Higher rates can create both benefits and costs for plans.
By Ed McCarthy
After a quick run-up in early 2021 that put the 10-year Government of Canada bond rate in the 1.5% to 1.6% range, rates dropped back to the 1.2% range from mid-July to mid-September. The upward trend resumed in late September and as of late October, the 10-year rate had climbed to 1.6%. Rates matter for defined benefit pension plans, so we asked several investment market participants for their thoughts on the potential impact of rates on plans.
Rate Outlook
Ian Riach
Ian Riach, senior vice president, portfolio manager and director of Balanced Portfolio Management with Franklin Templeton Investment Solutions in Toronto, expects inflation pressures to subside over the next few quarters and that interest rates will rise modestly from current levels. However, he says, “the Bank of Canada will likely not want rates to rise too much as that will derail the economic recovery. They are a large player in the bond market now with their quantitative easing program so they can influence longer-term rates. Normally, they would just maneuver short-term rates.”
Riach notes that the 10-year Government of Canada (GoC) bond has already seen a big move from last year (rising around 70 basis points since July 2020 and 40 basis points since summer 2021) to 1.6% today. “We don’t expect too much more of a rise for the 10-year GoC bond, but maybe it will go to 1.8%,” he says.
Higher rates can create both benefits and costs for plans. Yusuke Khan, partner and director of strategic research (investments) at Mercer Canada in Montreal, notes that while the circumstances of each DB plan will be different, higher interest rates are, all else being equal, beneficial to the financial health of DB pension plans as higher interest rates will typically result in lower current values of their liabilities.
Yusuke Khan
However, plans should carefully consider “what else may coincide with a higher interest rate environment, such as a potential correction in the equity markets, higher inflation, or the potential for a recession in highly indebted economies,” he says. “These events would most likely be detrimental to DB pension portfolios.”
Contingency Plans
Sponsors can consider several responses when planning for potentially higher rates, says Riach. One step is to reduce their discount rate or expected rate of return, but this has an impact on funding ratios and could increase the overall liability of the plan sponsor to fund shortfalls in funding ratio.
Another option is to take on more portfolio risk in the hope of increasing returns. Measures could include increasing the plan’s equity allocation and taking a more dynamic approach to fixed income management, including:
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Increasing the allotment to high quality corporate bonds where the yields are higher.
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Looking to higher yielding fixed income investments like asset-backed securities, bank loans and private debt instruments.
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Diversifying geographically to higher yielding regions, but this introduces foreign exchange risk, as well as country risk, which must be managed.
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Looking at alternative investments like real estate or infrastructure to get higher yields and a long-term income stream from contractual arrangements. Also, these types of assets can act as a diversifier because they are not perfectly correlated to bond and equity markets.
Carmen Staltari
Carmen Staltari, director, investments with Willis Towers Watson in Toronto, believes that once a plan sponsor has determined the overall mix for the pension plan, in terms of strategies, it makes sense to consider non-traditional investments in addition to equities and bonds to better diversify the sources of return. “Since no one has a crystal ball when it comes to the capital markets, we believe a plan sponsor’s best chance of achieving their goals and objectives is to build a diversified portfolio designed to do well in all market environments,” says Staltari.
“That means exploring asset classes like private debt, private equity, real estate and infrastructure. Each will have different outcomes under different market environments, providing the portfolio and ultimately the plan sponsor to a smoother journey.”
Ed McCarthy is a longtime financial writer and author of three books, including “Foundations of Computational Finance with MATLAB.”
