What Happened:

On September 18 the U. S. Federal Reserve (the Fed) announced a 0.50% decrease in the Target Feds Fund (TFF) rate, lowering the upper bound to 5.00%. This follows fourteen months with the Fed Funds at 5.25% - 5.50%. Additionally, the Fed reduced the Interest on Reserve Balances (IORB) rate by 0.50%, moving to 4.90%.

The Fed continues to execute monetary policy actions to support its dual mandate of maximum employment and price stability. After a series of TFF rate increases in 2022 and 2023 to combat elevated levels of inflation, the Fed acknowledged that inflationary risks have moderated, while risks to the labor market have grown. Given this shift in the balance of risks, the Fed has pivoted to a less restrictive monetary policy with the September TFF rate cut. Additionally, Fed economic projections reflect that a series of additional cuts are anticipated in 2024 and 2025.

The Fed actions will likely have a corresponding effect on the yields on high quality corporate and municipal bonds.

What Pension and OPEB Plan Sponsors Should Expect or Think About:

While lower interest rates will make borrowing less expensive for companies and governments, they will also result in lower discount rates for the determination of balance sheet liabilities for programs such as pension or retiree benefit plans. Employers that have enjoyed the impact of the Fed rate actions on their balance sheet and income statements for the last several years are now likely to see an upward push on those entries. Many commentators are forecasting that the Fed will decrease rates by a total of 1.00% before the end of the calendar year. This could mean a 15%-20% increase in the liabilities (depending on the plan) being reported on the organization’s balance sheet. In addition, lower bond yields could impact the expected long term investment return determination for those programs that are funded through a Trust fund. Annuity purchase rates and lump sum cash out rates are also likely to decrease heading into 2025, which will increase the liabilities associated with these risk-transfer activities. Plan sponsors should consider:

1. How significant is a 1.00% increase in discount rate on financial statements? Plan sponsors and finance teams should begin modeling the impact of the lower discount rates on financial reporting now. This will help with understanding the potential magnitude of a possible shift as well as helping executives understand and communicate the impact and its causes.
2. Is a change in the long-term asset returns warranted? This assumption is often less formulaic than the discount rate leaving some room for judgement. However, auditors and other interested parties may ask questions about the determination, and having a prepared response will help the audit process go more smoothly.
3. Are benefit payout levels tied to interest rates? In some plans, single sum cash out levels may be affected by the rate changes. Lower rates may mean higher cash out values which could incent more employees to take benefits at this time. Employers contemplating a lump sum window program may want to accelerate that process before the new rates take effect.
4. Check timelines and status for potential plan termination. Lower rates may make annuity purchase costs more expensive. Employers should work with their advisors to understand the potential impact on annuity purchase prices as well as on their asset balances. While plans that have adopted a liability-driven investing approach are generally insulated from the adverse effect of large interest rate swings, the rising cost of lump sum distributions can impact how much cash is liquidated out of the investment portfolio, and when.

We recommend organizations take an active role in preparing for and understanding the impact of the rate changes. Any change brings potential risks and opportunities, and by being proactive now, plan sponsors are positioned to take advantage of the impact these rate changes might create. Understanding the full impact of the rate cuts will help educate leadership, evaluate possible strategies, and put you in a better position to make the best decision for the plans and the organization.