Pension funds and insurers may become insolvent if interest rates continue at current lows, the International Monetary Fund (IMF) has warned.
In its latest global financial stability report, the IMF discussed the challenges facing pension funds and life insurance companies given the current low-rate environment.
“Sustained low interest rates are eroding the viability of business models for many life insurance companies and pension funds, threatening solvency over the medium term,” the report stated.
For pension funds in most countries, low interest rates mean higher liabilities, as lower discount rates increase the present value of future obligations. Many pensions already face funding gaps, and these have been “exacerbated” by low rates, the IMF said.
“Defined benefit pensions of US and European companies have seen their funding gaps worsen since the onset of the crisis,” the IMF said. “This reflects a combination of low asset returns (especially on safe assets, such as sovereign bonds) and falling interest rates.”
Furthermore, the IMF said that the shift toward liability-driven investing strategies, which rely on fixed income products, will contribute to declining yields on those assets. This will in turn reinforce funding gaps and generate additional demand for bonds in a “potentially negative spiral,” the report warned.
A period of prolonged low rates could also have disastrous effects on insurance companies. In the US and the UK, the IMF said low rates are “straining their ability to control longevity risk because of the higher cost of hedging.”
Meanwhile, insurance companies in Germany and Japan, which often offer guaranteed returns, are at risk of “an eroded asset-liability management gap as policies continue to pay out a return higher than current rates.”
To address these risks, the IMF said the International Association of Insurance Supervisors should “act promptly to ensure the ongoing strength of insurance company balance sheets.” In particular, the IMF highlighted a need for “high and robust standards” on insurance capital—but warned that chances for consensus on an international standard have been threatened by Brexit and the disinclination of the US Federal Reserve to adopt such a standard.
As for pension funds, the report suggested stronger regulations in Europe to ensure a common framework for risk assessment and enhanced transparency, including valuing assets and liabilities on a market-consistent basis to facilitate standardized reporting and analysis. However, similar proposals have proven unpopular with European funds.