Fed’s Quantitative Easing Program Could Hurt Pensions

November 9, 2010 (PLANSPONSOR.com) - The Federal Reserve’s program of quantitative easing (QE2) has the potential to cause further deterioration in the funded status of U.S. pension plans if its objective of lowering long-term interest rates is achieved, according to Mercer.

A Mercer news release noted that the primary tool the Fed is employing in this new round of quantitative easing is the commitment to purchase roughly $600 billion of Treasuries over the next nine months. These purchases are designed to lower long-term interest rates and are likely to keep interest rates low for the near term, reducing the potential for relief on the liability side of the pension equation.   

Although pension plan liabilities are valued using yields on high-quality corporate bonds, and not Treasuries, if the spreads between corporates and Treasuries do not change as a result of the purchases, pension discount rates are expected to stay at all time lows for the short term, Mercer contends.  

Longer term, inflation could begin to creep upward as a result of the Fed’s actions, which could drive interest rates higher, potentially lowering liabilities; however, it is unlikely that there would be any significant movement before late 2011 or early 2012. “The short run effect is a greater demand for Treasuries, which will pressure short and intermediate rates to remain low. The longer term impact of QE2 is to risk higher actual inflation than the market is currently pricing.” said Louis Finney, Chief Economist for Mercer, in the news release.  

However, on the equity side, QE2 is intended to stimulate economic growth, which could lead to a continued rally in the equity markets, and given that most U.S. pension plans allocate between 50% and 70% of their assets in equities, this could provide a favorable tailwind for pension funding.  

“Over the long term, if the Fed hits the mark with QE2, the funded position of pension plans, and the associated level of contributions, could improve,” said Jonathan Barry, Partner in Mercer’s Retirement, Risk and Finance Group, in the announcement.