Quantitative easing creates fresh challenges for pension schemes
The very first month of quantitative easing (QE) has come and gone. Albeit early indicators are positive, it will take some time to tell whether QE will ultimately lift the euro zone out of its economic malaise. But the instantaneous influence of QE on defined benefit (DB) pension schemes is clear, and it is creating massive challenges.
QE has dealt Irish DB pension schemes, which are facing exceptionally low interest rates, yet another deepthroat. The €60 billion per month of bond purchases in which the European Central Bank (ECB) is engaged is distorting an already stressed market very significantly.
Albeit QE has boosted asset comebacks, the considerable associated reductions in bond yields have shoved DB liability values to ever-dizzying heights and diminished expected comebacks on asset portfolios. This brings further massive financial reporting pressures for plan sponsors, who are committed to delivering pension benefits to their employees.
Liabilities
Yields on long-dated German bonds have now fallen below zero at maturities up to just under ten years. As a result, local insurers are or may soon be pricing annuities at negative interest rates, resulting in the rather bizarre outcome that it may cost more than the sum of expected future payments to buy out a pension benefit.
For schemes that are required to reserve to this level under the local regulatory test, this provides significant funding difficulties.
For schemes in wind-up, it may result in an even more unfair distribution of assets from the viewpoint of non-pensioners.
The concept of building a regulatory funding hurdle around what is a very uncompetitive annuity buy-out market in Ireland remains a concern. This has not been adequately alleviated by the advent of sovereign annuities, which remain a relatively unused and unwieldy solution.
How should trustees react to these QE-related challenges? Very first, they need to realise that QE will not be permanent. It is scheduled to run until September two thousand sixteen and albeit it may be extended beyond then, there are some challenges in upsizing the programme. As a result, the current issues, albeit utterly challenging, may be improvised.
2nd, they need to be aware that QE has provided massive support to asset prices but that this support will not be permanent and, at some stage, assets will have to stand on their own feet.
Caution
In its two thousand fourteen annual report, it voiced concern about the level of investment risk to which Irish DB pension schemes are exposed.
Risk management and diversification away from volatile equities should certainly be encouraged and supported. However, now is a very expensive time to reduce risk by enlargening allocations to euro zone bonds. De-risking in this form, while QE is influencing the market, will likely have a permanent influence on pension benefits (through benefit reduction or a coerced budge away from DB schemes).
The regulatory framework should ideally take account of the unprecedented market conditions Irish schemes face due to QE and permit schemes that are well managed, have defined risk management strategies and are sustainable over the long term to navigate the current short-term challenges.
Unluckily, there emerges to be little sign of pragmatism or even acknowledgement that we going through extreme market conditions. The Pensions Authority says “ . . . there should be no question of switching the standard in order to give schemes and their members the false impression that the situation is lighter than it actually is . . . ”
Accordingly, it falls to trustees and sponsors to make sensible risk management decisions and do their best to plot a course for the long term while managing short-term financial challenges.
Paul Kenny is senior investment consultant at Mercer Ireland