Pension Duration Dilemma - Why Pension Funds Are Driving The Biggest Bond Bubble In History

Tyler Durden's picture

We've frequently discussed the many problems faced by pension funds.  Public and private pension funds around the globe are massively underfunded yet they continue to pay out current claims in full despite insufficient funding to cover future liabilities...also referred to as a ponzi scheme.  In fact, we recently noted that the Central States Pension Fund pays out $3.46 in pension funds for every $1 it receives from employers (see our post entitled "407,000 Workers Stunned As Pension Fund Proposes 60% Cuts, Treasury Says "Not Enough""). 

The pension problem is often attributed to low returns on assets.  As Bill Gross frequently points out, low interest rates are the enemy of savers and pension funds have some of the biggest savings accounts around. 

That said, the impact of declining interest rates on the asset side of a pension's net funded status is dwarfed by the much more devastating impact of declining discount rates used to value future benefit obligations.  The problem is one of duration.  By definition, pension liabilities represent the present value of future benefit payments owed to retirees which is a virtually perpetual cash flow stream.  Obviously, the longer the duration of a cash flow stream the larger the impact of interest rate swings on the present value of that stream.

We created the chart below as a simplistic illustration of the pension "duration dilemma."  The chart graphs how a pension liability grows in a declining interest rate environment versus the value of 5-year and 30-year treasury bonds.  As you can see, a $1BN pension that is fully funded at prevailing interest rates would be nearly $700mm underfunded if interest rates declined 300bps and all of their assets were invested in 30-year treasury bonds.  The result is obviously even worse if the fund's assets are invested in shorter duration 5-year treasuries. 

Pension Duration

So what do you do when perpetually declining interest rates continue to drive your funded status lower and lower despite your return profile?  Well you move further and further out the yield curve, of course, in an attempt to match your asset duration with that of your liabilities.  As the Wall Street Journal recently pointed out:   

By their nature, the liabilities of these kinds of investors—the money they promise to pay their clients when they retire—span very long into the future. Their assets—the securities they buy—are generally shorter-dated. This means their assets and liabilities have different “duration.” Duration measures sensitivity to interest-rate changes, so higher-duration liabilities change in value much more than their assets if rates change.


Mr. Di Domizio argues that, in order to contain the size of this gap, institutional investors have little choice but to buy more longer-dated bonds, to lengthen the duration of their assets. This would explain why demand for 30-year debt that yields peanuts hasn’t dropped.

The problem is that by "reaching for yield" (or "reaching for duration" if you prefer) large pension funds enter into a negative feedback loop that only serves to exacerbate their problem.  As billions of dollars are plowed into longer-dated securities the yields of those securities are driven even lower.  Even worse, as yields fall, negative convexity causes the duration gap between assets and liabilities to expand.  With that, pensions have no choice but to go even further out the yield curve and the cycle continues.  The Bank for International Settlements wrote about this topic in October 2015:

In a paper published last year, the Bank for International Settlements made a similar claim. BIS economists argued that a large chunk of the fall in long-term yields since mid-2014—in the part of the yield called “term premium”—was due to insurance firms and pension funds trying to fix these problems.


“If a sufficiently large segment of the market is engaged in such portfolio rebalancing, the market mechanism itself may generate a feedback loop whereby prices of longer-dated bonds are driven higher, serving to further lower long-term interest rates and eliciting yet additional purchases,” they said.

The problem of course is that pensions will never be able to match the duration of a perpetual obligation stream.  And even if they could, the best case scenario is that they would be able to lock in their existing underfunded status while doing absolutely nothing to close the gap. 

As we've said before, the looming pension catastrophe is an inconvenient fact for elected officials as well as union bosses and their membership.  Rational solutions like cutting benefits are not palatable to employees or the elected officials that require their votes.  As such, we suspect the problem will continue to be ignored until it boils over...


The full report from the Bank of International Settlements can be reviewed below:

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Here2Go's picture
Here2Go (not verified) Aug 16, 2016 2:08 AM

I don't know what's worse. The criminals who are working to keep the Ponzi going, or the Sheep who continue to give up their freedoms which results in enabling the Ponzi to keep going.

cognitive dissident's picture

I think we both know how this ends, but which group blames the other? Those who blame first, usually blame best...

Escrava Isaura's picture

Welcome to the human race. No one want less. Listen to most Hedgers, listen to the blacks from Milwaukee, they too want more growth. Everyone does.


The irony is, the more these solutions are tried, the larger the gap of “the have not” versus  of “the haves” will wide. Go figure.


"The definition of insanity is doing the same thing over and over again and expecting a different result." — Albert Einstein


spanish inquisition's picture

Everyone can have more, you just need to be willing to make slaves of your children and grandchildren to pay off your more.

MalteseFalcon's picture

There must be 10 ZH articles on the problems of Social Security for every one on pensions.

Pensions and annuities are in far greater trouble than SS.

Pensions and annuities are guaranteed to collapse.

Almost completely.

Escrava Isaura's picture

Great observation.

Did not think that way.


