100-basis-point (bp) decline would likely have about twice the impact on liabilities as an identical decline from rates that prevailed in mid-2007. Similarly, an interest rate decline of only 50 bps today would have about the same dollar impact as a 100-bp drop would have had in 2007.
Of course, if long-term rates were to fall by another 100 bps from current levels (which would bring them to historical lows), there would likely be significant consequences on the asset side of the ledger. Potentially negative returns on return-seeking assets (in addition to unhedged liability growth) could translate into funding ratio percentage point declines in the high single-digits. With a 200-bp rate drop (which would drive long-term rates into negative territory), the funding ratio deterioration could reach the mid-teens in percentage points.
Those undesirable outcomes would lead to equally unpleasant consequences, such as significant increases in plan contribution requirements, higher insurance premiums to the Pension Benefit Guaranty Corporation (PBGC), and adverse pension accounting implications.
Implications for LDI investors
It is risks such as these that have led many corporate pension plans to seek to minimize balance sheet volatility through liability-driven investing (LDI). But plan sponsors must still be prepared for all scenarios. In our view, they should:
- Not let behavioral biases drive risk tolerance. Even if the zero bound is still an untested concept for longer maturities, it’s a possibility that shouldn’t be ignored. Therefore, today’s rates, though perceived as extremely low, could turn out to be attractive if the final destination is indeed zero or negative.
- Recognize that long rates do not have to fall to near zero to trigger a significant decline in a plan’s funding position. Convexity effects are exacerbated in lower interest rate environments.
- Understand potential second-order effects before taking the focus away from liability matching. If rates were to continue to melt, some plans might need to reach for returns in an attempt to offset ballooning liabilities. Yet they could end up assuming risk well beyond their comfort level.
As Joachim pointed out, it would take a number of factors for negative rates “to go from theory to reality” in the U.S. While it is unknown whether it will happen or how long it could take, the time to plan for such an adverse scenario is now.
For more on liability-driven investing, please see “The Great LDI Paradox: Long Government Bonds and Active Management.”