(Adds remarks on low rates, paragraphs 9-13)
By Marie-Pier Cayer
QUEBEC CITY, May 15 (Reuters) - Interest rates are likely to stay low for an extended period, posing a major challenge to the pension industry, Bank of Canada Deputy Governor Lawrence Schembri said on Thursday.
“By far the biggest challenge faced by defined-benefit pension funds since the financial crisis has been the low level of long-term interest rates,” Schembri said, noting that low rates had reduced solvency ratios.
“These ratios have now partially recovered, as low interest rates have boosted equity prices, but interest rates are likely to remain relatively low for an extended period as the Canadian and global economies slowly recover,” he said in the prepared text of a speech he was delivering in Quebec City.
He welcomed the fact that many pension funds searching for yield had made alternative investments in real estate, private equity and infrastructure but said liquidity and credit risks had to be prudently managed.
Increased longevity may in some cases require adjustments to contribution rates and benefit levels, Schembri said, addressing the Pension Investment Association of Canada.
He decried what he termed “short-termism” investment strategies, whereby some funds may be prompted by fair-value accounting and solvency rules to shorten their investment horizons to minimize volatility. Such strategies may be costly, and fortunately most funds are instead committed to disciplined rebalancing, he added.
Schembri said new resolution regimes for financial institutions seen as ‘too big to fail’ may provide attractive equity-like investment opportunities for pension funds.
Such big banks and other institutions will have to issue large amounts of “bail-in” debt and preferred share instruments, which can be converted to common equity to absorb losses if the bank gets in trouble.
The Bank of Canada has kept its benchmark interest rate at 1 percent for 3-1/2 years and said as recently as last month that even lower rates cannot be taken off the table at this stage.
Asked about the effect on assets, he acknowledged that one of the channels through which monetary policy works is by boosting asset prices.
“So by keeping rates relatively low, we’re encouraging substitution toward assets that would likely go up in value,” he said.
He cited the example of the U.S. Federal Reserve’s purchases of government bonds, with people taking the funds they receive and reinvesting in other assets, which pushes their prices up.
“With that reinvestment, you see increases in wealth, which help sustain the recovery,” he explained.
In regards to pensions, the challenge confronting defined-benefit plans has caused some funds to move to defined-contribution plans, which shift the risk to the beneficiary from the company.
Last month the Canadian government proposed a third way as an option - a targeted benefit plan that would be hybrid of the two. (Writing by Randall Palmer; Editing by David Ljunggren and Meredith Mazzilli)