Are Higher Interest Rates a Silver Lining for Public Pension Funds?
By: Bill Hallmark, ASA, EA, MAAA, FCA, Cheiron
While higher interest rates are causing pain in many sectors of the economy, public pension plans may benefit from them because they increase the investment returns they can expect.
This is an excerpt from NCPERS Spring 2023 issue of PERSist, originally published March 21, 2023.
The Federal Reserve is aggressively raising interest rates to tame high inflation.
The federal funds rate, set by the Federal Reserve, has risen from near zero in March 2022 to almost 5% in February 2023, and is expected to continue rising and remain above 5% into 2024.
As a result, mortgage and other borrowing rates have increased dramatically, slowing demand, and raising the possibility of a recession. But, there may be a silver lining for public pension plan sponsors. Higher interest rates make public pension plans less expensive because they increase the investment returns plans can expect.
Impact of Higher Interest Rates on Public Pension Plans
Capital market assumptions for 2023 are significantly higher than 2022, reflecting the change in interest rates and their impact on asset valuations. If high interest rates persist, public pension plans will have the opportunity over the next few years to consider increasing margins for conservatism in assumed investment returns, reducing investment return volatility, and increasing their discount rates.
It isn't clear yet whether the higher interest rates will be temporary or represent a longer-term change. Plans are likely to take a cautious approach to any changes, as they did when interest rates dropped during the Great Recession.
For 2023, there should be considerably less pressure to reduce discount rates than in the last several years, and some plans may even consider increasing their discount rate. Most plans, however, will likely wait to make sure the change in return expectations is not temporary before making any adjustment to their discount rates. If higher interest rates prove to be temporary, plans will have been prudent in waiting and avoiding the need to reverse course when interest rates come back down.
Historical Impact of Declining Interest Rates on Public Pension Plans
The situation today appears to be the reverse of what pension plans experienced over the last 15 years of declining interest rates. In 2007, the yield on the 10-year Treasury was higher than 5% but following the Great Recession it dropped to between 1.5% and 3% and with the onset of the pandemic it dropped to below 1%. While public plan discount rates are not tied directly to these interest rates, the median discount rate for public pension plans dropped during this period to 7% from 8%, increasing the measure of plan liability for a typical public plan by 12% to 15%.
Chart from Cheiron Public Plan Data Tool using data from the Federal Reserve and PublicPlansData.org
At the same time, public plans adjusted their investment strategies to improve the chance of achieving their expected returns in the low interest rate environment, boosting their holdings of hedge funds, private equity, real estate, and alternatives while reducing fixed income and public equity holdings. These changes raised investment return expectations but also increased the volatility of public plan investment returns.
Chart from Cheiron Public Plan Data Tool using data from PublicPlansData.org
In short, higher interest rates provide some welcome relief to public pension plan sponsors, immediately reducing the pressure to take additional investment risks or further lower the discount rate. If higher rates persist, some of the difficult trends of the last 15 years may start to unwind.
Bio: Bill Hallmark is a consulting actuary at Cheiron Inc. He is a nationally respected retirement consultant with more than three decades of experience advising pension plans. He often speaks about public pension plans at industry conferences.
Hallmark has held various positions with professional organizations, including vice president of pensions for the American Academy of Actuaries. He is an Associate of the Society of Actuaries, an Enrolled Actuary under the Employee Retirement Income Security Act (ERISA), a member of the American Academy of Actuaries, and a Fellow of the Conference of Consulting Actuaries.