Wednesday, February 4, 2015

Will Deflation Decimate Pensions?

Josephine Cumbo of the Financial Times reports, UK pension deficits double to more than £100bn:
Pension deficits at the UK’s largest companies nearly doubled over the past year to exceed £100bn, as record low interest rates continued to take a toll.

The combined accounting deficits for FTSE 350 companies with final salary pension schemes ballooned from £98bn to £107bn between November and December, compared with £56bn a year ago, a survey published on Tuesday by pension consultants Mercer found.

Consequently, funding levels — or the ability of schemes to make payments as promised to members of final salary plans — reduced from 86 per cent to 85 per cent over the same period.

Mercer said the deterioration was “substantially” driven by a further fall in corporate bond yields, which are used to measure the pension liabilities reported in company accounts.

“The sharp fall in both corporate and government bond yields to historic lows during the second half of the year has resulted in a sharp rise in pension scheme deficits,” said Ali Tayyebi, a senior partner at Mercer.

“The accounting deficit is 90 per cent higher at the end of 2014 compared to the position at the end of 2013.”

According to the Mercer estimates, pension assets held by the top 350 UK companies rose £2bn to reach £608bn between November and December last year. But over the same period liability values rose £11bn to £715bn.

Mercer said a “huge variety” of financial and economic factors worldwide had affected yields in 2014 but it expected continued volatility in 2015.

“Whilst the recent fall in yields may cause many pension schemes to review the hedging of their interest rates, schemes should be open to the opportunities that volatility provides,” added Mr Tayyebi. “Companies and trustees should be prepared.”

With UK pension scheme deficits continuing to soar, some commentators are calling for a review of the Bank of England’s Quantitative Easing policy, or asset purchase programme, which is designed to revive economic growth but depresses bond yields.

Ros Altmann, an independent pensions expert and investment adviser, said: “The impact of Quantitative Easing on corporate pensions and annuities has not been properly appreciated and is one of the dangerous unintended consequences of this policy experiment.

“The stronger economy and sharply falling unemployment would normally have heralded rising interest rates and equity prices. Instead, interest rates remained low and gilts became increasingly expensive as long yields fell to record lows towards the end of the year.”

In recent years pension funds have switched away from equity investment towards gilt and bonds, making them much more sensitive to movements in bond yields.

In 2006, more than 60 per cent of pension fund assets were in equities, but this fell to 35 per cent in 2014. In contrast, holdings of gilts and bonds have risen from 28 per cent to 44 per cent over the same period.
That last part of this FT article confuses me. If since 2006 UK corporate plans shifted away from equities into gilts and bonds in order to derisk their plans, then they should have benefited from the decline in interest rates. If they weren't invested in gilts and bonds, their liabilities would have been much worse!

Where they might have gotten hurt is investing in inflation-indexed gilts, which are inflation-indexed bonds, and are going nowhere as global deflation garners steam, punishing most investors that are ill-prepared for it.

One British corporation that is being scrutinized by regulators is BT, which is under fire for failing to meet commitments to pay off its multi-billion pound pension fund deficit by 2025:
The telecoms giant said on Friday that it had agreed a five-year extension with the trustees of the fund, who manage the retirement nest eggs of more than 300,000 members.

Such a delay would be against the Pensions Regulator’s rules for most private companies, but because BT is a former state monopoly its pension liabilities of nearly £50bn are guaranteed by the taxpayer. It means the fund is exempt from such regulatory safeguards.

The agreement came after a triennial review of the deficit found the company will need to pay in £7bn for the pension fund to meet its liabilities. This represents an 80pc increase on the deficit three years ago, when BT said it would cover the shortfall by 2025.

By extending the deadline, BT liberated more cash for investments in its new sport and mobile businesses.

John Ralfe, a leading independent pensions consultant, said: “It’s a pretty weak deal from the trustees’ point of view. From the point of view of a company that is trying to reinvent itself by spending on sports rights and mobile networks it’s very good.

“This is about the weakest deal the trustees could do for their members and still hold their heads up.”

BT said the agreement was a “good outcome” for both the company and its pensioners and that its taxpayer guarantee had no bearing on negotiations.

Paul Spencer, the chairman of the trustees, said the agreement reflected BT’s improved financial position since the deficit was last assessed.

Mr Ralfe also criticised the way the BT pension trustees invest only a low proportion of the fund in bonds.

