Rate hikes to help pensions but cool valuations

5 min read

While pension funds will catch a break on their funding levels if interest rates rise, they also may suffer if valuations fall at the same time.

One group absolutely praying for the Federal Reserve to start a rate hike campaign are the private companies with large pension fund liabilities.

That’s because interest rates play a key role in how a corporate pension fund’s future liabilities are calculated. Private-sector employers use an AA-corporate bond rate to calculate their pension liabilities for public disclosures, while a Treasury rate can be used to calculate solvency.

The lower current interest rates are, the more you have to invest, now and along the way, in order to have enough to make pension payments when they come due.

So a rise in market interest rates will make pension liabilities appear lighter, reducing pressure on corporations to make additional payments to their pension funds.

Falling rates are the reason why, even though returns in financial markets have been pretty good, pension liabilities have skyrocketed. The pension deficit among the Fortune 1000 group of companies more than doubled in 2014 by US$181bn, to US$343bn, according to consultants Towers Watson. In aggregate the group is now only 80% funded on its pensions, as compared to 77% in the dark days of 2008.

Interestingly, there has been a trend among pension plans to try to take risk off the table by reducing their interest rate liabilities, often done by buying out pensioners for lump sums or by buying structured fixed income solutions, usually funded by selling equities. Given that interest rates haven’t got far to fall, even given negative rates on many securities, this is arguably a bit of bad market timing among pension managers.

One other issue is that low interest rates have helped support high market valuations. Raise rates and equities or other risky assets may see their valuations fall.

This certainly doesn’t have to happen; valuations may go on rising, and could even rise in a rising interest rate environment. Still, if interest rates rise gradually, and financial asset valuations start to revert towards historical norms, pension funds could see increasing, and expensive, pressure to up corporate contributions.

Mean reversion, but when?

Fund manager GMO argues that what it sees as high valuations represent a risk that too many pension fund sponsors fail to adequately measure and mitigate.

“We believe that the biggest risk is valuation risk: the risk of loss that is realized when expensive assets revert to fair value. This risk is critically important today as we believe stocks and bonds are expensive globally,” Catherine LeGraw, a member of GMO’s asset allocation team, wrote in a recent white paper.

“Valuation risk is the risk of overpaying for an asset. We believe it is the biggest risk faced by investors: buying expensive assets can doom an investor to low long-term returns or the permanent impairment of capital.”

Start with an S&P 500 trading at a Shiller p/e of 20 to 48 and your typical 10-year forward real returns are less than 2%, according to GMO. Start with a Shiller p/e of 5 to 13 and you can expect more than 10% real annualized returns over that next decade. At least those figures hold true for the last 89 years.

Same goes for bonds, and this time looking at 195 years of data. Buy in at Treasury yields of below 3& and you get a negative annualized 10-year real return. Buy in above 8% and you are looking at something like 7% real annualized over your decade.

Put bluntly, GMO sees no value out there. On its measure, every single major asset class, except cash, would fall in price if it immediately reverted to ‘fair value’. A global market cap weighted equity portfolio would lose 32% if it suddenly started trading at fair value.

Mean reversion is one of those things which happens, but not, often, on a timescale fast enough to satisfy investors impatient with what they consider to be rich or cheap markets and securities. Give it seven or 10 years, though, and the reversion usually happens. The correlation between stock valuation and future returns is only 20% over one year, according to GMO calculations. Over 10 years, however, the correlation is 60%.

While the relationship between interest rates and market returns is not mathematical, there is a tendency for risk assets to have a tougher time in rising rate environments.

The next decade is likely to see rising rates but mean-reverting valuations, revealing whether the current under-funding of corporate pensions is just an interest rate illusion.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

James Saft