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.
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: