The Bank of Canada’s decision to put interest rate hikes on the back burner has undercut prospects for pension funds, insurers and banks, who had been hoping for higher rates to boost their returns.
“For anybody who is in the business of saving money, this is not good news,” Ontario Teachers’ Pension Plan chief executive officer Jim Leech said. “It will be tougher and tougher for people to save money to meet their retirement needs. And it doesn’t matter if you’re in a defined benefit [pension plan] or defined contribution pension plan or your own RRSP, your savings rates are going to be low.”
Canadian pension funds, which have spent much of the past decade struggling with large shortfalls caused by historically low interest rates, benefited from a rally this year as long-term rates began ticking up. That helped them to begin erasing some of their funding shortfalls. Data published last month by Aon Hewitt showed an average pension plan in Canada was 88 per cent funded as of Sept. 30, a huge increase from just 69 per cent at the beginning of the year.
However, the recent improvement for pension funds might be temporary amid efforts by central banks to spur growth.
The prospect of lower interest rates could halt the improvements, warns Paul Forestell, a senior partner at pension consulting firm Mercer. “The single biggest risk the Canadian plans have right now is interest rates, and it’s been that way for years,” Mr. Forestell said.
The same is true for life insurers, who have suffered in part because accounting rules call for the companies to set aside more capital to protect against the possible continuation of the low-rate environment. But analyst Rob Sedran at CIBC World Markets stressed that much of impact has already been felt.
“We’re not talking about rates going to new lows, we’re talking about rates not going as high as perhaps they might have been hoped for, say, six months ago,” he said. “Life insurance companies have taken a fair bit of the pain of the low rate environment already through their numbers.”
The insurers themselves expressed relative confidence. “We’re not overly surprised by the Bank’s statement,” said Doug Gardiner, senior managing director of Canadian public fixed income at Sun Life. “But it’s worth noting that even with the slight drop in interest rates following today’s announcement, rates are higher overall during the last few months, which is positive for insurers.”
Although the Bank of Canada no longer has a “bias” toward higher interest rates, it did not dramatically cut rates – a move that would have shocked the market. The new language was viewed as a realistic, albeit negative, adjustment given slower U.S. economic growth and falling demand for Canadian commodities. But the expectation is that rates will eventually rise – only at a later date.
“The eventual relief that the banks are going to enjoy is going to be further down the road,” said Barclays Capital analyst John Aiken.
And banks can also find more of a silver lining. Prolonged low rates should make mortgages more affordable, giving the banks’ lending arms some juice. However, there is no denying that their hopes of bigger lending profits – from mortgages to personal lines of credit to commercial loans – are kicked down the road.
Banks make money by borrowing short-term, at lower rates, and then lending money out for longer time periods, at higher rates. After long-term bond yields started to rise this spring there was hope that the banks had seen the bottom, but in the past month those yields have started to reverse course.
To adjust for the new reality, Ian Struthers, head of the investment consulting practice at pension firm Aon Hewitt Canada, said some pension plans have already been locking in by buying more bonds this year, which will help insulate them if interest rates fall going forward. “I think one of the things pension plans have done is take a more disciplined approach to derisking,” he said.
But Mr. Leech from Teachers’ says that if the outlook deteriorates any further, there are few strategies he can adopt to cope with a further possible drop in rates, including locking in now with bond purchases.
“There’s very little to do because rates are already very low. There’s not a lot of room left on the downside,” Mr. Leech said. “I think everybody was hoping there would be room on the upside as interest rates went up.”Report Typo/Error
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