Low interest rates: A challenge for pension funds

While many South Africans welcomed the recent 0.5% interest rate cut, the move poses serious challenges for Defined Benefit pension funds, says Nick Hibbit, an executive if insurance group Liberty.

In July the South African Reserve Bank dropped the repo rate by 0.5% taking South Africa’s lending rates to a record low to the joy of many debt pressures consumers.

 The challenges to Defined Benefit funds are partly coming out of potentially higher inflation which will push up the costs of providing benefits to members, said Hibbit.

A Defined Benefit pension fund is a pension plan where the employer commits to paying a pre-determined amount (benefit) for life starting at retirement of the employee. The benefit amount is based on a number of factors such as age, earnings and years of service. Usually the benefits increase annually and most often the increase is linked to inflation.

Hibbit the two major risks faced by a Defined Benefit pension fund are inflation or interest rate risk and longevity risk (how long a pensioner will live). “In very simple terms, increased inflation and/or an improvement in longevity could lead to a shortfall in the funding position of the fund. The funding position is the difference between the assets in the fund (the money it has available to pay pensions) and the liabilities (the money it needs to have to pay pensions).”

Hibbit says one of the results of the Reserve Bank’s decision to cut interest rates in July is that it puts more borrowing power into the hands of the consumers enabling them to purchase more and therefore grow the economy. “This growth in the economy leads to a natural increase in inflation and pushes up the cost of providing benefits under a DB pension fund.”

“Ultimately any shortfall in a DB fund needs to be funded by the employer or fund sponsor, who are ultimately liable for meeting pension pay out obligations.”

Hibbit says it is therefore critical that employers and the Trustees of DB Funds find ways to counter the effect that inflation and interest rate risk has on DB pension funds.

“Some of the solutions available include matching the assets to the liabilities and take the form of Liability Driven Investment (LDI) strategies, cash flow matching policies where returns linked to CPI are guaranteed and corporate annuities where the inflation/interest rate risk and the longevity risk is transferred to a third party insurer.” said Hibbit

 

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