Pension funds and life insurers are in peril in a historically low interest rate environment. Low interest rates may be problematic for those institutions which have sold policies offering annual guaranteed returns, making it increasingly onerous for them to meet their commitments. Such products have been sold across Europe, with especially generous guarantees in Germany. In addition, depressed bond yields are denting returns from insurers fixed income-dominated investment portfolios, driving these institutions toward excessive search for yield.
Euromoneys Giada Vercelli interviewed Larry Zimpleman, Chairman and Chief Executive Officer of Principal Financial Group at the launch of the OECD Economic Outlook in Paris. They discussed monetary policy and its implications for life insurance companies and pension funds.
EC: Larry, why are rates so low globally?
LZ: This is the result of an extraordinary monetary policy, first in the US and now in the EU. The economic fundamentals have been pushing for lower rates. In particular, this has been driven by lower inflation expectations. Other key drivers have been the lower perceived future productivity and the lower future labor force growth. We should highlight that we have been in a 50-60 year super cycle of growing global debt.
EC: Thats a long time. How long more might this last?
LZ: Extraordinary monetary policy could last another 3-5 years. This would result in 10 years of extraordinary monetary policy for the US. Economic fundamentals appear to be on course to continue for at least 3-5 years. Inflation seems likely to stay subdued due to slower consumer demand. Few businesses have pricing power today. 10 year sovereigns may begin a longer, slower climb from current low levels (0-2%) but it is doubtful that the US 10-year Treasury rate will get above 3-3.5% in the next 5-7 years.
EC: In such an environment, can pension funds and life insurers keep their promises?
LZ: The overall answer is maybe with the greatest pockets of stress in the public pension area. Public pensions are squeezed by demographic and economic factors and by the lack of meaningful pre-funding. Public pensions seek the riskiest asset allocations to try to preserve a higher valuation interest rate. Valuations are not done using dynamic valuation assumptions. Changes are already being made to those public plans in the worst financial shape (Detroit, Illinois, etc.).
EC: Do you expect more changes overtime?
LZ: I do expect more plans will need changes over time. If you look at corporate pensions, youll notice that substantial change has already occurred. We will see little to no defined benefit for small and medium employers. Most corporate plans will be able to keep promises, but costs will be higher than expected and/or benefit promises may be reduced for future workers. Insurance companies should generally be okay, although certain product types may be problematic. The longer the liability, the greater the concern. As an example, take the long-term care, variable annuities, possibly fixed deferred. I see that traditional participating life insurance should generally fare well. Insurers will clearly see slower earnings growth.
EC: Are regulators right to be concerned?
LZ: Regulators have a right to be concerned. However, they also need to balance the need for higher reserves against higher prices to consumers and less consumer choice. There is a whole set of institutions (defined contribution plans, government systems that are privatized like AFP in Chile, AFORE in Mexico) that will end up with inadequate benefits due to these lower interest rates. This will not bankrupt institutions but it will put pressure on governments for greater levels of Pillar 1 (state provided) benefits.
EC: How do you mitigate this impact?
LZ: You can only mitigate, hardly solve the underlying issue. The lower interest rates are so much lower that it is unlikely we can completely offset the impact of lower rates.
Mitigation would really mean finding new sources of fixed income alpha. This would be other fixed income classes, such as commercial real estate, infrastructure investing (Sukuk), preferred securities. It is to be noted that these need to be fixed income assets of intermediate or long duration to have any impact.
EC: What are the policy implications? Capital markets almost always front run monetary policy so how effective is it at the end of the day?
LZ: We must maintain an awareness of who are the winners and losers of easy monetary policy. The lack of coordination by monetary policy officials can further exacerbate the problem and/or prolong the period of sustained low rates. I think one lesson we've learned from the last financial crisis is that monetary policy globally works best when it's done in concert--not when each country or area is pursuing different types of monetary policy. The US went to an easy monetary policy early after the crisis but the EU was much slower to react--so this extends the period of low interest rates. We have also learned that economic recoveries work best when a combination of monetary and fiscal policy is applied. So, the various elected officials also have a responsibility to carry out their responsibilities in order to produce a robust recovery. Certainly in the US, the lack of legislative agreement on most issues has resulted in a prolonged period of low interest rates.
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