What Impact Will The Interest Rate Hike Have On Pensions?
This autumn will mark the beginning of the end of the low interest rate era.
Soon (potentially as early as next month) the US Federal Reserve is expected to raise its benchmark lending rate for the first time since 2006.The first rate rise will command huge attention, but it's the timing and scale of the subsequent rises that require forethought. Down the line, bigger questions include the allocation of assets in your portfolio over coming years as bonds and so-called “bond proxies” lose their lustre, and cyclical stocks are tipped to return to favour. But this must be weighed against the disruptive effect that higher debt repayments are likely to have on the consumer economy and potentially, the property market. At a personal level, this could translate into a decision to fix your mortgage now, grab a zero per cent credit card deal, or take advantage of a cheap car loan – or even check out tracker rate savings bonds.
But will this have an impact on pensions? The simple answer is yes. Retirement savers who rely on the interest from their savings to supplement their pension income will no doubt greet an interest rate rise with loud cheers. Other good news for this sector of society is that annuity rates which have been at historical lows could improve with a rise in interest rates, which means those planning to retire soon could secure a higher income. Less positive is the danger that pensioners could see a fall in the value of their pension funds. This is because when investors near retirement age, money is often automatically moved out of the stock market and into bonds as a way of de-risking pension savings. However, bond prices tend to fall when interest rates rise in order to increase the yields and attract buyers.
The market environment of the past five years has been extremely challenging for defined benefit pension funds. In particular, low long-term interest rates have led to an increase in the value of scheme liabilities which has, in turn, affected funding ratios despite overall sound investment returns. However, as signs begin to emerge of an economic revival and a higher interest rate environment, it is important for pension funds to be aware of how changes in interest rates can impact funding ratios and how trustees can mitigate some of the risk inherent in such changes. Given that long term interest rates are low by recent historical standards, pension schemes might assume they should hold off hedging until they return to 'normal' levels. However while interest rates are low in comparison to levels seen over the last 10 years this does not necessarily mean that schemes should delay hedging their liabilities. The key, therefore, is to anticipate this rate rise in order to best respond to it.