Rate cuts put pressure on defined benefit pension funds
While many South Africans may have welcomed the Reserve Bank’s recent 0.5% interest rate cut, the move does present significant challenges for Defined Benefit (DB) pension funds and their sponsors as the resulting higher inflation rates push up the costs of providing benefits to members.
A DB pension fund is a pension plan where the employer commits to paying a pre-determined amount (benefit) for life starting at retirement of the employee. The benefit amount is based on a number of factors such as age, earnings and years of service. Usually the benefits increase annually and most often the increase is linked to inflation (CPI).
The two major risks faced by a DB pension fund are inflation or interest rate risk and longevity risk (i.e. how long a pensioner will live). In very simple terms, increased inflation and/or an improvement in longevity could lead to a shortfall in the funding position of the fund. The funding position is the difference between the assets in the fund (the money it has available to pay pensions) and the liabilities (the money it needs to have to pay pensions).
One of the results of the Reserve Bank’s decision to cut interest rates in July is that it puts more borrowing power into the hands of the consumers enabling them to purchase more and therefore grow the economy. This growth in the economy leads to a natural increase in inflation and pushes up the cost of providing benefits under a DB pension fund.
Ultimately any shortfall in a DB fund needs to be funded by the employer or fund sponsor, who are ultimately liable for meeting pension pay out obligations.
It is therefore critical that employers and the Trustees of DB Funds find ways to counter the effect that inflation and interest rate risk has on DB pension funds.
Some of the solutions available include matching the assets to the liabilities and take the form of Liability Driven Investment (LDI) strategies, cash flow matching policies where returns linked to CPI are guaranteed and corporate annuities where the inflation/interest rate risk and the longevity risk is transferred to a third party insurer.
Nick Hibbit is the Head of Business Development, Intelligent Insurance at Liberty Corporate.