“They’re continuing to hold a very large percentage of hedge fund and equity assets,” he said.
BT isn't the only one investing in hedge funds and other alternative investments to make their actuarial target rate of return. But unlike large public pensions which are starting to give up on hedge funds opting instead for more illiquid alternatives like real estate, infrastructure and private equity, large corporations with DB plans prefer hedge funds because they're more liquid.

The problem is that it's becoming a lot more difficult to pick winners in this environment, which is one reason why Soros warned pensions to steer clear of hedge funds and why the stock market index fund Buffett picked in a bet continues to outpace a collection of hedge funds seven years into the 10-year wager.

As far as quantitative easing, central banks around the world continue to fight the spectre of global deflation with everything they've got. The Bank of England is on the same page as everyone else.

Also, as I explained in the coming war on pensions:
...the Fed is in on the game. How so? Because following the 2008 financial crisis, which was mostly Wall Street's doing, it basically bailed out big banks by pumping trillions of dollars of liquidity into the global financial system, keeping rates at historic lows.

Quantitative easing (QE) has been a boon for Wall Street because it forces pension funds to increase their risk-taking behavior in alternative investments, especially illiquid alternatives like private equity and real estate (and to a lesser extent, hedge funds). The alternative investment funds gain by charging pension funds excessive fees for managing assets and big banks gain by charging trading and other fees to their big alternative investment clients.

Think about it. You have underfunded pension funds trying to realize their rate-of-return fantasy taking on increasingly more risk in illiquid alternatives to "safely and prudently" achieve their bogey.

The only problem is they will never achieve this unrealistic bogey but I guarantee you hedge funds, private equity funds, real estate funds and big banks will continue milking pensions dry, feeding them all sorts of self-serving nonsense that basically enriches them but leaves members of these pensions out to dry.
I think Thomas Piketty should rewrite his grand manifesto on inequality to include a chapter on public and private pensions and how quantitative easing has exacerbated inequality, making a handful of overpaid hedge fund and private equity fund managers obscenely wealthy.

Of course, the bulk of hedge funds, including the one founded by Chelsea Clinton's husband, stink and can't perform in this volatile environment. You will hear all sorts of pathetic and lame excuses for their underperformance but the reality is this is a brutal investment environment, which is one reason that taking outsized bets anywhere can come back to haunt you.

Having said this, there will always be top hedge funds that deliver outstanding results but good luck finding them, getting an allocation and securing a proper alignment of interests. For the most part, the institutionalization of hedge funds is good, however, it's also creating a monster where a few top funds garner the bulk of the assets.

Now, let's get back to how the decline in rates is decimating corporate pensions. In early January, Milliman reported that U.S. corporate pension funding deficit grew by more than $100 billion in 2014 due to plummeting interest rates:
Milliman, Inc., a premier global consulting and actuarial firm, today released the results of its latest Pension Funding Index (PFI), which consists of 100 of the nation's largest defined benefit pension plans. In December, these plans experienced a $19 billion increase in pension liabilities and a $3 billion decrease in asset value, resulting in an $22 billion increase in the pension funded status deficit and a funded ratio of 83.6%. For the year, despite market returns of $81 billion, these pensions experienced a $105 billion increase in the pension funded status deficit, fueled by a $186 billion increase in liabilities as interest rates fell to a historic low at year end.

"What a difference a year makes," said John Ehrhardt, co-author of the Milliman 100 Pension Funding Index. "Last year at this time we were celebrating a historic rally for these pensions, thanks to—surprise surprise—cooperative interest rates. This year it's the opposite story, with interest rates falling to 3.80%, the lowest rate we've ever seen in the 14 year history of this study. With rates this low, the liability increase for these pensions outstripped strong asset performance by more than $100 billion."

Looking forward, if the Milliman 100 pension plans were to achieve the expected 7.4% median asset return for their pension portfolios, and if the current discount rate of 3.80% were maintained, funded status would improve, with the funded status deficit shrinking to $255 billion (85%.7 funded ratio) by the end of 2015 and to $217 billion (87.9% funded ratio) by the end of 2016. This forecast assumes 2014 aggregate contributions of $44 billion and 2015 and 2016 aggregate contributions of $31 billion.

