Investing August 9, 2019

Explaining the ‘New Normal’ for Interest Rates

"The new normal for interest rates simply means that retirement investors have to take more risk,” says Steve Foresti, CIO at Wilshire Consulting. 

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During a recent series of interviews with U.S. investment experts focused mainly on the topic of equity market volatility, another topic frequently mentioned was the machinations of the global bond markets.

Bob Browne, chief investment officer, Northern Trust, summarized the matter: “I continue to be surprised by my fellow asset management professionals who think that the long-term norm for the 10-year U.S. Treasury should be closer to 4% or even 4.5%,” Browne says. “This is just too high when you consider among other facts that there is $15 trillion invested the bond markets globally right now that is carrying a negative interest rate.”

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Browne and others explain this as one of the lingering legacies of the Great Recession. “On the day of this discussion the Swiss 10-year is at negative 90 basis points, the German 10-year is trading at negative 56 basis points, and the Japanese 10-year is at minus 20 basis points,” Browne says. “So, why would the U.S. 10-year trading at close to 1.5% or 1.75% seem low? It’s in fact unusually high in the global context.”

Steve Foresti, CIO at Wilshire Consulting, offers a similar take: “I don’t think we can expect to get back to the levels of the 1970s or 1980s in this new global world. I agree that if you compare where U.S. yields are versus Europe, it really puts things into perspective. In Germany, France and other places you have negative yields right now. That means you’re paying to hold these ‘safe’ assets, not getting paid. So, seeing a U.S. rate down below 2% makes sense in that perspective. They are relatively high compared with other developed markets.”

Why Fixed Incomes Rates Are So Low

Browne suggests the unprecedented ability of technologically enabled manufacturers and service providers to deliver supply fast and nimbly to the global marketplace has done a lot to reshape the inflation outlook. Among other outcomes, Browne says, this supply-side dynamic has allowed interest rates to move much lower than was the assumption 15 or 20 years ago.

“From a simple macroeconomic perspective, people have underestimated how quickly supply can shift and adapt to meet changes in demand,” Browne says. “This helps keep rates low because there is not much if any supply-based price inflation in the globalized and Internet-informed economy. We will need to see a fundamental shift in the demand curve in order to see bond yields go much higher, either in the U.S. or globally.”

Browne further observes that, in recent years, when U.S. GDP growth was in the range of 3%, the markets barely pushed the 10-year Treasury rate to 2.25%. In his opinion, the U.S. Federal Reserve is underestimating the likely response of the bond market to sub-2% GDP growth.

“We believe we have peaked in this rate cycle and that the 10-year yield could eventually go down to 1%,” Browne says. “Again, thanks to macroeconomic forces that are here to stay, it appears that yields can remain dramatically lower versus what people would have thought possible just 10 years ago.”

Portfolio Implications for Individuals and Institutions

What are the investment experts doing with this information?

“We’re looking for interest rate exposure without simply owning bonds, and we’re having to compensate by utilizing more equity exposure,” Browne says. “We’re buying global infrastructure equities, global real estate investment trusts [REITs] and high-quality stocks with growing dividends. These are liquid strategies that should be helpful for the retirement market moving forward. You can’t be overly dependent on one source of income.”

Foresti says the recent bout of equity market volatility has shown some of the risks in this approach, but it is nonetheless necessary in the new normal.

“Any time you go through a bout of volatility like we are in now, it tests a few things,” he says. “First, it tests whether the portfolio you have in place is truly consistent with your tolerance for risk.  Times like these are a really good test of the connection between perception and reality around risk and return. We’ve come off some market highs after an extended bull market.”

Foresti encourages investors, both institutions and individuals, to take the emotion out of the picture when adjusting to the new normal. “Each bout of volatility always feels a bit like the first time, and to some extent there is truth to that. It is always something different that causes the sell-off and it’s always a new set of concerns and expectations about the future which one must deal with,” he explains.

Facing this picture, institutional investors have the advantage of following a well-articulated governance structure that makes it harder to deviate and let negative behavioral tendencies impact the portfolio. Individual savers, on the other hand, don’t necessarily have the checks-and-balances of a governance structure and stated long-term goals. It’s easier for the individual’s gut to take over.

“This is important to understand because the new normal for interest rates simply means that retirement investors have to take more risk,” Foresti concludes. “If I need to generate 7% returns and a low-risk fixed-income investment is not even going to give me 2%, this outlook starts to paint the picture of the additional risk you’ll need to take with your growth assets. It will mean more investment in equities or perhaps having to take illiquidity risk in private market investments. It’s a challenge that both institutions and individuals are going to have to deal with.”

