NEW YORK — Rising interest rates are giving pension executives heartburn.
The increases are generating a host of problems, ranging from weakened equity markets, to slipping bond markets to faltering alternative investments that use leverage. The Federal Reserve increased the overnight borrowing rate to 5.25% from 5% on June 29, and is signaling that further hikes might be necessary to curb inflationary threats. Most observers, however, believe rate hikes are nearing an end.
In addition, continued low volatility in the U.S. stock market is dampening stock returns. Periods of low volatility general result in tepid markets.
The only silver lining is that higher long-term interest rates are lowering the value of pension liabilities. Discount rates used to value liabilities are based on the composite yields of high-grade corporate bonds and Treasuries. The total funded status of corporate pensions for companies in the Standard & Poor's 500 index was 90% at the end of 2005, up from 87% at the end of 2003, according to research done by David Zion, an equity analyst at Credit Suisse Group, New York.
In a study released last month of the 200 largest pension plans in the U.S., JPMorgan Asset Management, New York, estimated the combined liabilities of those plans will be about $60 billion lower than the approximately $450 billion they were at the end of last year because of rising rates.
The upshot is that institutional investors will need to seek non-traditional sources of alpha and beta, such as portable alpha strategies, commodities and currencies, according to investment experts.
Joanne Hill, managing director of equity product strategy at Goldman Sachs & Co., New York, said the current economic environment would further drive investors to seek higher sources of alpha, including portable alpha solutions and emerging markets equity. She said investors could also be driven to seek different forms of beta, such as commodities and currency management.