The Federal Reserve raised its benchmark interest rate Dec. 16 by 0.25%, which could have implications for both defined contribution and defined benefit retirement plans moving forward.
While most experts agree that a small bump in rates — 0.25% to 0.50% — would not have much of an immediate effect on either side of the retirement aisle, they believe this is just the opening salvo in an attempt to get rates back up where most people believe they should be.
Interest rates have been artificially depressed for the past nine years to help boost America’s economic recovery from the Great Recession.
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“You hear from people that maybe this rate increase won’t be a big deal but if they [Federal Reserve] embark on a series of increases it could have more of an impact,” says Rich McHugh, vice president of Washington affairs for the Plan Sponsor Council of America.
The rise in rates could prompt people to get out of longer term bonds in favor of more short-term bonds, he says. Investors also get nervous being in the equity markets because of the expected greater volatility once the market reacts to the increase in rates, he adds.
The good news is that in the past, when faced with rising rates, “we don’t see gross overreactions in [401(k)] plans and that’s probably good,” he says. “As people get closer to retirement they may be looking at this more nervously because they will be out sooner.”
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Marina Edwards, a senior consultant in Towers Watson’s benefits advisory and compliance practice, says that plan sponsors need to be aware of what will happen to 401(k) plan loans now that rates have gone up.
Most plans have an interest rate for their loans that is tied to the prime rate, either prime plus 1% or prime plus 2%. Plan sponsors should make sure that any new loans taken from their workplace 401(k)s are taken at the new rate.
“Usually a plan sponsor doesn’t have to remind their recordkeeper to update [their] loans, but it wouldn’t be a bad thing for a plan sponsor to check the first or second loan issued from the plan after prime goes up to make sure the system did pick it up correctly,” she says.
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If plan sponsors don’t catch a mistake like this and the recordkeeper issues loans under the old rate, the plan has a compliance problem because the loan won’t be following the written terms of the plan. These types of errors are fixable but “somebody needs to be paying attention to it to keep the plan in compliance,” says Edwards.
One potential upside to a rise in rates for employees taking loans from their plan is that they will have to repay those loans at a higher percentage rate, which seems bad until they realize they are paying themselves back. All of that extra money is going into their retirement savings. Many plan participants could see the higher interest rates as a deterrent to taking a loan from their workplace retirement plan in the first place.
Amy Reynolds, a partner and U.S. defined contribution consulting leader at Mercer, says that if interest rates move plan sponsors will need to monitor participant reaction to changes in investment performance to encourage them not to make short-term decisions. They should also revisit their loan policies to see if and when loan interest rates need to be modified — they have not moved in quite some time — and if any action is required by plan sponsors to execute.
Effect on DB plans
Rising rates eventually will have an effect on defined benefit pension plan liabilities, says Alan Glickstein, a senior retirement consultant with Towers Watson, but in the near-term it probably won’t even cause a ripple.
When rates go up, liability goes down, he says, but these rates bounce around all the time.
“Even if rates go up, equities could go down in a way that is offsetting. … and it could be net worse for the pension funded status,” he says. “In the near term, I don’t think it will have a profound effect.”
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He adds that, “rates are up 35 or 40 basis points for the calendar year and markets have been all over the place. I think equity markets, if up, they are not up by much and by less than pension accounting assumptions expected them to be so, as of today, a typical plan may be a little worse off than the beginning of the year, with asset values lower than they were expected to be, and this decent increase in interest rates will offset it but not enough to result in a better funded status.”
Matt McDaniel, U.S. defined benefit risk leader at Mercer in Philadelphia, says that any rate changes the Fed makes will exert more pressure on the short end of the interest rate yield curve rather than the longer end of the yield curve, which is what pension plan sponsors are more interested in.
“There’s a pretty good market expectation that the Fed is going to take action, but that is largely priced into the yield curve at this point. It is a steep yield curve because people believe rates will be rising in the not-too-distant future,” he says. “So the Fed taking that action validates that market assumption and fulfills the prophecy.”
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He adds that it is very unlikely that a company’s pension funded status would change tomorrow. The U.S. has been in a low interest rate environment for 10 to 15 years now.
“Everybody always thinks rates are going up, rates are going up. We have been waiting for that to happen and talking about it. This is concrete evidence that we are finally starting down that path,” says McDaniel.
Most experts agree that today’s decision by the Fed is the first of many incremental changes to interest rates.
“Plan sponsors have a fiduciary duty to be on top of this but acting prudently doesn’t always mean you act. Prudence is a process,” says PSCA’s McHugh. “Look at it and decide if there is something you should do. Plan participants should do the same. Will plan sponsors decide to change their array of portfolio options because of this? That strikes me as something that is not going to happen early on. Will plan participants shy away from long-term bond funds? It depends on how old they are. [Long-term bond funds] will be hurt more than anything.”
Paula Aven Gladych is a freelance writer based in Denver.
