What if interest rates stay low forever?

October 2014
low interest forever

Interest rates are very low at the moment and while some increase is expected, the market price of gilts and swaps suggests that the rate may not rise above 4% ever again, or at least not for the next 50 years. The projected market price of gilts implies that the Bank of England Base Rate will peak at around 4% in 20-30 years’ time before falling away thereafter. This startling fact has drawn surprisingly little comment. Everyone has seen that yields are very low but nobody is talking about the implication for the future Base Rate. And that’s a pretty radical change of view from the world we’re all used to. 

So, are you aware of this and what it implies for risk management strategies for pension funds? If so, you may want to put in place your protection now because this could represent a historic shift. Consider that as recently as 2007 rates were close to 6% and back in 1979 we lived through rates of 15%+. It seems we may be in a different world now. Yes, this is a bold presumption because long-term predictions are notoriously difficult, but the argument is compelling. You may even have noticed an increase in lifetime mortgage fixes being offered. What is being offered is effectively a 25-year mortgage on the expectation of a Base Rate no higher than 4%. 

So, what are the implications for pension funds? 

The way that you arrive at the present value of the expected cash flow payments for most pension funds is to discount them using interest rates from the market (see diagram) and this curve predicts a rate no higher than 4%. In the past we might have expected yields to get as high as 15% per annum, enabling funds to hold comparatively little in the way of assets as the value of the liabilities was low. However, if Base Rates don’t exceed 3-4% per annum, funds will need to hold a lot more money today to cover all the payments in the future. This is the heart of the pension fund problem: too many pension funds are underfunded and have too few assets to meet their liabilities. 

Of course, you may disagree with what the market price of gilts says and believe that rates will rise much faster. In this case, you should be conscious of how much risk you’re prepared to take. For example, if you’re projecting 8% Base Rates but they are actually just 4% and that compounds over a long period of time then you could soon be in a dire situation. And that’s effectively what’s happened to many funds over the last ten years. It’s human nature to base the future on the expectations of the present, but those expectations may have permanently shifted since Base Rates hit 0.5%. 

So, what should you do? 

If you believe rates will stay low

You should lock in the interest rate you’re receiving today and then find other assets to generate the extra performance to help you out over the long term rather than messing about with interest rates. You can protect against interest rates staying low or getting lower by buying interest rate protection using swaps and gilts. Here at Cardano we have recommended significant protection against rates staying low and we’ve been proved right on that major issue over the last 5-6 years.

If you think rates will rise faster 

We suggest you at least partly protect against interest rates staying low. You may believe 5%+ interest rates will return, but you should seriously consider the implications if you’re wrong. Would it sink your pension fund? Make sure you can afford to get it wrong. If you think now is not the best time to lock into fixed rates, at least consider a fixed rate deal for (say) 80% of your assets. 

The worst option is to do nothing 

Too many funds remain completely unprotected against long-term low rates. They have neither the predictability that comes from fixing nor the expected growth from other assets needed to improve their funding ratio.They’ve been assuming for a long time that interest rates will rise significantly, but they haven’t. The industry has been consistently wrong on this point. Obviously, if this has been your approach and interest rates shoot up you’ll be vindicated, but if interest rates really do stay low forever you’ll eventually have to go back to the sponsor for more money.