How Low Interest Rates Affect Pension Plans

Two weeks ago, I posted an article examining the health of Canadian defined-benefit pension plans in light of the battle between retired workers and the city of Detroit. I wanted to follow up with a basic educational article discussing how they work and why they are failing.

A pension plan is essentially a fund or scheme designed to provide funds at retirement. Contributions made by an employee through out his or her working life at a company eventually gets paid out when that worker retires. A defined-benefit plan determines the benefits to be received in the future, as is indicated in its name, it defines the benefits to the employee. In between that time, the fund will invest its assets in a number of investment vehicles. The problems that arose in Detroit and maybe for many in the future is that DB plans are only obligated to pay the debt if they can afford to. If a fund or employer declares bankruptcy, those obligations could become a part of a bankruptcy litigation.

The single biggest culprit to the failure of so many pension plans are interest rates. It is the backbone of economies because rates give value to assets and currencies, and determine the cost of borrowing. But when interest rates are as low as they have been, it significantly cuts returns. Although the chemical make-up of any pension plan will vary from company to company, most traditionally will invest in bonds, stocks, real estate, and other opportunities.

When interest rates are low, the income earned on bonds are reduced. In the world of lending, low interest rates push debt prices higher. If the government sets rates at 1 per cent, then a bond expiring in one year should yield about 1 per cent. The bond will be priced so that the purchaser of the bond (lender) receives just one per cent yield. So if the bond pays 3 per cent a year, the value of the bond must rise to offset the 3 per cent earned through interest income (known as the coupon). If a pension plan purchased a 10-year bond that matured (expired) today, the value of the bond will have risen and could be sold for a nice profit. But any new investment option purchased to replace it would be in the same asset class and yield less. And if rates do rise, then the value of the newly purchased bond will eventually decline.

Interest rates affect the prices of equities in the exact same manner with minor differences. The issue that money managers are faced with are low dividend yields as a result of low interest rates. Stocks are at all-time highs, yes, but money managers are in the business of creating income, not net worth.

The third common investment choice is real estate. Whether the property is a sky scraper or housing unit, these products are intended to earn income through rent or revenue-sharing. Think about it like this. You just bought a strip mall and rent out floor space to offices and business. A bad economy simply means lower demand for your space or lowered revenue-sharing opportunities. The value of your strip mall is moot because the intention of purchasing the mall was to generate income.

A reduction in the work force also negatively affects pension plans. When baby boomers retire, it pulls from the plan and obligations must be met. But, the supply and demand for workers continues to be low. Advancement in technology results in fewer workers required for the same job. And a struggling economy means companies are not ready to hire and worse, more ready to fire. The impact of employees matters for pension plans.

Pension plans are steady-state programs that use contributions from current members to pay owed retirees. Any difference is made up by withdrawing from the fund itself. Logically, the fund will release any cash first. Then, if a deficit remains, assets are sold. This is why income generation and cash flow is often more important than the net value of any fund. Combined with low interest rates yielding terrible returns and a smaller pool of workers to contribute to funds, we see that it is a recipe for the inevitable failure of many pension plans.

So, here is a long-winded summary of what money managers are faced with. Pension plans need high interest rates to survive. Central banks cut rates to spur economic growth, but it has failed. As a result, asset values rose to record highs creating low-yielding products for an extended period of time. Historically speaking, economic cycles hint that interest rates will rise, but based on tepid economic growth, rates will not rise until the pace of economic growth is comfortable. Rising interest rates are meant to deter growth. Since Central Banks are not yet ready to raise target rates, the only way to increase yields is to reduce the value of assets in some form. Now, with the baby boomers retiring and claiming benefits, pension plans must sell a chunk of assets at highs to offset shortages. This could be the supply side pressure needed to raise yields. However, these major moves hurt the economy and slow growth too, so businesses might cut hours or payroll numbers, mortgages rise, and demand for business space decline. Down the road, lower asset values means deficits are being offset by selling more asset units. And a reduction in contributions from fewer employees could be made up by increasing contribution payments, but reduces short-term money supply for the worker. A continued cycle exists all because the reduction in interest rates failed to spur growth.

Canadian Pension Plans Not So Good

The plight of Detroit is a somber reminder that the tragic falls of empires can still exist even in the modern-day era. Municipal bankruptcies have become all too common in America and a chapter 9 of this magnitude sent shock waves across the globe. Many questions can be asked how a former vibrant, manufacturing city with a population exceeding 1.8 million crashed to a city of ruins with just 700,000 citizens. Devoid of life and street lights, the city is terrorized by black and white jump suits instead of the traditional blue collars. It might sound like the plot to "Robocop," but the events that led to the financial collapse of a large American city resonates with so many working people all over the world because it exposed that public pension plans are not promises.

Government jobs are known to be lower-paid salaries relative to an equal private-sector job. But the trade-off in salary is off-set by better benefits and pensions. At least, that was the belief until Detroit unraveled and claimed its pension plan obligations as a liability to be considered in its bankruptcy decision. It is expected that all creditors will receive at most 20 cents to the dollar after proceedings are finalized: yes, that includes pension plan beneficiaries. With a world in turmoil and interest rates so low, are your pension plans safe?

