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Damage of low rates

The best thing that could be done for pension funds in 2015 is something they can't do themselves: increase interest rates.

An interest-rate increase is necessary for the financial health of pension plans because low rates continue to erode the funding levels of the plans, placing huge financial burdens on the sponsors and threatening the security of pensions.

One company conforming with market interest rates is AT&T Inc. According to its most recent 10-K filing, the company in 2013 raised its discount rate for valuing its defined benefit plan liabilities by 80 basis points, and lowered its obligation by $4.5 billion. But that wasn't enough to make up for the effect of 2012, when it lowered its discount rate by 100 basis points and increased its pension obligations by $7 billion.

Companies might have to reduce their discount rates again this year because of the steady decline in yields since the beginning of last year. As of Jan. 16, the 20-year Treasury yield had fallen to 2.17% from 2.41% as of Jan. 2, according to the Department of the Treasury. As of Jan. 2, 2014. the 20-year Treasury yield was 3.68%.

The continued unfavorable outlook on interest rates will likely accelerate pension plan freezes and closings.

The Federal Reserve, through its open market committee, has signaled that it plans to start raising short-term rates this year, and in theory that should be good news for U.S. pension funds and the economy, as it would seem to set a course for returning interest rates to normal levels.

But the Fed's move won't necessarily affect long-term U.S. rates, which have fallen over concerns that include continued weak growth in the global economy and, in the past year, a steady drop in oil prices. Global uncertainty is causing money to flow into the safe haven of U.S. Treasuries, pushing rates down.

And the move last week by the European Central Bank to pursue a different monetary course and seek to lower interest rates through a quantitative easing policy could thwart any attempts by the Fed to increase interest rates.

Mario Draghi, president of the ECB, announced Jan. 22 that the ECB will begin e60 billion ($69.4 billion) of public and private debt purchases per month as part of its quantitative easing strategy.

The Bank of Canada on Jan. 21 lowered its target overnight rate by 25 basis points to 0.75%.

Given the uncertainty over U.S. monetary policy, and the actions by Europe and Canada, prospects for a significant boost in interest rates in the coming year appear poor. As a result, pension plan officials will find derisking by moving to liability-driven investing a continuing challenge.

Considering the high cost of moving to fixed income because of the low yields, pension plans should take up the advice of Bob Geldof, musician, entrepreneur and activist.

At the U.K.'s National Association of Pension Funds annual conference last October, he called the low yields on bonds “ridiculous” and advised pension fund executives to look to new markets and asset classes in which to invest.

Low rates already have driven executives at many major pension funds to seek alternatives to fixed income. But such allocations come with additional costs and complexity for asset and risk management, while offering fewer opportunities for large-scale investments compared to fixed income. Pension executives must ensure they have the resources and governance structure to oversee new allocations.

Adding allocations to new strategies and asset classes brings no guarantee of increasing performance or reaching investment objectives.

The $292.9 billion California Public Employees' Retirement System, Sacramento, announced last September it was dropping its $4 billion hedge fund allocation, citing high costs, complexity and scalability. A normal fixed-income market can overcome those kinds of obstacles.

Other pension funds have reconsidered alternatives for various reasons. Officials at Pensieonfonds Zorg en Welzijn, Zeist, the Netherlands, eliminated the fund's $5 billion hedge fund portfolio over the past year.

PFZW cited the allocation's failure to make a “sufficient contribution” to a diversification objective.

Under the pension fund's new investment policy “all investment categories are assessed for their sustainability, complexity, costs and their contribution to PFZW's objective of index-linking pensions,” a news release said.

Whether a European policy of reducing rates will achieve the objective of boosting the European economy, it likely will damage European pension funds by reducing their level of funding.

U.S. corporate average pension funding levels dropped for the year ended Dec. 31 to 83.6%, according to the Milliman 100 Pension Funding Index, 87.3%, according to BNY Mellon, and 79%, according to Mercer. They represent drops ranging from 4.7 percentage points to 9 percentage points.

Canadian plans have had similar experiences, with the median funding level dropping to 90.6% from 93.3% a year earlier, according to Aon Hewitt.

In the U.K., funding levels of the combined FTSE 350 companies fell to 85% from 90.9% in the same period, according to Mercer.

For the public sector, the aggregate funding level of U.S. city and county pension plans rose to 73% in fiscal year 2013, up from 69% in 2012, according to a Wilshire Consulting data. But these public plan funding levels likely will worsen as rates have fallen since that date.

Central banks should realize that trying to achieve roaring recoveries through very low interest rates has devastating effects on pension funds, and likely in the long run on retirees. The policies also can weaken the stimulative power of the lower interest rates.

That's because the resulting lower funding levels mean plan sponsors have to increase their plan contributions, taking resources from business expansion, hurting corporate investment spending.

The low interest-rate policies also put defined benefit plans on an accelerated path toward extinction, damaging the idea of a prudently funded and financially secure safety net of retirement income.

The efforts to stimulate the economies in the short run with very low interest rates come with long-term costs.

This article originally appeared in the January 26, 2015 print issue as, "Damage of low rates".