Interest rate levels are critically important to the financial health of defined benefit pension plans.
Many DB plans are in their best financial positions in decades, largely due to the dramatic rise in interest rates over the past few years, but decreases in interest rates could pose a major risk for many plans.
Changes in interest rates have such a significant effect on DB plans’ financials because, when the plan actuary measures liabilities and costs, they use a discount rate assumption to calculate the present value of expected future benefits to be paid to its members. Higher interest rates usually mean the actuary will use a higher discount rate assumption, while lower interest rates are usually associated with lower discount rates.
The effects of interest rates and the discount rate assumption on DB plan financials are complex. The following are some important considerations for plan sponsors to keep in mind:
- When the discount rate assumption increases, pension liabilities and costs decrease and vice versa.
- Pension liabilities and costs tend to be very sensitive to the discount rate assumption. This is because pension benefits are paid for many years into the future, so they’re discounted over long periods when calculating their present value.
- Given the long-term nature of DB pension liabilities, long-term interest rates matter much more than short-term interest rates when measuring liabilities and costs.
- Long-term interest rates are difficult to predict. At the end of 2021, the yield on long-term Government of Canada bonds was 1.7 per cent. At the time, not many analysts were predicting that, by the end of October 2023, the yield would rise to 3.9 per cent. While much media attention is focused on predicting future changes to the Bank of Canada policy rate, it’s important to keep in mind that it’s a short-term interest rate and changes to this rate don’t necessarily flow through to long-term interest rates.
- Changes in interest rates affect pension plan assets as well as plan liabilities, with the effect on plan assets heavily dependent on the plan’s investment strategy. Investment de-risking strategies often focus on better matching the impact of interest rate changes on plan asset values to the changes in plan liabilities.
The effects of interest rate changes on the discount rate assumption depend on the type of actuarial valuation the plan actuary is conducting. A solvency valuation is premised on the pension plan winding up on the valuation date and the settlement of all plan obligations. Plan obligations are typically settled in a windup through a combination of the payment of lump-sum commuted values and the purchase of a group annuity from an insurance company.
The discount rate assumption for the calculation of commuted values payable from DB plans fluctuates with changes to Canadian long-term provincial and corporate interest rates. The discount rate assumption for pension obligations that, in a plan windup, are assumed to be settled by a group annuity purchase depends on group annuity pricing. While annuity pricing tends to be highly correlated with long-term interest rates, it’s also affected by additional factors such as credit spreads and the availability of assets to back the purchase.
A going-concern funding valuation is premised on the pension plan continuing indefinitely and the discount rate assumption is based on the actuary’s estimate of the long-term expected rate of investment return on the pension plan’s assets.
The going-concern discount rate assumption tends to be less sensitive to interest rate changes than the assumption for solvency valuations. This is particularly the case for pension plans with assets that have a significant allocation to return-seeking investments, such as equities. As a result, the financial position on a going-concern basis for many pension plans hasn’t improved nearly as much as the position on a solvency basis due to the interest rate increases that have occurred over the past few years.
The effects of interest rates on the financial health of DB pension plans are complex and can be very plan specific. It’s important for plan sponsors to avoid jumping to conclusions regarding these effects based on media headlines or rough rules of thumb. Tools are available to measure and stress test these impacts, enabling plan sponsors to assess and proactively monitor the interest rate risks embedded in their plans and implement strategies to manage these risks.