Pension Funds Are “Compromising Their Solvency” OECD Warns

Pension Funds Are “Compromising Their Solvency” OECD Warns

Tyler Durden’s pictureSubmitted by Tyler Durden on 06/28/2015 19:15 -0400
http://www.zerohedge.com/news/2015-06-28/pension-funds-are-compromising-their-solvency-oecd-warns

Four months ago in “The Global War On Pensioners”, we highlighted the impact perpetually suppressed risk-free rates are having on pension funds. The critical point is this: the lower the investment return assumption (the assumed discount rate), the higher the present value of pension liabilities, meaning funds must either concede that liabilities have ballooned in the low yield environment, or take greater risks to justify elevated investment return assumptions.

This state of affairs has exacerbated an already bad situation for many public sector pension funds in the US and has helped fuel a shift towards “alternatives” by funds determined to maintain investment return assumptions despite the fact that ZIRP and NIRP are making those assumptions more unrealistic by the day. For a detailed recap, see the following:

The Global War On Pensioners
Junk Rated Chicago Has A Billion Dollar Pension Problem
Almost Half Of US States Are Officially Broke
States Turn To Pension Ponzi Scheme To Close Funding Gaps

For more on the risks posed by the intersection of pension funding gaps and persistently low rates, we go to the OECD’s Business and Finance Outlook (first discussed here in the context of bond market liquidity last week):

The relationship between the liabilities of pension funds and annuity providers and the assets backing those liabilities (i.e. the funding ratio) determines the financial situation of these institutions, including their solvency. Interest rates play a role for both the asset and the liability side of the balance sheet of these institutions and understanding how interest rates affect both is essential to understanding the potential impact of low interest rates.

Low interest rates affect the liabilities of pension funds and annuity providers because the liabilities depend on the discount rate used to calculate the present value of future promises. The discount rate used to calculate the net present value is generally assumed to be the risk-free rate, usually the long-term government bond yield (e.g. the 10-year government bond yield). Other things equal, when government bond yields decline, the estimated value of future liabilities increases.

The impace of a reduction in interest rates on the value of the assets backing the liabilities of these investors depends not only on the proportion of the portfolio invested in fixed income securities, but also on the valuation methods, and the maturity of those securities.. To the extent that interest rates remain low into the future and the fixed income securities in the portfolio reach maturity, reinvestments into new fixed income securities carrying lower yields would reduce the future value of assets, in proportion with the share of the portfolio invested in fixed income securities. As a result of this lower future value of assets, pension funds’ and insurance companies’ assets might not be sufficient to back up their promises, unless the pension orpayment promise is adjusted to the new environment of low interest rates, low inflation, and growth..

The extent to which pension funds and insurance companies engage in a ‘search for yield’ is the main concern for their outlook. Pension funds may shift their portfolio allocation towards investments that could potentially fetch higher returns but in exchange for an increased overall risk profile for their investment portfolio. As pension funds move into riskier investments in search of higher returns to fulfil their pension promises, they may be seriously compromising their solvency situation in the event of a negative shock (e.g. liquidity freeze).

As you can see from the above, pension funds in the US, Canada, and the UK have moved increasingly into “other” assets over the course of the last decade.

What does the OECD define as “other” assets you ask? Here’s the list: “loans, land, unallocated insurance contracts, hedge funds, private equity funds, other mutual funds, and other investments.”

If that sounds risky to you, or if you have doubts about whether pensioners would knowingly stake their retirements on the performance of alternative assets that probably have no place in a conservative portfolio, just know that you’re not alone. We’ll leave you with the following warning from OECD Secretary General Angel Gurría:

“Pension funds and life insurers are feeling the pressure to chase yield  and to pursue higher-risk investment strategies that could ultimately undermine their solvency. This not only poses financial sector risks but potentially jeopardizes the secure retirement of our citizens.”

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