The Federal Reserve’s “Operation Twist” is intended to boost consumer spending, but it could cause lots of problems for defined benefit pension plans who haven’t adopted a liability-driven investment (LDI) strategy. Here’s what plan sponsors need to consider:
1. If long-term interest rates drop due to “Operation Twist”, then pension liabilities will likely increase and have a negative effect on many plans’ funded status. This issue will be compounded by market turmoil that is lowering the value of equities in pension trust assets.
2. The effect of lower pension discount rates should be muted to the extent that a plan has adopted an LDI strategy. The fixed income investments that are part of the LDI portfolio will increase in value due to the interest rate drop and offset the increase in liabilities.
3. As we’ve mentioned in previous posts, frozen pension plans aiming for termination should monitor the situation carefully. Any increase in liability could be a big setback to their lump sum and annuity purchase strategy.
There often isn’t an ideal time to switch to LDI, but a gradual shift in policy is always possible and will help offset future interest rate volatility. Plan sponsors should work with their advisers now to see how their year-end accounting and 2012 funding contributions might be affected by the “Twist”.