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Analysis: Pension funds in new crisis as deficit hole grows

Sep 5, 2011, 7:05 a.m.

By Natsuko Waki

LONDON (Reuters) - 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, 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.

FALLING YIELDS

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.

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