Experts: QE2 could worsen funding woes

A second round of quantitative easing in the U.S. and U.K. is likely to worsen funding levels of defined-benefit pension funds in both countries, according to consultants and managers.

A drag on bond yields that would result from further easing — widely called QE2 — would raise pension fund liabilities far above any increase in assets, experts said.

And although expectations of easing have driven prices higher in most asset classes, investors said gains may be temporary, as markets have already priced in as much as $1 trillion based on the anticipated change.

Ultimately, further funding pressure on pension funds would cause corporate-plan officials to increase contributions and force public plans to scramble to find ways to plug budget gaps, industry pundits contend.

“At least here in the U.S., there’s a lot of belief that quantitative easing is the path of least resistance” in terms of providing economic stimulus, said Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics. “But quantitative easing is not free. There are costs to be had.”

Quantitative easing refers to securities purchases and loans made by central banks to stimulate a country’s economy. In the U.S., the Federal Reserve System Open Market Account as of Oct. 6 held in excess of $2 trillion in U.S. securities, about half of which were agency-sponsored mortgage-backed securities. The Fed’s first round of quantitative easing began in 2008 and finished in March.

‘MEANINGFUL’ STEP

In August, the Fed began reinvesting principal repayments in Treasury securities, and most investors expect that the Fed will return to easing starting shortly after Wednesday’s meeting of its monetary-policy arm and that the Bank of England will do the same.

“The question is how much, rather than if” the Fed will return to quantitative easing, said Phil Page, client manager at Cardano Risk Management BV in London. “This is not a short-term injection; this is something meaningful that is going to be needed.”

The typical U.S. corporate plan was 75.9% funded as of Sept. 30, according to BNY Mellon Asset Management. In February, a report from The Pew Center on the States estimated an aggregate funded status of U.S. public plans of 70%, with 21 states having an aggregate funding status of less than 80%, the minimum safe level, according to Pew. The report noted that the data used were for fiscal year 2008, so the funding situation was probably much worse by the time the report was published.

The 200 largest corporate plans in the U.K. were 84% funded as of Aug. 30, the latest data available, according to Aon Hewitt.

Another round of quantitative easing would put added stress on public-pension plans such as the $6.1 billion Arizona Public Safety Personnel Retirement System, which because of actuarial smoothing has not absorbed the full effect of market losses from 2008 and 2009, James Hacking, the plan’s administrator, wrote in an e-mail.

“So since liabilities have continued to escalate, our funding ratios are expected to decline even as contribution requirements for employers continue to rise,” he wrote. The system was 68.2% funded as of June 30, 2009.

State and local governments already have felt the sting of higher pension costs, cutting pay, implementing furlough days and eliminating jobs. “But the consequences for the retirement fund may mean a declining payroll base, and that, in turn, will put further upward pressure on contribution rates,” Mr. Hacking wrote.

Mr. Kirkegaard said that even the most optimistic outlook on investment returns caused by QE2 would be “nothing near the sustained bull market that may be necessary to match up with the assets you’d lose on the liability side.”

He said the underfunding problem is so acute in the U.S., especially among public plans, that “we’re almost talking about a liquidity issue here very soon.”

As bad as the outlook may be for U.S. plans, QE2 would hit U.K. corporate DB plans even harder, experts said. That’s because U.K. plan liabilities have a longer duration, or are more sensitive to interest rates, than U.S. plans because U.K. sponsors must tie payouts to inflation. Mr. Page estimates that a 1-percentage-point move in interest rates results in a 10- to 13-percentage-point change in liabilities for U.S. corporate plans, versus a 15- to 20-percentage-point change for U.K. corporate plans.

Also, QE2 would delay the adoption of liability-driven investments or other risk reduction tools among U.S. and U.K. plans by making them more expensive.

“To hedge [interest rates] here, you could be locking in rates at record lows,” said Richard Urwin, managing director and head of investments in BlackRock Inc.’s fiduciary-mandate investment team in London. The move would make sense if pension officials believe the U.S. or U.K. were about to enter a period of extremely low rates, akin to Japan’s “lost decade.” “It’s a market view,” Mr. Urwin said. “It’s up to each pension scheme [to determine].”

The loss of use of risk reduction tools underscores the heightened uncertainty. Such an environment would be another call for pension funds to step up governance efforts, experts said.

For example, QE2 provides a reason for pension fund executives to think more tactically about investments, said portfolio manager Cedric Scholtes, who oversees investments in Treasury inflation-protected securities at Fischer Francis Trees & Watts Inc. “We are at an inflection point,” he said. “You could leave a lot of money on the table by burying your head in the sand and sticking to [a strict] asset allocation.”

QE2 would also usher in a new era of international investment as accelerated flows into developing countries drove central banks to adjust currency valuations and implement capital controls as yet unseen by money managers and global custodians, said Cynthia Steer, managing director and chief research strategist with Rogerscasey Inc.

Mr. Page and other money managers said that it is hard to calculate how much easing already has been priced in to the market but that Wall Street and London are anticipating a significant amount — $500 billion to $1 trillion — of further easing.

Although experts agree that expectations of further easing have already affected securities prices, whether and how QE2 will do so is unknown. That’s partly because quantitative easing is considered a blunt instrument and because of the uncertain economic environment.

“We’re in a place where people just don’t know what’s going to work,” said one consultant, who asked not to be identified.

Although one effect of quantitative easing is flooding the economy with more money, “the problem we had with QE1 was that … we didn’t [see] strong demand in the economy,” said Tim Hodgson, a London-based senior investment consultant and head of Towers Watson & Co.’s Thinking Ahead group. Easing made lending cheaper, but banks didn’t lend, so there wasn’t a pickup in the amount that businesses and consumers borrowed and spent.

“I find it very difficult to see how this round of quantitative easing will be any different from the previous round,” said Chris Wagstaff, head of investment education at Aviva Investors Global Services Ltd. and a trustee director of the Aviva Staff Pension Scheme. Further easing will lead to higher inflation, which “gives [U.K.] pension schemes even more of a headache further down the line.”

At least in the short term, bond prices are expected to rise, but “the question of which bonds to buy is more difficult,” said Mr. Page.

A FLIGHT TO RISK

On the other hand, lower bond yields should force investors into riskier asset classes, such as equities, which would bump up prices in the short term, said Mr. Urwin. “If the Fed … is going to carry on applying stimulus, in the short term, it’s good for risk assets such as equities, bad for the dollar and probably neutral for government bonds,” he said.

Mr. Urwin said the Fed has made it clear that it will provide as much stimulus as needed to spur growth in the economy, which should give stock investors confidence.

But government stimulus efforts don’t always work, so investors need to consider who’s more powerful, the government or the market, Mr. Hodgson said. “That’s probably the question you need to answer to invest right now.”

More important than the immediate effects on market prices are medium-term asset class trends, which will be driven by investors’ views on whether further easing would actually improve the economy and spur real growth.

Mr. Page said global macromanagers and asset allocators will have an advantage.

“There are great opportunities [for global macromanagers] in a market that is constantly swinging between fears of a double-dip recession and deflation on one hand, to fears of inflation and much higher growth on the other hand,” he said. “You’re looking for somebody who is nimble, who can focus on the macroeconomic factors and has a good risk discipline.”

Further easing in the U.S. and U.K. will only accelerate the flow of money away from Western markets as investors continue to seek to benefit from higher interest rates and stronger currency markets, Ms. Steer said.

But she warned that the influx of capital — especially into smaller economies — will force investors to pay close attention to currencies, operational issues and geopolitics like never before.

Drew Carter is a staff reporter at sister publication Pensions & Investments.

Related Topics: Federal Reserve