The Rise in Interest Rates
2022 must be hugely disappointing for those who were hoping for a return to normalcy. While the pandemic seems to be transitioning to its endemic stage, 2022 has brought about a whole host of new challenges and concerns – disrupted supply chains, Russians in Ukraine; commodity price shocks, declining tech stocks; vaccination, inflation; labour shortages, higher mortgages – this is all starting to sound like a particular late 1980’s pop anthem.
The rise to-date
From December 31, 2021 through to early May 2022, we’ve seen a dramatic increase in interest rates. For instance:
- The Bank of Canada’s target overnight-rate has increased from 0.25% to 1.00% (with increases of 0.25% and 0.50% in the Bank of Canada’s last two announcements);
- The yields on short-term government of Canada bonds have increased by about 1.8% (from 0.91% at December 31, 2021 to 2.67% at May 6, 2022);
- The yields on long-term government of Canada bonds have increased by about 1.4% (from 1.66% at December 31, 2021 to 3.08% at May 6, 2022);
- The yields on real-return government of Canada bonds have increased by about 1.3% (from -0.14% at December 31, 2021 to 1.19% at May 6, 2022); and
Further, Corporate and Provincial spreads have also widened over this period, leading to even higher increases in the interest rates which underly the solvency and accounting liabilities for pension plans. As a case in point, the accounting discount rate for a typical pension plan has increased by about 1.60% from December 31, 2021 to April 30, 2022.
With inflation at rates in both Canada and the US that we haven’t seen in a generation, it seems overdue for the central banks to insert themselves and to increase interest rates aggressively. To this end, even with the increases made so far, central bankers have signaled that they are nowhere near done increasing interest rates as they try to wrangle inflation under control.
Equity markets have also had a challenging start to 2022. In the first few months of the year, the negative returns on equities were largely confined to the tech sector, however, in the past couple of months, the sell off has been more widespread. Year to date, the Canadian equity market is down 5%, with US equity markets down about 10% to 15% (and tech indexes down about 25%). Interestingly, markets have cooled dramatically over the past couple of weeks – perhaps in part as a leading indicator that future interest rate increases will cool an economy that has been fairly robust since the early days of the pandemic.
What this means
For pension plan sponsors, this dramatic increase in interest rates means there has been a meaningful decrease in their solvency and accounting liabilities – potentially decreasing by as much as 25% in some instances.
Pension plans that have “de-risked” will largely be more immune to these shocks as their assets and liabilities are expected to move in tandem.
For “unhedged” pension plans, there is the possibility that the underperformance on the assets side of the balance sheet will be better (i.e. less than) the decrease in liabilities caused by interest rate changes. However, there is risk that the opposite could occur too (that is, that future equity returns are worse than the reduction in liabilities caused by increases in interest rates).
What plans sponsors should do
We always encourage plan sponsors to balance the various risks inherent in their plans, and in particular, regularly reviewing their investment and funding policies. Given the dramatic changes in the market conditions that have occurred so far in 2022, it would be prudent for plan sponsors to review their current investment strategies to ensure they have comfort with the forward looking expectations for risk and reward.
We also encourage plan sponsors to think more strategically about their long-term strategy for providing pension benefits. As noted in the introduction, another trend that has emerged in 2022 is the challenge to attract and retain employees and providing desirable pension benefits can be a key differentiator in a challenging labour market. For more on this topic, stay tuned for my next blog.
In the meantime, it is my prediction that interest rates will continue to rise, and that we can expect more volatility in financial markets in the months ahead. What do you think?