BUSINESS

Downturn in long-term interest rates a challenge for pension funds: experts

01/23/2015 03:28 EST | Updated 03/25/2015 05:59 EDT
TORONTO - A downturn in long-term interest rates near the end of last year has left pension funds in a difficult position, and with low rates expected to continue, companies will likely have to dig a little deeper into their pockets to make up any deficits.

After years of falling interest rates stemming from the financial crisis and subsequent recession, 2013 brought some hope for pension funds as the economy began to recover, stock markets were buoyed and long-term rates started to rise.

Air Canada, for instance, reported in early 2014 that its pension plan was finally in a surplus position, after years of posting deficits as high as $4.2 billion. The Ontario Teachers' Pension Plan began 2014 with its first funding surplus in a decade.

But by the end of last year the hopes of Canadian pension plans were dashed again, as fears about Europe slipping into a recession caused investors to move away from stocks and back into safer vehicles like bonds, driving yields on long-term bonds lower.

Manuel Monteiro, a partner with global pension consulting firm Mercer, says all of the gains made during the previous year have been reversed, with long-term interest rates once again hovering around 60-year lows.

That could spell trouble for some pension plan sponsors, who are usually required to pay back deficits over five years, Monteiro said.

"As long as your company is healthy, even if the pension plan is in deficit, it's probably not a big deal," Monteiro said.

However, companies who can't afford to cover their pension plan deficits could find themselves facing difficult choices, Monteiro said.

"If you need to put a whole bunch of cash into your pension plan and your business isn't generating the cash then certainly you could be in trouble."

Long-term interest rates are used to calculate defined benefit pension plan liabilities — the amount of they are required to keep on hand today to make the future payments promised to pensioners.

While gains in the stock market have helped pension plans growth their assets, the drop in interest rates will offset those gains.

When interest rates decline, liabilities move higher says Ken Choi, director of the investment consulting practice at Towers Watson.

"When you calculate that liability, you're assuming that you're going to get a certain amount of interest on the money while you're waiting to pay out these monthly benefits," said Choi. "And if interest rates are lower than you assumed, you're going to need more money today to make good on your promises."

Pension plans had been hoping a reprieve was on the horizon. The Bank of Canada was widely expected to nudge its short-term lending rate higher by the end of this year, a move that experts say would have helped push long-term interest rates — the ones used to calculate pension plan liabilities — to rise, as well.

"Long-term rates are, in a way, expectations of what short-term interest rates will be in the future," Choi said.

But in a surprise move Wednesday the central bank cut its overnight lending rate to 0.75 per cent, from one per cent. Experts say the shift will be bad news for pension funds in the long term, despite the temporary boost to stock markets.

"The Bank of Canada is signalling that perhaps interest rates will stay low for a very long time," Monteiro said.

"If they keep short-term interest rates at this level, eventually it will translate into long-term yields staying down, or going down further."