The Bank of Japan’s introduction of negative interest rates in January put a media spotlight on what the move means for the market values of life insurers’ and pension funds’ assets and shone the occasional shaft on their liabilities.
Sometime soon attention will most probably turn away from ‘the hunt for yield’ towards the effect on solvency ratios and pension benefit obligations (or PBO), the yardsticks used to measure these institutions’ ability to meet their obligations.
Such gauges are poorly suited to negative interest rate environments.
Assets – fixed income
Fixed income investments form an essential part of life insurers’ and pension funds’ portfolios. As this debt paper is issued for fixed terms the maturity dates of holdings can be matched to those of obligations becoming due to policy holders or pensioners.
In Japan, where the corporate bond market was moribund for many years, most of the paper available has been issued by government and thus has the additional advantage of offering absolute capital preservation as well as liquidity.
A low interest rate environment pushes up demand for this paper which, in turn, drives down the yield (a function of the price at which it was bought plus the rate on the coupon) and keeps the return on it in line with the market rates on other debt instruments.
However, while the market value of the fixed income paper held in portfolios theoretically rises, the huge buyback operations begun two years ago Bank of Japan so distort supply and demand interaction that there is nothing which is recognisably a ‘market’ and therefore no valid value-fixing mechanism.
The impact of this absence on institutional investors’ balance sheets makes it difficult to say whether their assets meet their liabilities and the bigger the exposure to bonds the bigger the distortion.
Assets – equities
Low interest rate theoretically push up prices for equities, allowing them to compensate for at least part of value lost on fixed income. But Japan’s stock market has been falling, possibly because has become so distorted by years of official intervention that it now responds only to government stimulus packages.
Either that or the implications of a shrinking population have become too clear for investors to ignore.
Even so, as the equities market still functions, its prices are remain a valid valuation tool.
Real assets such as direct investments in property or infrastructure facilities present different valuation problems as the markets in them are not so liquid.
The liabilities on an institution’s balance sheet are its obligations to insurance policy holders or pensioners and these stretch out for many years into the future. In order to measure the sufficiency of the assets held to meet them, these commitments must be calculated as single figures.
Japanese insurance companies’ solvency ratios are easier to compute today than in the time when they offered products with guaranteed returns but negative interest rates make the calculations more difficult.
Pension funds PBOs are arrived at by discounting future obligations to bring them to a ‘present value’. The rate at which they are discounted is tied to the yield on various maturities of government bonds. The lower the discount rate goes the greater the obligations become.
Yet negative interest rates and government buybacks mean Japan now lacks a market deciding those yields and there must be a strong possibility that pension funds’ discount rate will have to be decided by government fiat if they are not to disproportionately impact sponsoring companies’ bottom lines.
Something like this has happened before and in Pensions in Crisis, published in 2003, what was then Watson Wyatt set out its impact on US pensions. It is well worth a read despite the different circumstances and it is here.
For those who do not recall the times:
“In the latter part of the Clinton presidency, the federal government began to buy back federal debt, especially long-term debt. This continued during the early days of the Bush administration and, in early 2002, the government stopped issuing 30-year Treasury bonds. The combination of the federal government buying back its 30-year bonds and suspending the series contributed to declining returns on these bonds, as their increasing scarcity drove their prices higher relative to other low-risk, long-term bonds. This development convinced many people that using the 30-year Treasury rate to value pension liabilities overestimates true liabilities. Because of concerns about potential pension funding requirements hurting the economy, policymakers increased the upper side of the interest rate corridor from 105 to 120 percent of the trailing average rate for 2002 and 2003. Despite these efforts, declining interest rates have been driving up funding requirements.”
© 2016 Japan Pensions Industry Database/Jo McBride. Reporting on, and analysis of, the secretive business of Japanese institutional investment takes big commitments of money and time. This blog is one of the products of such commitment. It may nonetheless be reproduced or used as a source without charge so long as (but only so long as) the use is credited to www.ijapicap.com and a link provided to the original text on that site.
This blog would not exist without the help and humour of Diane Stormont, 1959-2012