Low interest rates and pension promises a threat to government stability

Dec. 22, 2016

Low interest rates are good for borrowers. That’s a common statement, but not entirely true. For pension sponsors falling interest rates can be a huge problem – and even lead to bankruptcy. Professor Joshua Rauh from Stanford University visited Swedish House of Finance to explain how pension promises threaten stability.

Conventional wisdom suggests that declines in global interest rates help borrowers. Yet there is one type of borrowing that is strongly disadvantaged by falling interest rates: the borrowing from employees undertaken by defined benefit pension sponsors.

Professor Joshua Rauh from Stanford University has studied the effect of low interest rates on pension sponsors. During a seminar at the Swedish House of Finance, he explained that two factors decide if a low interest rate will hurt a borrower, rather than help: if the borrowing cannot be refinanced, and if the ability of the borrowers to meet the fixed debt varies positively with the level of rates.

This is the case in an unfunded, or partially funded defined benefit pension promise. In such a situation, the pension sponsor has to pay out a fixed amount of money, no matter what yield the sponsor can get on the pension funds.

“The environment of low interest rates is affecting all providers of pensions. It means that the pension package is much more expensive to deliver on now, than it used to be. It’s much less expensive to pay out a fixed benefit if you can earn 6 percent per year on government bonds, than if you can only earn 1 or 2, or even 0 percent”, says Joshua Rauh.

 

What’s the most important practical consequence of your findings?
“That funding and financing pension promises has become a lot more expensive”, says Joshua Rauh. “And as a result, state and local government finances are under considerable pressure in the US. State and local governments face great challenges and important trade-offs in figuring out how they are going to meet these obligations. Whether it is by large tax increases, or cuts in government spending. Or whether it is at all going to be possible to meet all the obligations.”

 

What is your advice to policy makers?
“Policy makers that want to address these problems have two choices. One is to start measuring the pension promises correctly, using the principles of financial economics. And then having a discussion about what is the best way to meet those promises”, says Joshua Rauh.

“The other is to move their pensions systems to defined contribution structure. Those do not create unfunded liabilities for the sponsor.”

If nothing is done, it can lead to debt crisis, or even bankruptcy for some large American cities.

The difficulty, explains Joshua Rauh, is that people who are currently working for state and local governments have begun their careers under defined benefit plans.

“They expect them to continue. In some cases, attempts by cities or states to change the nature of these retirement benefits midcareer have been declared illegal and struck down. As a result, it may be that defined contribution plans can only be put in place for new employees.”

 

Step one: proper calculations

An important first step towards addressing the problem is to properly calculate the cost of offering defined benefit pensions, advises Joshua Rauh.

“When I say properly calculating, I mean using the standards of measurements that are used all over Europe for occupational defined benefit plans. The US state and local governments have not implemented such standards. Instead they prefer to rely on optimistic thinking about how their investments are going to perform, instead of recognizing the fact that pension promises of employees is a kind of debt, and need to be measured as such.”

It’s politically very difficult to convince politicians and legislators in the US to change this form of measurement, explains Joshua Rauh.

“Because it will inevitably mean the recognition that there are a lot more pension promises out there that are a lot more expensive than people have recognized. But that’s the reality of the situation and at some point state and local governments will have to come to grips with that reality.”

 

What is your advice for Swedish policy makers?
“I would advise Sweden to address this issue. Unless anything gets done, it will grow bigger. My understanding is that in Sweden these problems will now start to be reflected in the financial reports of municipalities in a clearer way. It’s going to go on the balance sheets, and those kind of disclosures are a good start. In addition, municipalities in Sweden should be thinking about how they are going to meet these rising obligations to pay public employee pensions.”