Infocat's picture

The Ponzi is just an opportunity for all insiders to stuff their bags with Precious Metals:

Latitude25's picture

So that means ZHers are insiders.

elmo jones's picture

The real insanity is that millions of professionals do nothing except manipulate data to create this Ponzi fraud. Those pros could have spent their lives creating real wealth working a real trade. Finance pros are nothing more than PC GAMERS. They sit behind a screen and play a game that produces ILLUSION and consumes electricity. Social Security and Pensions are all SOCIALISM. SHUT them down and organize churches and philanthropy groups to aid needy. A senior who no longer works deserves food and housing. NOT luxury items, a new macbookpros. 

Inzidious's picture

Shrug. Feds will print and bail all this crap out. Why wouldn't they ?

Jayda1850's picture

Yes they will indeed print, but just like TARP it will be added on to the taxpayer's with interest. The FED only creates free money when they do QE and that all is going to the primary dealers.

azusgm's picture

And the bill goes to the kids.

asteroids's picture

One day it ends in a supernova. In case you haven't noticed debt is not increasing at a linear rate, but an expotential rate. Negative interest rates (an absurd notion) are a clear sign that the end is near.

johnrxx99's picture

Hey babe, tell it as it is. Rather the using "feedback loop" and important sounding retoric, why not say the simple fact is that central banks are diluting the monertary base so that future liablities are reduced as near to zero as they can because they have spent your money to stay in power.

Interest rates can NEVER rise because if they did the increase in payment to bond holders would require a substantial rise in tax rates. Who does that affect? Certainly not pensioners so keep spending and the power, suckers.

falconer's picture
falconer (not verified) johnrxx99 Aug 16, 2016 3:04 AM

Where have you been? Property taxes have been on the increase for the last 4 years- a big part of artificially propping up the real estate market was to keep tax revenues from cratering in lockstep with home values. Your local cop needs those new matching jet skis in the garage.

azusgm's picture

Your local school district is doing it to you. They pass bonds so that they can demolish existing school buildings to build new ones because the school district next door has a shiny new school. Meanwhile, education drops into the ditch.

falconer's picture
falconer (not verified) Aug 16, 2016 3:00 AM

The states and municipalities' quest for yield to fund pensions is now achieved by raising property taxes 5% a year

JerseyJoe's picture

So who gets a pension these days?   Largely public sector unions from bankrupt states and counties?   Promises made with other people's money by corrupt, kick-the-can politicians (mostly Democrats from Democrat run states, counties and cities).   

Neither my wife nor I have a pension both of us worked in the private sector 30+ years...but yet we are taxed endlessly to pay pensions to overpaid and over benefited unions in the public sector.  

Can you sense my "Oh fucking well remorse?"  


falconer's picture
falconer (not verified) JerseyJoe Aug 16, 2016 3:56 AM

It is absolutely ridiculous that states cannot declare bankruptcy like municipalities can

azusgm's picture

That would be the end of any states' rights.

mpyre's picture

And you will be taxed even more when these things go belly up...reduce the pension of a teacher, a policeman, a social worker, or a keyboard drone at the IRS? Never!

Latitude25's picture

Shut up and keep working slaves.  Not happy?  Here's some more credit.

chief's picture

8 yrs of yields have moved from pensions and insurers to stocks... just shows low interest rate is not free, simply redistributes money from one side to the other, like a tax, but without representation and put on by clueless book worms...

Infield_Fly's picture
Infield_Fly (not verified) Aug 16, 2016 6:02 AM

NIRP will fix all of this.



brushhog's picture

They'll print and bail out the pension funds.

Break_the_Bank's picture

Of course this article says nothing about the other pension killer. Inflation!

The Fed has an inflation target of 2%. Bonds yields are less than that or are negative in this crazy world. So even if pension funds met their goals, inflation woujld eat up the value of the payment stream.  

In.Sip.ient's picture

Which is hilarious.


On the one hand the very mechanism they'll

use to meet their obligations ( inflation ) will

be torpedoes by the other mechanism ( ZIRP/NIRP ).


Imagine holding your own neck in a tight squeeze,

while trying to swallow...


theprofromdover's picture

Presumably the chart assumes that for every retiring worker,there's a new one ready to start their career and take his / her place.



obthedgehog's picture

They can print to make it "work" in nominal terms but nothing nothing nothing can make it work in real terms.

Iconoclast421's picture

Central States Pension Fund pays out $3.46 in pension funds for every $1 it receives from employers?


No worries. This jsut means the Swiss central bank will print and buy 3.46 shares of stock for every share of stock sold by the pension fund to make its payments.

azusgm's picture

Cede & Co. keeps it all honest. Right? /s

Boris Badenov's picture

In that point of view, why would The Federal Reserve be in competition with future retirees' income checks?

Oh, so they are not as bi-partison as we are led to believe.  Hey, Donald, over here.....

Swamidon's picture

When none of the sides are willing to change the deal then the solution, and the reality, is pay out benefits as promised until the money is gone, or until the participants decide to compromise.  The best response is to "wait it out" and see what happens.