Interest Rates, Recessions and Pension Plan De-Risking

Bob Browne, chief investment officer at Northern Trust, recently sat down with PLANSPONSOR for a broad conversation about the global economy and the 2019 performance of stock and bond markets.

Browne also had some insight to share specifically with pension plan sponsors. He noted that many of Northern Trust’s pension plan clients are seeking new ways to take uncompensated risk off the table.

“This has become a very serious conversation for many clients, given that they are pursuing, many of them, an end-state for their plan,” Browne said. “We encourage all pension plans, whether they are open or closed, to consider their objectives and evaluate their unique horizon.”

Browne said pension plan sponsors will benefit from taking a step back and remembering the journey of the last 10 years. Relatively few plans may carry a 100% funded status, but relative to the funding positions seen during the depths of the Great Recession, plans are broadly speaking much better off today. Many are within striking distance of risk transfers, in fact.

“If you have benefited strongly from the long rally we’ve had in equities since the Great Recession, and if your funding status has greatly improved, why not ask yourself if it is time to lock some of that in?” Browne asked. “What we hear from plan sponsors is that they don’t want to lock in their gains now because they are assuming that interest rates are too low right now. To us, that’s a big bet.”

As Browne explained, there is some sense to the argument that rates could move substantially higher in the coming years. But there are also reasons to argue that interest rates may not move much higher in coming years, certainly not at a rapid pace. 

“I think the argument for greater rates is coming partly from the discussion of Modern Monetary Theory [MMT],” Browne said. “Certain parties are talking about the idea that budget deficits can be larger and carried for longer than was traditionally believed. In addition to this, people say more coordination between fiscal and monetary policy could start to develop a framework that is much more expansionary here in the U.S.”

Browne said his opinion is that the U.S. bond market could handle this type of framework “for a little bit of time, but not forever.” He said it is hard to see how the U.S. bond market would respond to another trillion dollars in government debt. For this and other reasons, rather than making decisions based on pure speculation about what interest rates may do in the next five years, Browne said it is much wiser to conduct an honest reassessment of goals and risks in the context of the unique benefit liability profile.

“In my estimation, it is actually an unexpectedly low rate environment that would really crush pensions,” he warned. “If we unexpectedly enter another recession and the five-year Treasury is trading at 1%, and the equities give up part of their recent gains, that’s a really painful scenario for pensions.”

The takeaway, Browne said, is that pension plans should embrace the idea that their goal is not necessarily to achieve the maximum returns each year. Performance is critical, but pension plans must also prudently assess their projected liabilities and design an investment approach that seeks the necessary returns in a risk-controlled and cost efficient way.

Browne also pointed out that a recession is “something to be prepared for, but at this stage we see the probability of recession as low.”

“We think the chance of a severe recession in the short term is a low risk,” Browne said. “We don’t see the same excesses built up in the system that we had in 2008. We don’t see a massive deleveraging cycle ahead of us within, say the next five years. But at that point, if there are five more years of good times, it will become a different conversation. Such a long bull market could bring a lot of greed into the marketplace, which could change the conversation.”

Getting Off the Funded Status Rollercoaster

During a recent webinar on this topic, executives on the PGIM Fixed Income team offered a few practical recommendations for pension plan sponsors to consider when it comes to “getting off the funded status rollercoaster.”

These include raising the pension plan’s interest rate liability hedge ratio to help mitigate interest rate risk; reducing spread duration and/or risk asset exposure to help lower funded status drawdown risk; moving from a market benchmark to a liability cash flow benchmark to help manage credit migration risk; and treating risk allocations and interest rate hedge ratios as distinct decisions to help achieve a high interest rate hedge ratio with desired risk asset exposure. Such strategies can be complex to design and operate, the speakers admitted, and will likely require the engagement of a specialist consultant or investment provider.  

Importantly, the PGIM Fixed Income team emphasized that the move to a liability-driven investing (LDI) strategy is a serious decision requiring a diligent planning and execution process. They said plotting the rollercoaster exit strategy first requires that sponsors identify the primary risks to funded status. For most corporate defined benefit pension plans, they are declining long-term U.S. interest rates; tightening long-dated corporate spreads; credit migration in investment grade corporate bonds; and falling risk asset prices, principally in the U.S. and international equity markets.

The speakers concluded that pension plans have already benefited from the rise in interest rates and strong equity markets following a long period of easy monetary policy and, more recently, the 2016 presidential election, fiscal stimulus and corporate tax reform. The said the fundamental question for pension plans to ask today is, “Should you stay on the funded status rollercoaster or move toward a recession-ready LDI strategy?”