Global Pensions Facing New Crisis?
Pension funds in developed economies are facing a new crisis as falling equities and tumbling bond yields widen their deficits, threatening the incomes and retirement dates of future retirees.
At the heart of their problems is a steady move by pension plans in the United States, euro zone, Japan and the UK to cut exposure to risk after the financial crisis.
But this "de-risking" may end up depressing their long-term returns from stock market investment and challenge the conventional wisdom that shares generate higher returns than bonds.
With weaker holdings and increased liabilities, companies will find it more difficult to fund existing pension schemes. They may cut new business investments as they use more cash to pay pensions.
For future pensioners, it means they will potentially face a lower retirement income and a longer working life -- or both.
This year has been a nightmare for many in the industry -- which controls $35 trillion (21.7 trillion pounds), or a third of global financial assets -- and funding deficits are posting double-digit rises.
"We had a credit crisis and government bond crisis, and the third one we have is the pension crisis. This is the one where everything is going wrong and there's no obvious way out," said Kevin Wesbroom, UK head of global risk services at consultancy Aon Hewitt.
The sharp retreat in stocks through the summer has hurt them again by weakening their asset positions and threatening to erode stock market recoveries seen since the equity collapse surrounding the 2007-2009 credit crisis.
Even lower bond yields are proving to be a new headache.
"The real killer is liabilities are going up because in the flight to quality everyone gets out of equities and runs for cover in safe assets like government bonds, and yields are falling," said Wesbroom.
Many defined benefit(DB) pension plans -- where benefits are pre-determined -- pay a fixed stream of income to retirees.
The low-yielding environment makes it harder for the funds to meet these bond-like liabilities, forcing them to accumulate even more fixed income instruments to try to meet their obligations, creating a vicious circle.
Recent data on pension deficits highlight the plight of many pension funds.
In the United States, funding deficits of the 100 largest DB plans rose $68 billion to $254 billion in July, according to the Milliman Pension Fund Index. July marked the 10th largest deficit rise in the index's 11 year history.
Even if these companies were to achieve an optimistic annual return of as much as 8 percent and keep the current benchmark yield of 5.12 percent, their funding status is not estimated to improve beyond 93 percent by end-2013 from the current 83 percent.
Aon Hewitt estimates deficits of DB pension plans for FTSE 350 companies as of end-August rose 20 billion pounds from July to a 2011 high of 58 billion pounds. Their funding ratio stands at 89.8 percent, down from 94.1 percent three years ago.
The drop in the funding ratio is driven by a rally in the fixed income market. In Europe, the double-A rated corporate bond yield -- one of the benchmark rates used by regulators -- fell 300 basis points in the last three years to 3.55 percent, according to Barclays Capital.
The widely used rule of thumb is that a 50 basis points fall in the discount rate roughly results in a 10 percent increase in liabilities.
"Things look substantially worse now than they were during the credit crisis," said Pat Race, senior partner at investment consultancy Mercer.
In reaction to the past few years of an equity decline and volatility, many pension funds are indeed planning to buy more bonds, a move highlighted by Mercer's survey of over 1,000 European DB pension funds in May.
"Trustees do want to de-risk but financial directors have irrational desire to have equities. They are too wedded to equity markets," Race said.
"You still have massive uncertainties with a potential for another dip into recession. I don't see any reversion to days when equities are dominant part of DB plans."
JP Morgan's data shows pension funds and insurance companies in the United States, euro zone, Japan and UK bought $173 billion of bonds in the first quarter, boosting their bond buying for the third quarter in a row.
At the same time, they cut equity buying for a fifth quarter in a row, selling $22 billion of stocks in Q1.
In Europe, pension funds slashed their weightings for equities to an average of 31.6 percent in 2011 from 43.8 percent in 2006, while fixed income holdings rose to 54 percent from 47.8 percent in the same period, according to Mercer.
EQUITY PREMIUM PUZZLE
Growing pension funds deficits on corporate balance sheets may make it more difficult for companies to access credit and discourage firms which are already hoarding cash from spending cash to expand business.
For wider financial markets, the giant industry's gradual move away from stocks could hit equity risk premium -- excess return of equities over risk-free securities which compensates investors for taking on the relatively higher risk.
This may reinvigorate an academic debate where some economic analysis suggests the equity risk premium should be small, in most cases less than half a percentage point, as opposed to the widely-used range of 4-6 percent.
Indeed, 10-year U.S. Treasuries gave higher total returns in the past 10 years on a rolling basis than world stocks. link.reuters.com/nyv53s
"The puzzle... is that for the past 20 years, there has been no net equity risk premium. With the recent sell-off in risk and the rally in bonds, I think there might have been a net premium on bonds," Stephen Jen, managing partner at SLJ Macro Partners, said in a note to clients.
"This has turned financial theory on its head, and managers of pension funds and sovereign wealth funds need to think about this very carefully."
Indeed, there is a net premium on bonds -- a bit too much for my liking-- but market participants are worried that policy blunders will lead to debt deflation. The Fed and other central banks will fight this outcome with everything they got to support the global financial system. As they print money, I'll be trading risk assets.
One thing about the article above that caught my attention. Corporations that still offer DB plans are supposedly de-risking by cutting public equities in favor of bonds and alternative investments which include hedge funds, real estate and private equity. Many of these corporations are hoarding cash, not hiring, in case they have to top up their pensions. But remember, most corporations have done away with DB plans in favor of less expensive (and less predictable) DC plans tied to the stock market. They're not hiring because they don't need to hire and are worried about what the future holds.
As far as public plans, most mature public plans, most of which are underfunded, they are also de-risking, cutting allocations to equities in favor of bonds. But this too causes problems for them because they're not able to achieve their required rate of return. And de-risking brings about other problems -- witness the illiquidity in the corporate bond market as everyone tries to cut allocations at the same time. One senior VP at a well knowns asset management firm confirmed to me that the illiquidity in corporate bonds is a real problem for major institutions looking to cut risk, which is why spreads keep widening.
I'm still in RISK ON mode, trading and buying the dips on large cap tech stocks like RIMM, JDSU and some other stocks in other sectors that got slammed in August (check out solars like LDK Solar -- news of a possible Eurozone breakup has sent them to 2008 lows). A few other stocks I'm tracking include Ciena (CIEN), Juniper (JNPR), Mosaic (MOS) and Cameco (CCJ).
Please note, I am in Crete, away on vacation, but will be blogging off and on. You can track pension news on Jack Dean's Pension Tsunami and follow me on Twitter (@PensionPulse) for news on pensions, markets, trading, the Greek economy, and highlights of my trip. I already dread the day I have to leave this paradise. Who knows, maybe I'll stay and get a job running some Greek public pension fund. This way I can collect millions as I trounce my benchmarks based on four-year rolling returns. Just need to specify that I want to get paid in US dollars, not euros or God forbid, Greek drachmas.