Interest rate increases cause problems but lower liabilities

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.

"The policy direction most appealing to pension plans is to think of buckets or budgets in terms of risk characteristics rather than percent of assets, than to make sure there are numerous and well-diversified sources of risk and associated return," she said.

Greg Fedorinchik, executive director of the global asset allocation solutions group at UBS Global Asset Management, Chicago, concurred.

"I think people have really begun to embrace the idea of portable alpha and risk budgeting," he said. "I think they are beginning to rely less on their policy portfolios as a crutch, and that isn't a fad, it's here to stay. It's this notion of risk capital. That's not to say the policy portfolio is obsolete, but plan sponsors don't want to constrain the opportunities to add returns."

James Haskel, director, portfolio strategy at Bridgewater Associates Inc., Westport, Conn., said investors will continue to seek sources of alpha, especially in portable alpha strategies. Bridgewater offers a portable alpha strategy that uses what it claims is 71 different sources of alpha. "Separating alpha and beta is inherently a better and more efficient way to manage money," he said.

But rising interest rates may continue to give investors fits.

One problem is that rising rates are causing stocks and bonds to be more highly correlated, giving plans less diversification if stock and bond markets go south in tandem. "The recent weakness in both stocks and bonds does provide some early indication that their correlation will be more positive going forward," Ms. Hill said. "I think this positive correlation going forward will be a long-term trend."

Increasing rates also hurt investments that rely on leverage.

"All things being equal, rising interest rates reduces the benefits of borrowing. We can probably expect to see a decline in the use of leverage, and it could hurt general arbitrage strategies," said Stephen Nesbitt, a partner at Cliffwater LLC, Marina Del Rey, Calif., a consulting firm specializing in alternative investments.

John Birdwood, director of fixed-income strategy at Baring Asset Management, London, said rising rates could put a squeeze on the equity markets globally. "(When interest rates were low) the whole private sector looked at doing things with debt financing; that's going to become less true. If it turns out the Fed goes to 6% and beyond, it will trigger much more ?severe effects on the corporate finance world."