IMF Warns of Pension Fund Risk?

Ian Talley of the WSJ reports, IMF Sees Risk in U.S. Pension-Fund Strategies:
U.S. public pension funds and life-insurance companies are building up potentially dangerous levels of risky investments that could threaten their solvency, the International Monetary Fund warned Wednesday.

It is a gamble that could harm not only on pensioners and insurance customers, but also on the financial system, the IMF said in its Global Financial Stability Report.

Returns from traditional investments and contributions have dwindled during the recession. And as the Federal Reserve lowered interest rates to try to revive growth, those firms have been unable to match their funding levels with future liabilities.

For example, the IMF says public defined-benefit pension plans won't be able to fund nearly a third of their future obligations based on their current portfolios.

That funding shortfall has encouraged pension funds and insurance companies to bet on higher risk, and potentially higher-return, investments to meet those needs.

To be sure, the IMF says the Fed's actions are essential to reviving U.S. and global growth. But the cheap cash and low interest rates don't come without a cost.

The fund says that at the weakest pension funds, money mangers have boosted their holdings of alternative investments such as hedge funds and financial derivatives to about a quarter of their assets from virtually zero in the last 10 years.

Life insurance companies, meanwhile, have tried to compensate for the lower returns by renegotiating policy terms and getting rid of some insurance benefits. But there is a limit to what they can do, and so many insurance companies have bulked up on riskier investments too.

Most pension funds and insurance firms have cash on hand to weather near-term shortfalls, the IMF said.

"But a protracted period of low rates could depress interest margins further and erode capital buffers, potentially driving insurance companies to further increase their credit and liquidity risk," the IMF said.

The IMF said pension funds need to address their future funding shortfalls "without delay," through "restructuring benefits, extending pensioner's working years and gradually increasing contributions to close funding gaps."

At the same time, some insurance companies may need to get rid of some of their more costly products and restructure their investment portfolios to meet future needs.
Kevin Olson of Pensions & Investments also reports, IMF: U.S. public pension funds increasing risk to dangerous levels in search of yield:
U.S. pension funds, especially poorly funded plans, are increasing their risk exposure to dangerous levels in the current low-interest-rate environment, according to a report from the International Monetary Fund.

The Global Financial Stability Report states that vulnerabilities are growing in the U.S. credit markets while pension funds and insurance companies are moving into more risky assets.

“Reduced market liquidity could amplify the effects of any future increase in risk-free rates,” the report states.

Public DB plans have gone from fully funded in 2001 to a 28% shortfall at the end of 2012. In that same time period, weaker funded plans have increased their allocations to alternatives to 25% from virtually zero, which exposes plans to more volatility and liquidity risks, according to the report. Low interest rates have led plans to search for higher yields elsewhere.

“Low yielding assets may induce excessive risk taking in a search for yield, which may manifest itself in asset price bubbles,” the report states.

The IMF recommends pension plans engage in active liability management operations immediately, including restructuring benefits, extending working years and gradually increasing contributions to close funding gaps.

“An undesired buildup of excesses in broader asset markets is a potential risk over the medium term,” according to the report. “Asset reallocations of institutional investors to alternative asset managers, excess cash holdings by those asset managers, the decline in underwriting standards, and the sharp rise in bond valuations are all intertwined. Constraining those potential excesses is a financial stability imperative.”

You can read the details in the IMF's latest Global Financial Stability Report, entitled Old Risks, New Challenges, by clicking here for the PDF version.

Is the IMF right to warn U.S. public pension funds of the risks of plowing into alternatives which include real estate, private equity and hedge funds? Yes but this warning will fall of deaf ears. The reality is most U.S. public pension funds suffering from chronic deficits and still holding on to their rate-of return fantasy are increasingly betting on alternatives to get them out of their pension hole.

On Tuesday, went over the great pension derisking, explaining how U.S. corporate plans are implementing different strategies to either offload pension risk or significantly curtail it. It's worth noting that corporations are derisking their pension plans while public plans are taking on more risk in a low rate environment.

Nonetheless, one of the strategies corporations are using to derisk is to allocate more to alternative investments. And this is going on all over the world, not just the United States. Historic low rates are forcing pensions all around the world to take on more risk in illiquid investments.

So what? Rates are likely to remain low for quite a while and it could be a boon for alternative investments. Or it could be a major bust. While some hedge fund managers are making a killing on structured credit in the low rate environment, most are struggling in a market where the facade of strength is masking serious deflationary headwinds that could bring about a trend reversal.

Deflation, deleveraging are not good for markets or pensions. Shoving more money into private equity and real estate, taking on too much illiquidity risk, can seriously imperil the liquidity of the weakest public pension funds if another crisis hits.

Pensions and other institutional investors are hoping and praying that global central banks will keep pumping liquidity into the system to avert a protracted period of low rates. And central banks will oblige. That's why sovereign wealth funds, including China's CIC, are betting on a global recovery.

Hope they are all right but if we learned anything from 2008, it's to expect the unexpected and prepare for the worst. That is why Jim Keohane, president and CEO of the Healthcare of Ontario Pension Plan, warned my readers when going over their 2012 results that the "risks of not owning bonds is huge," especially for severely underfunded pension plans.

Why are U.S. bonds rallying? Several reasons. First, forced liquidation, margin calls are sending commodity and gold prices tumbling, intensifying investors' concerns on global growth. Second, every time there is a global crisis, investors seek refuge in U.S. bonds. Third, Japan's experiment is forcing Japanese insurers and pensions to look elsewhere for safe yield. Guess what they're buying as the Bank of Japan buys up JGBs, reducing supply of Japanese bonds? (stay long USD)

Below, José Viñals, Financial Counsellor and Director of the IMF's Monetary and Capital Markets Department, discusses old risks and new challenges from their latest Global Financial Stability Report.