The Economic Impact of Protracted Low Interest Rates on Pension Funds and Insurance Companies
A period of protracted low interest rates is a feasible, even if not the most likely, scenario going forward and such a scenario would adversely affect pension funds and insurance companies. Protracted low interest rates affect investment opportunities and have a potentially significant adverse effect on life insurance companies and institutions whose liabilities consist of a fixed investment return or benefit promises, such as is the case for defined-benefit pension funds. It cannot be ruled out that the financial institutions affected engage in “gambling for redemption” in an attempt to match the level of return promised to beneficiaries when financial markets were more elevated.
This paper discusses select issues regarding the impact of protracted periods of low interest rates on pension funds and insurance companies. While no set time period is associated with the word “protracted”, in this article we define protracted as lasting for at least several years. Certain other empirical studies on the same topic have used time horizons of more than 10 years in their
simulations.
A scenario of protracted low interest rates is to be distinguished from a scenario where interest rates are rising or declining. Actually, a scenario of protracted low interest rates essentially requires that interest rates have already fallen, namely to low levels, where they might stay for some time.
At the outset, it should be noted that the scenario of protected low interest rates may not be the most likely one. In fact, judging by the recent pricing of interest rate futures, market participants’ expectations indicate a gradual increase in nominal interest rates going forward. Rating agencies and other observers point out that the main interest-rate risk is that rates will rise rapidly in anticipation of higher inflation, especially if this change occurs more quickly than expected and is built into the interest-rate and risk-management models maintained by insurance companies. Nonetheless, a protracted period of low interest rates is a feasible scenario for a number of countries currently, with potential severe effects for pension funds and some insurance companies.