London - 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, eurozone, 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, 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 northern hemisphere
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
Recent data on pension deficits highlight the plight of many
In the United States, funding deficits of the 100 largest DB
plans rose $68bn to $254bn in July, according to the Milliman Pension Fund
Index. July marked the 10th-largest deficit rise in the index's 11-year
Even if these companies were to achieve an optimistic annual
return of as much as 8% and keep the current benchmark yield of 5.12%, their
funding status is not estimated to improve beyond 93% by end-2013 from the
Aon Hewitt estimates deficits of DB pension plans for FTSE
350 companies as of end-August rose £20bn from July to a 2011 high of £58bn.
Their funding ratio stands at 89.8%, down from 94.1% 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%, according to Barclays Capital.
The widely used rule of thumb is that a 50 basis-point fall
in the discount rate roughly results in a 10% increase in liabilities.
"Things look substantially worse now than they were
during the credit crisis," said Pat Race, senior partner at investment
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 a dominant part of DB plans."
JP Morgan's data show pension funds and insurance companies
in the United States, eurozone, Japan and UK bought $173bn 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 $22bn of stocks in Q1.
In Europe, pension funds slashed their weightings for
equities to an average of 31.6% in 2011 from 43.8% in 2006, while fixed-income
holdings rose to 54% from 47.8% 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 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% to 6%.
Indeed, 10-year US Treasuries gave higher total returns in
the past 10 years on a rolling basis than world stocks.
"The puzzle... is that for the past 20 years, there has
been no net equity risk premium. With the recent selloff 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