Key inflection points in history are seldom appreciated for what they are until considerable time has passed. An extreme example is Zhou Enlai’s response when asked about the historical significance of the French Revolution two centuries earlier. He said it was too soon to tell.
By the same token, the sudden jump in bond yields in the past two months may signal a major shift for DB pension plans, though more time will be needed to confirm this. When the U.S. Federal Reserve does finally end quantitative easing—and it will—long-term interest rates will probably surge quite dramatically on both sides of the border.
DB plans have been under constant attack for well over a decade now, largely because Canadian long-term interest rates on government bonds fell from a level exceeding 15% in 1981 to just 2.3% in 2012. However, there is some evidence that bond yields are cyclical, with rates rising for 30 years and then falling for the next 30. If bonds have truly bottomed out, the next 30 years may offer up a reversal of almost all the significant pension-related events that we have witnessed over the past 30 years. Let me offer a sampling of what we can expect.
For starters, the solvency deficits in DB plans will diminish and eventually be eliminated. This is not to say that employers will embrace DB pensions again. Perceptions lag reality and the risk of DB plans will be feared for many years to come.
We will see a flurry of plan windups as the many DB plans that closed their doors to new entrants in recent years will be in a better position to purchase annuities and shut down their DB plans for good.
Within the public sector, the sustainability of DB plans that today seems so questionable will cease to be a concern; the various benefit cutbacks that have occurred or have been proposed in public sector plans may be reversed as a result. Unions will be looking for payback for the concessions they made during the crisis.
Organizations that adopted a liability-driven investing (LDI) approach after suffering losses during the financial crisis of 2008 and its aftermath will wish they had weaned themselves off of LDI before interest rates started rising again. Fixed income investments will perform poorly as interest rates climb and plan sponsors that employed an LDI strategy may find out too late that they have merely locked in the solvency deficits they incurred when yields were falling.
All of these events are likely to transpire if long-term Government of Canada bond yields climb back to 6% or so. Given that yields are currently a shade under 3%, this might sound far-fetched. On the other hand, I recall a time in the early 1990s when long-term yields were 9% and 6% seemed equally far-fetched because it was so low.
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