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Analysis: Pension funds in new crisis as deficit hole grows

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

The widely used rule of thumb is that a 50 basis points fall in the discount rate roughly results in a 10 percent increase in liabilities.

"Things look substantially worse now than they were during the credit crisis," said Pat Race, senior partner at investment consultancy Mercer.

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 dominant part of DB plans."

JP Morgan's data shows pension funds and insurance companies in the United States, euro zone, Japan and UK bought $173 billion 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 $22 billion of stocks in Q1.

In Europe, pension funds slashed their weightings for equities to an average of 31.6 percent in 2011 from 43.8 percent in 2006, while fixed income holdings rose to 54 percent from 47.8 percent 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 cash 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 4-6 percent.

Indeed, 10-year U.S. Treasuries gave higher total returns in the past 10 years on a rolling basis than world stocks. http://link.reuters.com/nyv53s

"The puzzle... is that for the past 20 years, there has been no net equity risk premium. With the recent sell-off 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 very carefully."

(Editing by Anna Willard)

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