The Impact of Persistent Low Rates on Pension Funds and Life Insurers

Life insurers and pension funds have been shifting money away from equities to buy more long-dated low-yielding government bonds due to the prevailing low interest rates. The asset-liability mismatch is posing some serious dilemma for these institutions.

The problems of asset-liability mismatch

Life insurers and defined benefit (DB) pension funds¹ have long-term liabilities, which they must match with long-term assets.  So, naturally, they seek to invest a substantial portion of their funds in long-term government bonds.

The current environment of ultra-low interest rates presents these organisations with a problem, typically described as a “duration” mismatch.  Duration is a measure of the sensitivity of a fixed income instrument to changes in interest rates.  For example, assuming a pension fund needs a yield-to-maturity of 10% to meet its obligations to its members. To achieve that, a 10 year bond with a 10% coupon (paid annually) has a duration of 6.76 years, which would increase to 7.66 years if the coupon is reduced to 5%, or to 8.73 years if the coupon is reduced further to 2%. What this essentially means is that the fund must invest more capital to generate enough income to pay its members their guaranteed monthly pension.       

A negative duration gap (i.e. when the duration of liabilities exceeds that of the assets) indicates there is a risk of the insurer or DB pension fund not being able to meet its future obligations.  When long-term interest rates fall, the duration on both sides of the balance sheet increases, but it increases more on the liability side than on the asset side,² forcing life insurers and DB pension funds to buy more long-term bonds.

Another way to understand the problem of duration mismatch is to look at the impact of low rates on the funding ratio of these institutions, which is the ratio of the present value of assets to that of liabilities.  A funding ratio of below 100% indicates that the fund/insurer is underfunded and that there will be solvency risk if the deficit persists.  When the Bank of England cut interest rates from 0.5% to 0.25% after the Brexit vote, the total pension deficit among FTSE 350 companies was estimated to have increased by some £10 billion (the £4 billion rise in asset value was more than offset by the £14 billion increase in liabilities), pushing their average funding ratio lower to 83%.³ In the US, the pension plans of S&P 1500 companies are estimated to have a total shortfall of US$562 billion as of the end of July, an increase of US$160 billion from seven months earlier.⁴

Source: Financial Times

How are insurers/pension funds responding to the mismatch?

So with near-zero to negative yields prevailing on trillions of dollars’ worth of government bonds, what measures are being taken by life insurers and DB pension funds to “de-risk”?

On the asset side, firms are trying to pull off the tricky juggling act of closing the negative duration gap on the one hand while lifting expected returns on the other, though often at the cost of increased credit risk, liquidity risk and asset price volatility.⁵ Typical actions include:

• Increasing allocation to long-duration bonds at the expense of equities – For instance, the nominal value of government bond holdings by Eurozone insurance companies increased by 16% in 2014 (compared to an average increase of 6.9% for the preceding three years), and the duration of government bond holdings increased by almost 40% (from 11.3 years to 15.7 years).⁶  However, the “hunt for duration” by these institutions may have in fact amplified the decline in long-term rates.⁷ That is because increased demand drives the prices of long-duration bonds higher, thereby depressing interest rates further, which in turn cause insurers/pension funds to require more long-term bond holdings to close the negative duration gap (a self-feeding cycle). Moreover, this re-balancing process can make an entity’s funding ratio less responsive to future rate increases and favourable returns in other assets, thus creating a “stall” situation and making it harder to improve the funding ratio.⁸
• Increasing allocation to defensive, bond-like equities (such as consumer staples, utilities and telecom) in spite of lower growth in their underlying businesses and lower overall yields, once share buy-backs are factored in.⁹ The attraction of “bond-like” companies such as Nestle, P&G and Coca-Cola is that, with their steady 3% dividends, they offer long durations with somewhat higher yields than bonds, plus, ownership interests in real assets are better protected against inflation.  Crowding, however, has made these defensive stocks very expensive, and this is so particularly when compared to growth sectors such as tech, healthcare and consumer discretionary. The spread between the price-to-earnings multiples of the S&P defensives and those of the S&P growth sectors is at its widest in 20 years.¹⁰ The trouble is that the higher the price paid today for a stock, the lower the expected returns tomorrow, which ultimately does not help solve the problem of funding deficits for defined benefit pension funds and life insurers.  (For further commentary on the overcrowded consumer staples sector, refer to the Market Panorama charts and Platinum International Fund commentary in the Platinum June 2016 Quarterly Report.)
• Increasing allocation to higher yielding overseas securities – and thus adding currency risk to the mix.  To illustrate, while a simple yield differential seemingly suggests that foreign (e.g. Japanese) buyers can still make money from buying US Treasury Bonds, that yield advantage is in fact near zero, or has crossed into the negative territory, once adjusted for currency hedging.
   