Browne and Foresti conclude that it is as important today as ever to educate people about what volatility really means. Just because the dollar value of a portfolio went down for two or three days, if one didn’t sell anything, one didn’t suffer any harm in that respect.

Administration August 9, 2019

Lower Interest Rates Continue to Plague DB Plan Funded Status

“Plan sponsors should review their risk management toolkit to consider whether their investment policy is aligned with the current market environment and to explore potential risk transfer activity,” suggests Scott Jarboe, with Mercer.

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Defined benefit (DB) plan funding ratios decreased throughout the month of July, primarily driven by tightening credit spreads, resulting in a decrease in the discount rate, according to Legal & General Investment Management America (LGIMA). It estimates that the average plan’s funding ratio fell 0.8% to 82.3% through July.

LGIMA’s Pension Solutions’ Monitor report notes that, “The rates market once again took its cues from the central bank. Echoing sentiments other members had voiced in June speeches, Fed Chair Powell’s comments before Congress at the Humphrey Hawkins meeting emphasized concerns over trade issues, slowing global growth, and inflation trending below target. This testimony, coupled with the release of the June FOMC minutes, set the groundwork for the first Fed cut since the financial crisis. At the July 31 meeting, the Fed cut interest rates by 25 basis points and ended their balance sheet runoff two months earlier than planned.”

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LGIMA estimates the discount rate’s Treasury component increased by 1 basis point while the credit component tightened 7 basis points, resulting in a net decrease of 6 basis points. The negative impact due to the change in Treasury rates is a function of positive carry of the liabilities. Overall, liabilities for the average plan increased 1.21%, while plan assets with a traditional “60/40” asset allocation increased by approximately 0.28%.

Due to lower interest rates, liability values increased, and were only partially offset by muted asset performance, according to Ned McGuire, managing director and a member of the Investment Management & Research Group of Wilshire Consulting. According to the firm, the aggregate funded ratio for U.S. corporate pension plans decreased by 0.4 percentage points to end the month of July at 85.6%. It says liability values increased 0.7% for the month, while asset values increased 0.3%.

Northern Trust Asset Management (NTAM) also says positive returns in the equity market were not enough to offset higher liabilities which led to lower funded ratios. It estimates the average funded ratio for S&P 500 DB plans slipped in July from 86.5% to 86%. NTAM says global equity market returns were up approximately 0.3% during the month. The average discount rate decreased from 3.06% to 2.99%, leading to higher liabilities.

According to Mercer, the estimated aggregate funding level of pension plans sponsored by S&P 1500 companies decreased by 1% in July to 86%, as a result of a decrease in discount rates. As of July 31, the estimated aggregate deficit of $322 billion increased by $14 billion as compared to $308 billion measured at the end of June. The S&P 500 index increased 1.44% and the MSCI EAFE index decreased 1.26% in July. Typical discount rates for pension plans as measured by the Mercer Yield Curve decreased from 3.44% to 3.38%.

“Plan sponsors should review their risk management toolkit to consider whether their investment policy is aligned with the current market environment and to explore potential risk transfer activity, such as a lump sum window, which may be attractive to pursue before the end of the year,” said Scott Jarboe, a partner in Mercer’s Wealth Business.

However, River & Mercantile’s “Retirement Update – August 2019” calls July “uneventful.” “Modest movement in discount rates with generally small equity gains should leave most plans in more or less the same funded position at the end of the month as they were in at the end of June,” it says.

October Three reports pension finances dipped slightly in July as long-term corporate bond yields hit record lows. Both model plans it tracks lost a fraction of 1% in July and are basically treading water (Plan A down 1%, Plan B flat) through the first seven months of 2019. Plan A is a traditional plan (duration 12 at 5.5%) with a 60/40 asset allocation, while Plan B is a largely retired plan (duration 9 at 5.5%) with a 20/80 allocation with a greater emphasis on corporate and long-duration bonds.

Brian Donohue, partner at October Three Consulting, says, “Discount rates fell a few basis points last month and have now reached the lowest yields on record. We expect most pension sponsors will use effective discount rates in the 3.2% to 3.7% range to measure pension liabilities right now.” He also notes that, “Pension funding relief has reduced required plan funding since 2012, but under current law, this relief will gradually sunset by 2023, increasing funding requirements for pension sponsors that have only made required contributions.”

Aon’s Pension Risk Tracker shows the S&P 500 aggregate pension funded status decreased slightly in July, from 86.8% to 86.6%. Pension asset returns were positive in July, ending the month with a 0.6% return. The month-end 10-year Treasury rate increased by 2 basis points (bps) relative to the June month-end rate, and credit spreads narrowed by 7 bps. This combination resulted in a decrease in the interest rates used to value pension liabilities from 3.20% to 3.15%.

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