An observation that may be made about the current economic condition is that it is penalizing savers in favour of spenders. Pension plans in particular, which represent the interests of long-term savers in many jurisdictions, are adversely affected by these conditions. Not the least of this impact is due to challenges from low interest rates.
Pension plans in Denmark were advised a few weeks ago that they would be allowed to raise the discount rates they use to calculate their liabilities to better reflect long-term growth and inflation prospects. In the U.S., a recently introduced transportation bill(!) set out a mechanism for smoothing interest rates for pension plans. The Canadian valuation model is a bit different, as it requires plans to reflect the current low rates but then allows some flexibility in the funding schedule. All of this is welcome news to pension plans.
However, the scenarios unfolding in Europe raise a number of interesting issues for pension plan sponsors to consider.
- It is becoming increasingly obvious that not all sovereign bonds represent a risk-free investment and that corporate bonds, in fact, may sometimes offer the more attractive (and safer) risk-adjusted return. The choice of which rate to use to discount the value of “risk-free” pension obligations becomes even more interesting.
- While it is hard to envision a protracted period of low interest rates, there are parallels between the European crisis and Japan’s scenario from a decade ago. Pension plans need to face the very real possibility that rates will remain low for much longer than previously expected.
- If there is inflation on the horizon, it may not correspond to the types of inflation that are best remembered from the 1960s and later—wage (demand pull) inflation or commodity (cost push) inflation. Bear in mind, however, that energy, food and housing prices are excluded from core inflation. Other types of inflation include monetary inflation (governments printing money), fiscal inflation (excess government spending) and foreign exchange inflation (devaluation of local currency raising the price of imported goods). These latter types of inflation may be less familiar to most of us but may represent the imminent danger from inflation more accurately.
Fortunately, Canadian pension plans may be less vulnerable than plans in other parts of the world to some of these inflation issues and should be fairly sheltered from the pure currency impacts of any European fallout. However, global events will affect us in terms of equity market correlations, continued low interest rates, financial counterparty risk and overall market contagion.
Are there any safe harbours to consider in asset allocation in this environment? Some of the investment ideas currently being discussed include the following:
- an appetite for high-quality corporate bonds and caution about government debt;
- an appetite for high-quality dividend-paying stocks in preference to fixed income obligations that have no upside; and
- a preference for real assets over financial assets to protect against most types of future inflation.
This may be one of the most interesting times to be managing a pension fund—and one of the periods in which our more recent experiences will deliver the least wisdom. In the famous words of George Santayana, “Those who cannot remember the past are condemned to repeat it.” It may be time to brush off our history books and see how long-term investors have responded to similar challenges in the more distant past.