Unintended Consequences of Low Rate Policy

    As we move through corporate earnings season, a major theme has emerged, which the Wall Street Journal wrote about today. The article discusses how the low interest rate policies of the last few years have had detrimental effects on corporate pension plans.  The Federal Reserve has kept the overnight interest rate pegged at zero for nearly four years, and has been engaged in various bond buying programs to push down longer-term interest rates for nearly two years.  While this has allowed many entities to borrow cheaply, and is seen as a way to stimulate economic growth and offset the headwinds posed by household deleveraging, there are negative side effects.  Corporations from AT&T to Verizon and Ford have seen their pension liabilities swell and the investment earnings on fixed income assets used to fund those liabilities fall, creating large funding shortfalls.  Corporations are required to use current market interest rates as the discount rate to calculate their pension liabilities, and when that rate falls, the liability calculation rises.  According to a study by consulting firm Towers Watson, the 400 largest corporate pension plans saw their liabilities increase $79 billion in 2012, which represents a 23% increase over 2011 and puts the total deficit in pension funding at these companies at $418 billion.  Another group affected, although not discussed by the WSJ, is municipalities.  Although municipal entities are not required to use the same current market rates to calculate liabilities as corporations, the low rate environment has affected them, too, as the investment side of the equation suffers from lower rates of return and is forcing plan managers into more risky investments to keep up with funding requirements.  The rate environment is causing a drag on growth and draining cash from balance sheets across all sectors.  We continue to view this issue as a major credit theme in 2013, and one that not only affects individual savers, but corporations and municipalities as well.