Viewpoints

What Do Low Interest Rates Mean

for Pension Plans?
By Carl Hess, global head of Investment Consulting, and Sylvia Pozezanac, senior consulting actuary

Many plan sponsors were hopeful that stronger market

performance in 2010 would significantly boost funding
levels. The reality for most plans is that a prolonged
low-interest-rate environment has held funding levels
basically steady.
Carl Hess

Sylvia Pozezanac

In fact, during 2010, the average pension plan funded

level for the 100 publicly traded domestic organizations with the largest U.S. pension obligations (also
known as the TW 100) increased by only three percentage points, from 80% to 83%. But there are ways for
employers to find opportunities in the current market
environment and prepare for whats ahead. A clearly
articulated financial management plan is an effective
tool for active plan governance and can help prepare
plan sponsors for the day when interest rates start
climbing again.

Proactive financial management

Proactive management is based on an understanding
of the financial risks embedded in the pension plan.
Its vital to be familiar with the plans cash contribution
requirements under varying market conditions and
asset allocations, and the likely impact on the financial
statements of the business. An employer that hasnt
done a thorough analysis could experience unwelcome
surprises and an adverse impact on the organizations
financials when market conditions change, with little or
no time to make adjustments.

Just as important, a financial management plan

can prepare sponsors to execute certain de-risking
activities, like a risk transfer or an asset allocation
change, when economic conditions align with business
needs. A thoughtfully constructed plan with established thresholds for action can expedite approvals
while helping leaders make the right decisions for the
organization. And it can help them take advantage of
business opportunities as they arise, when acting
quickly might be crucial.

Putting market performance in

perspective
The market performed reasonably well in 2010, delivering a 15% return on large-cap U.S. stocks. While this
was a welcome contrast from 2008 and helped restore
depleted fund balances, by historical standards, it was
still a median year. And three-, five- and 10-year returns
show that stock market performance for the first decade
of this century was distinctly subpar. While nearly all
plan sponsors would like to see more of a rebound,
its more likely that conditions will remain unsettled,
at least for the short term, given substantial economic
imbalances and political instability in some regions.

The impact of low interest rates on

pension funding
Positive asset returns and employer contributions
certainly helped pension funding levels last year.
Companies in the TW 100 contributed more than
$40 billion to their pension plans in 2010 and
experienced an average return of 13%. However, to
boost economic activity during the recent financial
crisis, the Federal Reserve reduced interest rates,
and theyve remained relatively low for some time.
For pension plans, the low-interest-rate environment
introduces a lower discount rate and increases
liabilities (as liabilities are simply the present-day
discounted values of future obligations). If discount
rates continue to fall, liabilities will increase even
more, because there will be less assumed discounting
on future benefit payments.

Companies are responding with

different strategies
Companies are finding innovative ways to use financial
management plans to respond to the contrary forces
of better market performance and low interest rates.
These different approaches will enable plan sponsors
to seize opportunities that might not have existed
when economic conditions were depressed (for example, de-risking through lump sum payments or annuity
placements, and evaluating cheaper financing for
pension contributions).
Organizations that fully understand the level of financial
risk in their pension plan generally have fewer financial surprises. Modeling different outcomes based on
various choices helps these companies fine-tune their
predictions and plan an appropriate approach. In the
face of todays lower interest rates, many plan sponsors have decided to stay the course, while others are
reducing risk by:
Lengthening the duration of fixed-income portfolios
to better align them with long-duration pension
liabilities
Moving away from large holdings in public equities
into either fixed-income or alternative asset classes
to get exposure to multiple return drivers and
better diversify their portfolios
Reducing the size of the overall plan by paying lump
sums to terminated vested participants and, in some
European countries, reducing plan size or risk exposures through annuity placements with insurance
companies

Copyright 2011 Towers Watson. All rights reserved.

TW-NA-2011-19573

towerswatson.com

An ongoing process
For some organizations, designing and executing a
financial management plan involves changing a mindset and behavior. Organizations that have historically
seen pension plan financial management as an
annual (or even less frequent) exercise will need to
begin thinking of it as an ongoing strategic process.

Companies

are finding

Employers can begin the process by asking themselves a few key questions, including:

innovative ways to use

How do we expect changes in legislation, market

conditions, interest rates and funding levels to
affect our plans financial health?
When will we take action (under what conditions)?
At what cost will action be attractive?

plans to respond to the

financial management
contrary forces of better
market performance and
low interest rates.

As we look ahead, it will be interesting to see how

and when an improving economy will influence interest
rates. While its tempting to predict rising rates, theres
no way of knowing with certainty when that will happen.
Theres also no clear indication of when volatility will
subside. Over the past year, weve seen swings in the
discount rate of almost 100 basis points at the long
end, with discount rates having gone up recently.
These conditions argue that plan sponsors should
take action now to develop a strong financial management plan. They also highlight the pressing need for
sponsors to gain a good understanding of their pension
plans financial and business risk exposure and to
develop a plan for dealing with risks that exceed the
threshold.

A financial management plan can:

Help you better understand your plans financial risk exposures and the
impact of those risks on your businesss financial statements
Prepare you to execute certain de-risking steps when economic conditions
match your business needs

About Towers Watson

Towers Watson is a leading global professional
services company that helps organizations improve
performance through effective people, risk and financial management. With 14,000 associates around
the world, we offer solutions in the areas of employee
benefits, talent management, rewards, and risk and
capital management.