• Increasing exposure to higher yielding securities with higher credit risks such as corporate and emerging market debt – Between 2006 and 2014, European life insurers’ holdings of AAA-rated assets fell from nearly 50% of total assets to less than 20% while B-rated securities rose from less than 5% to almost 15%.¹¹
• Increasing exposure to “alternatives”, i.e. asset classes that perceived as offering higher yield with lower volatility (though at the cost of lower liquidity), including private equity, real estate and infrastructure – Between 1996 and 2015, the allocation to “other” assets increased from 7% to 24% of pension fund assets at the expense of equities (52% down to 44%) and, to a lesser extent, bonds (36% down to 29%).¹²

On the liability side, typical actions include:

• Closing the defined benefit pension plan to new members who are instead moved to a sister defined contribution plan.  This is a shift that has been ongoing among US pension funds over the past two decades,¹³ whereas in Australia it was largely “completed” during the 2000s and today DB plans account for only 13% of Australia’s pension assets.¹⁴  Life insurers have been expanding their offering of flexible return guarantee products that do not entail interest rate risks.¹⁵
• Increasing age and contribution requirements.
• Incrementally reducing benefits, where possible.
• Taking out insurance (pension funds) / reinsurance (life insurers) – while it reduces the risk of being unable to meet future payment obligations, insurance/reinsurance adds to the economic cost of liabilities.¹⁶  Moreover, while reinsurance is a way to “de-risk” at an individual entity level, it is at best “re-risking” from a systemic perspective and is not an adequate solution if a repeat of the 2008 episode of AIG-in-crisis is to be avoided.
• Claims of improved underwriting and risk management processes.

If interest rates remain low for longer, life insurers and DB pension funds will likely need to make bigger adjustments to their business models.  These may include:

• Raising additional equity capital in the case of insurers and calling on additional contributions from plan sponsors in the case of DB pension plans, to make up for the funding shortfall.
• Issuing long-term debt at low yields to cover the underfunding (depending on the health of the overall corporate balance sheet of the insurer or plan sponsor).
• Undertaking aggressive cost-cutting within the organisation.
• For life insurers, reducing new business volumes by raising premiums, even though this will probably amount to commercial suicide if policy lapse rates start to soar.
• Merging to build scale, reduce cost and improve asset-liability matching.  However, the improved asset-liability matching will again be at an entity level, rather than at a system level.

What’s the endgame if interest rates remain too low for too long?

But these are only interim measures which at best will “kick the can down the road”.  If low interest rates persist for a prolonged period, some life insurers and DB pension funds will begin to show signs of distress and even larger funding injections from shareholders or plan sponsors will be required to shore up their solvency ratios.  This will also likely lead to a reduction or even cancellation of guaranteed benefits or a radical renegotiation of plan crediting rates.

If, finally, there is still no interest rate relief in sight, the business model will begin to break down and insurers and plan sponsors will need to turn to government guarantee schemes¹⁷ or special relief as a last resort.  By this stage, policy-holders and plan members will almost certainly need to take substantial haircuts, and taxpayers will ultimately be the ones writing the cheque as governments take over the risk both at the plan/insurer level and the reinsurer level (as were seen in the bail-outs of Fannie Mae and Freddie Mac).

The experience of the Japanese life insurance industry provides a telling example of the dangers of protracted low interest rates.  Between 1997 and 2003, eight life insurers failed as a result of the combined effect of low government bond yields, losses from equities when the stock market bubble burst in 1989, and losses from foreign currency exposures when the Yen appreciated rapidly.  The firms were also too slow in adjusting the rates of returns guaranteed under their policies, which was exacerbated by them being in competition with government sponsored insurers who kept their benefits high, a strategy that turned into a spectacular own-goal.  The resulting losses were estimated to amount to 0.5% of Japan’s GDP in 2000 and policy-holders ultimately took a 10% haircut even after receiving bail-out by the industry-funded Policyholder Protection Fund.¹⁸

What does it all mean for a contrarian equities manager?

Just where the financial system is positioned today is difficult to gauge, although there can be some markers (particularly in hindsight) such as falling insurer profitability, increasing pension plan deficits, asset allocations moving further up the risk curve and increased merger activity.  What is clear is that the current ultra-low rates are unsustainable and central banks must wake up to these signs and take rates to a more tenable level before the liability-based business model of life insurers and DB pension funds collapses and trillions of dollars of savings and retirement benefits are erased.While the present low yield environment is creating distortions in financial markets, as an equities manager focused on the out-of-favour, Platinum sees opportunities in certain undervalued sectors and stocks with promising growth.  A survey of the causes behind the current market distortions reveals which overcrowded areas should be avoided and affirms our belief that our portfolios should provide greater protection and superior long-term returns than both the long-dated negative-yielding government bonds and the very highly priced defensive stocks.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.