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Analysis: Pension funds may see the silver lining on the interest rate cloud

A trader looks up at a screen on the floor at the New York Stock Exchange, June 25, 2013. REUTERS/Brendan McDermid
A trader looks up at a screen on the floor at the New York Stock Exchange, June 25, 2013. REUTERS/Brendan McDermid

By Mike Dolan

LONDON (Reuters) - June's global markets quake suggests little positive in a rising interest rate environment but the flip side is significant relief for pension funds that may itself may provide a stabilizing mechanism into the bargain.

Bonds, equities and emerging markets have all lunged violently since the U.S. Federal Reserve last month started signaling a timeline for a reduction in its latest bond-buying program, in what some see as the beginning of the end of its four-year-old policy of quantitative easing.

Hyper-sensitive to a big turning point in the U.S. monetary policy cycle, benchmark 10-year Treasury yields have jumped up to a full percentage point - to more than 2.5 percent - since the first week in May - pushing up long-term interest rates across the globe and puncturing buoyant world equity.

This, of course, could be an overreaction by short-term markets. With little change of economic information and only minor tweaks to policy guidance, they have lurched within weeks from the euphoria of endlessly cheap money to conjuring up the gloom of ever-spiraling interest rates.

Policymakers themselves seem to think so. Bank of England Governor Mervyn King said on Tuesday investors had "jumped the gun". Dallas Fed chief Richard Fisher was blunter on Monday in referring to markets as "feral hogs" and "manic-depressive mechanisms."

But on a more measured view there is a positive side to at least normalizing interest rate levels, if not higher borrowing costs per se.

The most obvious is the one highlighted by Fed chief Ben Bernanke himself. "If interest rates go up for the right reasons — that is, both optimism about the economy and an accurate assessment of monetary policy — that's a good thing."

And if the monetary policy pullback is indeed commensurate with economic recovery, then equities could well resume their rise alongside higher interest rates and have done historically.

Yet a much more direct positive from higher interest rates, however comes via the impact on savers - and final salary pension funds in particular where average liabilities have in recent years been far higher than the assets in those funds.

"We may find everyone's going around with glum faces except pension schemes," said Kevin Wesbroom, senior partner at pensions consultant Aon Hewitt.

CLOSING THE GAP

According to JPMorgan, the bond selloff to the end of May alone pushed the accounting deficits of U.S. and UK "defined benefit" or final salary pension funds to their lowest since 2011. The subsequent rise in yields this month - another 40 basis points on 10-year Treasuries for example - will have helped further, outweighing the drop in equities.

And crucially, assuming asset prices such as equities hold steady from here, they reckoned defined benefit deficits would again be fully covered with a further increase of about 80-90 basis point in yields in the UK and slightly less in the U.S..

As defined benefit pension fund liabilities to pensioners and prospective retirees are pre-determined and bond-like, the discount rate used to calculate them is the yield on top-rated corporate bonds - which have also risen about 80 basis points since early May.

And so extraordinarily low yields have not only depressed returns on asset returns of bond-heavy funds, they also lead to a bigger liability calculation as the pension funds are deemed to need even more assets to pay retirees - leaving companies sponsoring the schemes to stump up more cash for the pot.

So the bounceback in bond yields is a big relief.

Aon Hewitt calculates that the cumulative deficit of the UK's FTSE 350 company pension schemes fell from 86 billion pounds ($132 billion) on May 2 to 65 billion pounds on Friday.

More dramatically, it calculated cost to these sponsoring companies of offloading their pension liabilities to insurance companies or banks - a costing that uses government rather than corporate bond yields as reference - has fallen by about 100 billion pounds to 320 billion over that same period.

The additional silver lining for the marketplace overall is that the yield shift may also see subsequent pension fund behavior act as a stabilising force in any further market turbulence.

As yields rise, the more nimble pension funds - who remain innately risk averse into peak retirement periods over the next 10 years amid considerable regulatory and sponsor pressure to better match their liabilities - will likely buy even more bonds to quickly lock into higher long-term rates.

"We've had a pent up demand for de-risk for an awful long time," said Wesbroom at Aon Hewitt.

"Rather than the 'Great Rotation' from bonds to equities, we could well see pension funds do a 'contra rotation'."

(Additional reporting by Natsuko Waki. Editing by Jeremy Gaunt)

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