The Economic Impact of Protracted Low Interest Rates on Pension Funds and Insurance Companies

Abstract

A period of protracted low interest rates is a feasible, even if not the most likely, scenario going forward and such a scenario would adversely affect pension funds and insurance companies. Protracted low interest rates affect investment opportunities and have a potentially significant adverse effect on life insurance companies and institutions whose liabilities consist of a fixed investment return or benefit promises, such as is the case for defined-benefit pension funds. It cannot be ruled out that the financial institutions affected engage in “gambling for redemption” in an attempt to match the level of return promised to beneficiaries when financial markets were more elevated.

Impact of a Low Interest Rate Environment – Global Liquidity Spillovers and the Search-for-Yield

“…However, the degree of interest rate dependence hinges on the variability of future cash flows and on the responsiveness of payable future benefits to the "new normal" economic environment of lower growth. The latter may diminish the returns on portfolio investments which in turn puts pension commitments (for defined-benefit pension funds, public or corporate) or guarantees under downward pressure or alternatively pushes contributions and premiums upwards (Antolin, Schich andYermo, 2011, andShilling, 2012a).…”

“…They just choose investments in higher-yielding, higher-risk instruments such as real estate, private equity, developing-country stocks and bonds, hedge funds and commodities in order to be able to pay the level of return promised to beneficiaries before the financial crisis. (Antolin, Schich and Yermo, 2011). However, the success of this strategy is highly unlikely since the plan sponsors may not fully understand the increased risks involved (Shilling, 2012a).…”

“…The drawback of these mitigating actions, however, is that they pass the connected risks to individuals and other financial institutions and, hence, cause additional distortions elsewhere (BIS, 2012). For instance, they put further downward pressure on bond yields which worsens the pension funds' and life insurers' situation even further (Antolin, Schich and Yermo, 2011).…”

“…The latter differs between life-insurance companies whose business contains long-run obligations, mainly fixed payments, to be matched by sufficient fixedincome returns and non-life insurers. The main problem from a prudential and financial stability perspective is that the life-insurers' "search for yield" changes the risk profile of the asset structure into an upward direction (Antolin, Schich and Yermo, 2011).…”

“…Seen on the whole, thus, a substantial period of low interest rates necessitates precautionary regulatory action and supervisory and monitoring activity including stress tests with respect to pension funds and insurers (Antolin, Schich and Yermo, 2011). …”