Fed’s half-point rate cut:
Impact on shorter term yields is clear, but less so for longer term yields.
A common misconception is that Fed rate changes have a direct impact on the rates used to value pension liabilities. Defined benefit plans use long-duration corporate rates to determine liabilities, while the Fed controls short-term rates. More importantly, to the extent that Fed rate actions are anticipated by the market, this information is already embedded in bond prices and yields. In many cases, Fed language on the direction and pace of future rate actions can have a stronger effect on long-term yields than the rate change itself.
The September 18th rate cut was a perfect example of this: the Fed cut rates by 50 basis points, but long-term yields actually rose by 5-10 basis points. All this highlights the difficulty of making active predictions on the direction of interest rates.
The benchmark interest rate (the “fed funds rate” or FFR) is the overnight interest rate at which banks borrow and lend to each other. If the Fed believes that the economy is growing too fast and/or that inflation is too high to achieve its mandate of stable prices (2% inflation is the Fed’s target), it may raise the FFR. Due to the impact of the COVID crisis, the Fed sharply raised these very short-term interest rates from a target of near 0% in early 2022 to a range of 5.25% to 5.50% in July 2023. The Fed’s current 50 bps cut to a target range of 4.75% to 5.00% was driven by steady progress toward its 2% inflation goal and in consideration of the Fed’s other mandate to maintain full employment.
To help gauge the potential impact on pension discount rates, we take a closer look at three rate cuts over the past 25 years, all occurring during recessions: the dotcom bust and 9/11 in 2001, the global financial crisis of 2007/2008, and the emergence of COVID in 2019/2020.
During the dotcom bust and also in 2019, the pension discount rate declined, though not as steeply or as quickly as the FFR2. Many defined benefit plans were under-hedged with regard to interest rates during this period, and saw their funded status deteriorate significantly. In 2007/2008, the pension discount rate actually increased during rate-cut actions as credit spreads ballooned, before gradually falling over the following decade. Sponsors who had effective LDI programs in place over this period generally protected funded status well.
Given that we are not currently in a recession, what might happen to pension discount rates as a result of these current Fed cuts? Forecasting the future path of interest rates (and pension discount rates) is notoriously difficult. We believe that long-term rates are slightly more likely to fall rather than rise from here over the longer term. However, anyone making a call on the short-term direction of rates does so at the risk of ignoring a long history of unpredictable rates. The actual path of rates is unknown and the impact on funded status will vary depending on the specific defined benefit plan. But if pension discount rates do decline, plans that are under-hedged with regard to interest rate risk are likely to see their funded status decline, resulting in potentially increased cash contribution requirements and higher pension expense.
Below is a chart illustrating what could happen to pension discount rates under varying economic scenarios. Under our base case scenario3, the pension discount rate remains relatively level for a few years, then begins a modest decline. The Fed’s most recent Survey of Economic Projections has the most likely path towards a FFR of 3.0% by the end of 20264, but we do not expect a similar decline in pension discount rates. The market has already priced in Fed cuts of at least this magnitude, and in our base case, we expect corporate spreads to widen, resulting in little movement in the discount rate
The funded status of US defined benefit plans rose to a 16-year high of 113% in 2023, and on August 31, 2024, stood at 107%5 with improvements largely driven by strong equity performance and a sharp rise in pension discount rates. If we begin to see a decline in pension discount rates, plans could see their funded statuses erode. A review of interest rate and credit spread risk is warranted.
In summary, we believe that interest rates are close to a neutral level and are as likely to fall as they are to rise from here. Having a low interest rate hedge ratio therefore brings risk with no expected benefit. We believe that all plans should be reviewing their interest rate risk exposure and taking action to mitigate where possible.
Fed’s half-point rate cut:
1Source: Federal Reserve. (2024, September 18). Federal Reserve issues FOMC statement [Press release].
2Federal Reserve; fed funds effective rate quarterly, not seasonally adjusted. Market yield on US Treasury securities at 1-year constant maturity, quoted on an investment basis, percent, quarterly, not seasonally adjusted. Pension discount rate, Mercer calculation for a sample defined benefit plan taken at each quarter end using proprietary corporate AA spot rate curve.
3Mercer calculations based on our most recent capital market assumptions as of July 2024. Actual results may differ and will depend on plan-specific provisions and liability profile. For discussion purposes only.
4Source: Federal reserve dot plot, median.
5Source: Bloomberg, Mercer. S&P 1500 funded status estimates are from Mercer’s proprietary database.
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