Pension funds need to provide for years of support in the future for pensioners. Actuaries match the lifetime of the pension funds’ assets to the anticipated future needs. Because the needs are far into the future, the lowest-risk assets are long-term bonds that yield interest payments over the anticipated time.
Present value and future value equations are used to determine whether a pension fund has adequate assets. Many pension funds are inadequately funded and cities have been bankrupted. Problems include (not necessarily true of all pension funds):
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Using outdated estimates of life expectancy. People are living longer and the cash stream will need to last longer than the calculation.
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Using inaccurate estimates of investment returns. Pension funds are supposed to be super-safe and reliable. When bond yields are low, they are either using outdated (too high) yields or stretching for yield by taking on more risk.
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When interest rates rise, as they are doing now, the value of bonds in pension funds (like all bonds) go down. Every bond loses about 1% of its value PER YEAR of duration for EACH percent rise in prevailing interest rates. So a 30-year bond will lose about 60% of its value if prevailing rates rise 2%. Pension funds are loaded with long-term bonds because of duration matching – they will need the cash flow long-term so they buy long-term bonds.
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According to the book, “The Price of Time,” the top 300 pension funds own about $15 TRILLION in assets, including bonds. This huge amount of buying depressed the interest rate of long bonds. “Thus, low rates begot a pension crisis and the pensions crisis begot lower rates.”
These problems affect pensions all over the world. The U.K. is currently suffering a pension crisis.
U.K. Pension Funds Rush to Raise Cash as Central-Bank Deadline Looms
Bank of England says it will stop buying bonds on Friday
by Julie Steinberg, The Wall Street Journal, 10/12/2022
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Many U.K. pensions are rushing to raise cash to satisfy collateral calls triggered by rapid moves in usually staid government bonds. Adding to the urgency: the Bank of England’s plans to end its emergency bond-buying this Friday, after which many fear volatility could surge again…
At the center of all this are a handful of big financial firms that have helped pension funds push into so-called liability-driven investment, or LDI. The largest players are a unit of Britain’s Legal & General Group PLC, Bank of New York Mellon Corp.’s Insight Investment division and BlackRock Inc., according to ClearGlass Analytics, a research firm.
LDI strategies use derivatives to help pension funds manage their exposure to changes in bond yields, which move in the opposite direction of prices. That is meant to free up capacity to invest in higher-returning assets like stocks…
Thirty-year gilt yields have surged this year from 1.1% to about 4.9%… Stocks, credit and real-estate fund investments have all been sold to replenish collateral. ( £200 billion to £300 billion in extra funding.) The offloading has rippled through areas such as the market for collateralized loan obligations…[end quote]
OUCH! Gilts are the U.K. equivalents of U.S. Treasury bonds.
Unlike the Federal Reserve, the U.K. central bank is not giving the pension funds an open-ended promise of support.
Two of the largest players are U.S. firms. This makes contagion highly likely. This could be a black swan.
I never heard of “LDI” before. Derivatives strategies that are supposed to decrease risk have blown up before.
The risk of pension funds collapsing and roiling markets is very real in the U.S. as well as Europe. Most state pension funds have 2/3 of their assets in stocks and other non-bond investments.
https://equable.org/2022-pension-funding-trends/
Pension fund shortfalls mean potential locality and/ or state bankruptcy, lower retirement benefits and higher taxes.
Companies also have pensions. When DH and I received offers of pensions from the companies we worked for decades ago, we took the lump-sum payment and invested it ourselves. I didn’t want the risk of the companies potentially being taken over and pensioners whacked.
The underfunding and risky investments of pensions have terrifying risks, both short and long term.
The UK’s pension problem could cause a financial panic as early as next week.
The long-simmering pension problem, which relies on extremely low interest rates, will blow up in the medium to long term if interest rates rise.
Wendy