To view the complete study, go to http://us.milliman.com/pfi/. To receive regular updates of Milliman's pension funding analysis, contact us at pensionfunding@milliman.com.
The latest data from Mercer corroborate this, showing S&P 1500 pension funded status dropped 5% in January as interest rates continue to fall:
  • Deficits increased by $150 billion in January to $654 billion, reaching highest levels since 2012
  • The funding level of 74% is the lowest since 2012, completely wiping out the gains from 2013
  • Interest rates decreased by 48 basis points, the largest monthly interest rate drop in three years
  • The S&P 500 index experienced a 3.1% loss in January
The estimated aggregate funding level of pension plans sponsored by S&P 1500 companies decreased from 79% as of December 31, 2014 to 74% as of January 31, 2015. Sharp decreases in interest rates used to calculate corporate pension plan liabilities, coupled with losses in equity markets, brought funded status down by 5%. Gains in the fixed income market were not enough to offset increases in liabilities. The estimated aggregate deficit of $654 billion as of January 31, 2015 increased $150 billion from $504 billion at the end of 2014, according to Mercer.[1]

The S&P 500 price index decreased by 3.1% in January, while MSCI EAFE index increased by 0.4%. Typical discount rates for pension plans as measured by the Mercer Yield Curve decreased by 48 basis points to 3.33%.

“Not the start to the year that plan sponsors were hoping to see”, said Jim Ritchie, a principal in Mercer’s Retirement Business. “After a 9% drop on average in 2014, sponsors are hit with a further 5% drop right out of the gate in 2015. The continued volatility in fixed income and equity markets, as well as the expected improvements in mortality, together make risk transfers a more attractive strategy in 2015. While many plan sponsors settled their liabilities with former vested employees in 2014, more will likely consider settling their liabilities with active employees and retirees in 2015. There is an unprecedented opportunity in 2015 for many plan sponsors to terminate their pension plans at a discount to accounting liabilities.”

Mercer estimates the aggregate funded status position of plans sponsored by S&P 1500 companies on a monthly basis. Figure 1 (next page) shows the estimated aggregate surplus/(deficit) position and the funded status of all plans sponsored by companies in the S&P 1500. The estimates are based on each company’s year-end statement[2] and by projections to January 31, 2015 in line with financial indices. This includes US domestic qualified and non-qualified plans and all non-domestic plans. The estimated aggregate value of pension plan assets of the S&P 1500 companies as of December 31, 2014, was $1.89 trillion, compared with estimated aggregate liabilities of $2.39 trillion. Allowing for changes in financial markets through January 31, 2015, changes to the S&P 1500 constituents, and newly released financial disclosures, at the end of January the estimated aggregate assets were $1.90 trillion, compared with the estimated aggregate liabilities of $2.55 trillion. Figure 2 shows the interest rates used in Mercer’s pension funding calculation (click here to view figures).
As I've discussed plenty of times on my blog, declining rates are the primary driver of pension liabilities, especially when rates are at historic lows. In finance parlance, the duration of liabilities is a lot higher than duration of assets which means when rates are ultra low, a decline in bond yields disproportionately impacts pension deficits.

But wait, won't the Fed save the day by hiking interest rates later this year? I wouldn't bet on it because if it does make such a monumental mistake, it will bring about an epochal deflationary crisis, which means rates will go lower and stay low for a prolonged period, ensuring the destruction of many underfunded public and private pensions.

In this sense, pension deficits which are much worse among U.S. public plans because of the insanely optimistic discount rate (based on rosy investment projections) they use to discount future liabilities, are very deflationary because they force monetary authorities to continue pumping liquidity into the global financial system to stoke inflation expectations and boost returns of traditional and alternative investments.

There is a lot to ponder in this comment but my biggest fear remains that most pensions are ill-prepared for global deflation, which means a prolonged period of declining and/or ultra low rates will continue to wreak havoc on many underfunded public and private pensions around the world (plug that into your optimization models!).

Below, Michael Gapen, Barclays chief U.S. economist, discusses the Fed and the U.S. economy and why he thinks the Fed will raise rates.

Earlier in the morning, Jack Welch, Welch Management Institute, explains why the Fed would be crazy to raise interest rates right now. Also Welch shares his thoughts on the strong U.S. dollar and the outcome of a "sweetheart" deal between the ECB and Greece.

I agree with Welch, raising rates now would be ludicrous. Larry Summers explained why in much more elaborate and convincing terms, but the Wall Street crowd remains unconvinced. They will be proven wrong once again and pensions listening to their nonsense will get decimated once deflation sets in.


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