DBRS evaluated the health of 461 defined-benefit (DB) pension plans world wide and is "mightily concerned." For the first time in a decade, the aggregate fund status was 78.6%, below the 80% minimum threshold they deem safe. More concerning was that 45% of funds world wide are in the "danger zone." For Canadians, news could not be worse. Not a single private DB pension plan had a surplus. Surprisingly, the government-run CPP had a surplus last year and is estimated to have enough funds for 75 years, although this is a defined-contribution fund.

Among the worst funds were three financial firms and two telecommunications companies. Check the list below to see if your DB pension plan is on the list, courtesy of DBRS.



Stay tuned for a second post explaining how a pension plan works and why they are failing.

Summer Not so Hot for Stocks

If you're an investor looking to make some purchases, you may want to wait out the summer. There has been a huge shift in the market's sentiment over the last few weeks and traders are showing signs of fatigue. Many traders and professionals are predicting that this summer won't be so hot for stocks.

Last year, traders following the adage “Sell in May, stay away” lost out on a decent summer run up. But this year, the market is entering summer with a little less optimism. May 22 was a critical juncture as charts went bearish. For traders using candlestick charts, there were signals that bullish sentiment was fading. Ben Bernanke’s remarks about cutting back on monetary stimulus has introduced much needed volatility back into the market. For the first time this year, the Dow Jones Industrial Average lost value for three consecutive days this week.

Sentiment has shifted from a “buy on the lows” to “sell on the rallies.” The indices have been unable to break new highs and many large cap leaders have seen their shares revisit support levels instead of testing resistance. The charts do not look very favourable in the near to short term. Many stock charts look nearly identical to that of the indices, which does not bode well for traders looking to find leaders. Although the uptrend is still intact, the double retracement to the support trend line in a matter of days could be seen as a sign of sellers taking over.

Here are some big-name NASDAQ components that have showed some decay in bullishness.

Google (GOOG), a market leader, has not seen its shares climb back above $900. It was touted as being the next stock to hit $1,000, but those predictions will have to be delayed.

Shares of Netflix (NFLX) are developing a head and shoulders top. And if the stock trades below $200, shorts may come in.

Other leaders like Apple (AAPL) tried to reverse upwards but has seen its shares fall.

Facebook (FB) moved higher earlier in the spring courtesy earnings but have fallen to the lowest levels of 2013. Optimism has worn out as the company introduces insignificant updates to enhance shareholder value.

Volatility and uncertainty have taken focus no doubt. It appears big traders are placing bets that the market will make a big move in one way or another. Check out these option trades from Monday.

Staples (SPLS) reached new highs but saw one trader buy to open 10,000 September 15 put options for just $0.15 and then another 5,000 contracts for $0.85. The shares closed at $15.51 on Monday. Total volume on the day was 15,084. The trader makes profit if the stock falls below $14.62 by September or if the option values rise above $0.38.

Pfizer (PFE) options also pointed to a big move. A trader implemented a long straddle buying 65,000 $35 calls and puts for July - prices not available. A long straddle combines two different predictions that the stock will be above $35 and below $35 on the third Friday of July. Because this is not possible, the goal of the trade is that the winning option’s gain is larger than the losing option’s loss. The further the stock trades from $35 in any direction, the more the trader earns. This is a strange trade as the stock is $28 today.

On the other hand, Dupont (DD) was on alert on Monday when 15,000 October 57.50 calls were bought to open and 15,000 October 50 puts were sold to open. Some are saying a trader or firm is making a bet that it will break out above its resistance. However, taking the options route is a cheaper alternative than buying the shares out right, as it cost this trader just $0.30 a share versus $55 to control the 1.5 million shares.

Prior to the three-day loss, put options to open on Monday outgrew call options. On Monday, traders ready to capture on the decline bought to open 2.08 million put contracts versus 1.67 million calls. It appears that short-term traders were anticipating this decline. Get ready for an exciting summer, traders.

The Origins of my Inspiration

There I was, a young man from the Canadian Prairies situated in unfamiliar territory. With the inability to swim, I was submerged under millions of gallons of water trapped in a vessel with seal doors and no way out. Was I scared? Absolutely not. It was a riveting, eye-opening moment that changed me forever.

It was my 25th birthday, and my best friend at the time and I went down to Hawaii. For my birthday, we went on an excursion on a submarine ride off the coast of Kona. We had to take a small passenger boat from the dock to the submarine located a few miles off the coast. The weather was perfect and not a cloud was in sight. The sun beamed down on us and reflected off the surface of the ocean so I was unable to see what was below us. The ocean looked like an endless blue field of nothingness stretching eternally into the horizon.

Getting quickly to the point, after boarding the submarine and receiving quick safety updates and pamphlets, we submerged below the ocean's surface, diving slowly into a world I could never experience back home. Just a few meters down and my reality was shaken. The ocean was not the boring blue I thought it was. It was teaming with life. My only glimpse of the ocean world was from the Discovery Channel and it did not do it justice.

