Throw away your crystal ball

Throw away your crystal ball

October 2016

Why future interest rate levels don't matter as much as you think. 

Authors: Brent Simmons and Valerio Valenti
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Many Canadian defined benefit (DB) plan sponsors are playing a waiting game hoping that interest rates will rise – some have parked their fixed income assets in the FTSE®/TMX Canada Universe Bond Index in anticipation.

In our latest issue of DB Solutions InSights "Throw away your crystal ball – why future interest rate levels don't matter as much as you think", we examine whether this strategy is working. We looked at a hypothetical example of a DB pension plan and compared two different investment strategies 1) investing in the FTSE®/TMX Canada Universe Bond Index and 2) a liability driven investment (LDI) strategy (i.e., the plan's assets were managed to match its liabilities).

We found that the waiting game strategy led to more volatility and an uncertain future:

  • A 0.92 per cent yield mismatch each year between the plan's assets and the plan's liability discount rate, which based on our forecast, would lead to about five per cent decrease in funded ratio over the next five years.
  • Interest rates would have to increase by more than 2.50 per cent over the next five years for this strategy to pay off.

Given the unpredictability of where interest rates will go – with some even predicting negative interest rates – an LDI strategy may be the better option for pension plans worried about risk and volatility. It provides a more stable funded status under most scenarios by making fixed income assets work smarter.

"TMX" is a trademark of TSX Inc. and is used under license. "FTSE®" is a trademark of FTSE International Limited and is used under license.