Falling interest rates wreak havoc in US pension system
General Electric’s recent decision to freeze retirement benefits for 20,000 employees provides the latest unwelcome illustration of the problems confronting millions of US workers battling to secure a decent income in old age.
The pain felt by GE’s employees is shared by more than half a million workers across multiple US industries that also face cuts to pension benefits, according to the Washington-based Pension Rights Center.
GE’s pension obligations stood at $91.8bn at the end of last year, significantly higher than the industrial conglomerate’s $66bn market value on December 31.
It faces a funding shortfall of $22.4bn across its US and international pension funds. GE aims to reduce this by up to $8bn by cutting benefits and moving more staff into a defined contribution scheme, which places more responsibility on to individual workers for building a retirement saving pot.
Shifting workers out of generous salary-linked defined benefit pension schemes is a tactic widely adopted across US corporates. Just 16 per cent of Fortune 500 companies offered a salary-linked defined benefit retirement plan to new employees in 2017, down from 59 per cent in 1998, according to Willis Towers Watson, the pension scheme adviser.
The strains on US corporate defined benefit pension plans are likely to intensify, due in part to the steep decline in long-term interest rates that are used to measure (discount) the value of future obligations to employees.
With the Federal Reserve Board cutting interest rates this year, the yield on the US 30-year Treasury bond has sunk to an all-time low at 1.94 per cent in late August, down from 3.12 per cent at the start of March.
This dramatic fall has led pension plan sponsors to cut their discount rate to nearly 3 per cent compared with 4.2 per cent in 2018 and 7.2 per cent in 2001, according to Goldman Sachs Asset Management.
“The most notable and direct impact from falling interest rates is to exert upward pressure on [the value of] pension obligations and downward pressure on funded ratios,” says Michael Moran, a pensions strategist at GSAM.
Goldman estimates that the funded status of the US corporate defined benefit system has dropped to 86 per cent from a high of 91 per cent as recently as April 2019.
The deterioration has occurred in spite of strong gains for US equities with the S&P 500 hitting an all-time high this week, up 21.5 per cent this year.
Declines in interest rates have also boosted the value of fixed income holdings for many pension funds but liabilities have risen even faster, resulting in the fall of funding levels.
Mr Moran says US corporate pension plans, particularly those at or near fully funded levels, should maintain or increase hedges that would protect them against unexpected shifts in interest rates.
This is a potentially expensive strategy because reductions in interest rates have driven up hedging costs. But GSAM says it is “prudent” given many companies have pension obligations that stretch far into the future beyond the duration of their bond portfolios.
GSAM also advises corporate clients to “make low interest rates work for them” by borrowing in the debt market and using those proceeds to bolster their pension plan.
“Both UPS and FedEx have recently executed ‘borrow to fund’ pension transactions. We would not be surprised if more companies revisit this strategy if interest rates remain at these historically low levels,” says Mr Moran.
Jay Love, a partner at Mercer, the investment consultant, says low rates have encouraged more companies to undertake pension risk transfer deals where they pay an insurance company to take on the responsibility for pension liabilities.
The value of these deals, also known as pension buyouts, reached $27bn in 2018, up more than a fifth on the previous year, according to LIMRA Secure Retirement Institute, a data provider. A further $9.5bn were completed in the first half of 2019.
“We expect high levels of activity to continue in the de-risking market,” says Mr Love.
Ultra-low rates also present a profound challenge to the health of the US public pension system which oversees more than $4tn in assets on behalf of 20m active and retired public sector workers.
Public pension plans use an assumed return based on their historic performance to calculate their future liabilities, instead of the discount rate used by corporate defined benefit plans.
Public pension plans have gradually reduced their assumed return from 8 per cent in 2001 to 7.2 per cent but they have consistently underperformed this objective, according to the Center for Retirement Research at Boston College.
The average annualised return for US public pension plans since 2001 was just 5.9 per cent. The top quartile of performers delivered 6.7 per cent over that period while the bottom quartile underperformed with an average annualised return of just 5.1 per cent.
“As the period of underperformance nears 20 years, pressure has increased for public pension plans to use assumed returns that are better aligned with the reduced expectations for future market performance,” says Jean-Pierre Aubry, assistant director of state and local research at the CRR.
That pressure appears likely to increase given the subdued outlook for fixed income returns and the reduction in the discount rate which has already occurred across the US corporate defined benefit sector.
The failure to meet return expectations contributed to a clear deterioration in the aggregate funded ratio (assets as a share of liabilities) for US state and local pension plans which has sunk from a high of 102.7 per cent in 2000 to 72.8 per cent last year.
Although state and local governments have increased their cash contributions over the past decade to help plug the gap, the public pension system still faced a deficit of around $1.4tn in 2018.
The aggregate data obscures funding developments among individual state pension plans. Boston College split public pension funds into three groups based on how well they were funded.
The top third saw their funding ratio drop from 110 per cent in 2001 to 91 per cent last year. But the deterioration was much more significant for the weakest third which saw their average funded ratio sink from 92 per cent to just 55 per cent over the same period, suggesting the gap between the top and bottom has doubled.
“Much of the divergence has occurred since the financial crisis as the worst funded group has continued to deteriorate,” says Mr Aubry.
A study by economists at the Federal Reserve of Boston published in July found public pension funds tended to take on more risk when their funding ratios were weak and interest rates were low between 2002 and 2016.
“Public pension funds from states in worse fiscal condition (measured by higher debt levels or weaker credit ratings) took on more risk, especially during periods of low interest rates,” said the Boston Fed.
US interest rates have declined since 2016, suggesting that pension funds with weak funding ratios will have further increased their exposures to risky assets.
One explanation is that these public pension funds are “reaching for yield” and investing more in riskier assets such as private equity, hedge funds and real estate to drive up returns.
Another less innocent explanation highlighted by the Boston Fed is that public pension funds are attempting to mask the true extent of their underfunding by increasing their holdings of riskier assets. Holding riskier assets with higher expected returns allows public pension plans to reduce the reported value of their liabilities under US accounting rules. It also means that there is less pressure on state and local governments to increase their contribution to close funding gaps.
The Boston Fed says that the benefits promised to workers by public pension funds are nearly risk-free because they enjoy strong legal protections and so these liabilities should be valued using a much lower discount rate than the assumed return.
This, however, could force states to increase taxes or to cut pension benefits, exposing public sector employees to the same problems as workers at GE.
A health check for the US pension market
The US is the world’s largest pension market with assets of $27.5tn but it ranks as the 16th healthiest retirement system globally from 37 nations reviewed annually by the Melbourne Mercer Global Pension Index, the most comprehensive assessment of its kind.
Issues the index measures include the generosity of retirement benefits compared with average wages and whether pensions payments are adjusted regularly to reflect changes in inflation and living standards.
It also examines the sustainability of pension systems and whether they hold enough assets to continue to pay pensions given the challenges of increasing longevity, a measure that the US scores relatively well on.
“There has been an improvement in the overall health of the US pension since 2015, the year of the first MMGPI assessment,” says Peter Stewart, a principal with Mercer in New York.
Further improvements that could be made include raising the state pension age, increasing the minimum pension paid to low-income pensioners, boosting the level of mandatory savings contributions, limiting the access to savings pots before retirement and providing incentives to delay retirement.
Falling interest rates wreak havoc in US pension system
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