The Federal Reserve has left savers, pensions, and annuities twisting in the wind. Buying long-term Treasuries has resulted in the 10-year bond yielding less than 2%.If we take into account inflation, especially of items needed for survival like food and energy, investors are essentially paying to lend the government money. The Fed is pushing investors into riskier assets. Higher yields don’t make the downward volatility any easier on the heart. Savers live with the pain day to day. But for pensions and annuities, the pain may not become evident for months. For some investors, it will be too late to do anything about the policy mistakes that could have been avoided.
Public pensions are already under tremendous pressure. They just don’t know it, or aren’t reporting it. They use a discount rate based on an expected rate of return that has nothing to do with today’s low-interest-rate realities. The average expected rate of return is 8%. As PIMCO reports:
Public sector pensions do not mark their liabilities to market like private sector plans. If they did, the increased funding hole would be on the order of $200 billion. They discount liabilities by an assumed rate of return on assets which is stickier than market rates. This is almost universally 8%. Given their asset mixes and the current yield curve, to realize these numbers would require a forward-looking long-run equity risk premium of nearly 10%. Barring something truly remarkable, in time these plans, too, will be showing the strains of very low rates.
Annuities basically take your money today, make a bag of payment promises to you, invest your money, and hope it all works out in the end. As the PIMCO report continues:
Life insurers are hampered by low rates across a number of product lines. The gap between current book yields averaging roughly 5% and those available in the market currently will cause book yields to fall roughly a quarter percentage point or more per year on average and weigh on earnings. Fixed annuity business faces many similar challenges to pension funds, and as sufficiently long bonds do not exist to hedge the far off future liabilities, maturing debt needs to be re-invested at rates below those in force when policies were sold. Further still, given that the imbedded fees in variable annuity contracts for guaranteed benefits and charges typically run to 2.5%–3.0%, these products are not economically viable in the current rate environment.
What is clear as day is that Operation Twist isn’t helping savers, pensions, or annuities. Savers feel the pain now, and the latter groups won’t be able to hide from reality forever. For now, they can hope the markets get better. But for my money, hope is never a good investment strategy.