Schools of fish surrounded our windows, some drifted by apathetic to the daily submarine dives. While I tried to capture every moment on film, I realized I could not capture how I felt, so I sat back and just looked. This changed my life! I learned that the world I live in had so much to offer and all I had to do was explore it, experience it, and share it. By simply changing my angle of perception a few meters from above the surface to below, I gained knowledge of what never existed before. It was this moment that inspired me to explore the world more and make adventuring on my birthday an annual thing. It is why I went to California for my 28th birthday and why I spontaneously drove down to Mexico to experience the dangers and craziness of the city, but that is another story for another day.

I learned one valuable lesson that Hawaii trip: inspiration comes from within. When we arrived back to our cabin on the cruise, I was enthused, ecstatic, and full of energy. I remarked how much life existed just a few meters below the surface, but my friend, who had a great time as well, did not see it the same way. I remember being shocked by that. He did not view it as a life-changing event. He just saw it as a fun experience. I was glad that he enjoyed it, but to my dismay, it did not bring out what he needed to move forward. At the time, he was stuck in a rut, not really growing as an individual in any facet of life. It was disappointing.

We draw inspiration from outside forces, such as role models, a great book, or perhaps adversity, but ultimately, what we need to push forward comes from inside us. Find something or someone that helps nurture a culture of ambition, of inspiration, of motivation, so that when you have nothing, you look to yourself for inspiration. Find ways to remind yourself how far you've come. And most importantly, be an inspiration to somebody else. It does wonders to you spiritually and is a catalyst for inspiring yourself, almost self-remedying.

A person can have the best motivational speaker in the world, but that does not guarantee a successful individual. Given the same set of variables and external forces and role models to a million people in identical starting conditions with exactly similar situations, we will find that there are a million possible outcomes. A handful will be great successes, the mass will be drones to these kings, and the remaining will be the slums of society. Don't be a drone, and never be the slum.

This year, I have been blessed to have two people in my life that have pushed me so much that I can not thank them enough. I have set new goals last week to catch up to my friend who is in the pursuit of his dream job. He had a glimpse of it very recently and has that goal in his grasp. My other friend has re-entered my life and has been the crutch I needed when I felt unchallenged, unmotivated, uninspired. She has been a huge factor in my growth and she has given me the opportunity to reciprocate, which is a huge compliment to me. I hope everyone can find something or someone that inspires you to be the best you can be. Nobody lacks the essential ingredients. We all lack the oven that let's us rise to the top.

Shame on America?

The Boston Marathon: an athletic event that has lost all of its meaning because of terrible events that took place. And in the aftermath, the goons of America jumped online to Tweet and share how it was the "sand niggers" and "Gooks" fault. This is why nobody likes America. These people jumped to wild accusations backed by unsubstantiated evidence stemming from a culture of racism, intolerance, and ignorance. This is the only country that would tell you that one plus one equals two dead Arabs.

A viral tmblr post (click here) revealed a mass of Americans hiding, waiting to pounce on the enemy for whatever reason. Their knee-jerk reaction's re-iterate our views of America.

With every destructive event that takes place in America, the hordes of haters come out, but so do those that stand for civility and represent the good side of America. I hope we can all ignore the few Americans, the hypocritical, racist dogs that have destroyed the reputation of America and focus on what is good. Aside from minor differences, we are all brothers and sisters. And in a time of disaster, we must stand together as one to console our neighbours. We are after all, divided only by borders and oceans.

What if the culprit turns out to be a Caucasian male earning $55,000 a year working as a mechanic, driving his two children to school every morning in the suburbs, while his Christian wife prepares a home-cooked meal? What if? The public shaming should put these trolls on the map and hopefully get rid of them too.

The epitome of America is no longer defined so simply. I don't know what it is, but it was once a place where a man could dream and fulfill it. Where a man could try and save the lives of children without being accused of pedophilia. Where a mother showing strength on-camera all the while mourning quietly in the shadows off-camera is not called an actress. Where people had the strength and courage to stand for morality. Americans, you are letting a minority of hateful people re-define your country. America is still a proud nation, often too proud, fired by passion and a desire to succeed. But it is being ruined by the immoral, ill-valued citizens that call America home.

What I saw and focused on in the wake of the aftermath was a large majority of Americans clinging to the foundations of humanity. Strangers carrying strangers to the nearest ambulance. Restaurants opening their doors to the bewildered and exhausted offering comfort, coffee, and Wifi to contact family for free. Amputees from the west coast providing solace to the east. This is what I wish all of us non-Americans remember when we think of their nation. There is no need for us to vilify an entire nation in the same manner as the Tweeters calling for war.

Why am I standing up for America? Because I am Canadian and they are our biggest allies. Because an attack on its citizens by terrorist bombs or by slander is unfair to all that is good. They are like any other country with a diverse range of opinions, some moral and some hateful. 85 per cent of their firefighters are volunteers. There is still a lot of good that exists within America and if we want to stand tall as a global unit against anything, we can not knock anybody down, whether it be Arabs, Koreans, or Americans.