Savings, Interest Rates and Pensions.

Low interest rates in developed countries are becoming the new normal but pose problems. If traditional savings vehicles are offering close to zero rates for retirement monies or for pensioners then people look to more risky or volatile investments such as equities. Money going into equities keeps their prices historically high and lowers dividend yields. For companies or institutions still offering defined benefit pension schemes the headache is particularly severe. Apart from investments possibly not giving the required return there is a valuation problem. The traditional actuarial way of looking at the amount required for 100% funding of a scheme (or show as accrued in a company’s accounts) involves discounting back a future liability at long terms rates. Thus in South Africa’s case where the R186 bond yield is about 9% a R1,000 liability at retirement in one year could be discounted back at 9% to give a current funding requirement of R917 on the basis that a 9% return over the following year would produce the required R1,000. This would seem reasonable but for a country whose long bond rate is negative one gets the weird situation that the present value is greater than the future value. That is a difficult situation for any defined benefit fund because it means that over the last few years they have had to set aside (in cash and/or profits) massive amounts to continue to show 100% funding of the liability. What tends to happen is that schemes become underfunded and this has hit numerous companies and local authorities, especially in the US, to the point of bankruptcy where it is not just the pension liability involved but that for post retirement medical costs also. This becomes more complicated in that some US schemes are allowed to discount back not at the long bond rate but at the rate being earned on their investments. The schemes involved then invest in very risky schemes (junk bonds etc) so that they can discount back at high rates. To illustrate this a $1,000,000 liability in five years time discounted back at 0.5% produces a current liability of $975,371. If discounted back at 7%, which some are doing, it produces $712,986. On multibillion numbers this difference is enormous, even if meaningless to some extent, but it frequently makes the difference between solvency and bankruptcy. So much for international financial reporting standards and for prudent investing.

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