Government bond yields fell sharply mid-2019, especially at longer maturities. For defined benefit pension funds, lower yields tend to mean deficits widen as discounted liabilities increase by more than the value of their assets. How might pension funds respond to this?
In a recent working paper, we set out a model of defined benefit pension fund asset allocation.
As yields fall, deficits increase and pension funds’ corporate sponsors may need to make larger contributions to ‘top up’ the pension fund to plug deficits. Pension fund trustees face two competing incentives. They could move into riskier assets (e.g. equities) to grow the assets and close the deficit. Or they could avoid the risk of having to top up the fund further, and move into safer assets (e.g. bonds).
Pension funds don’t know how their assets will perform. And the corporate sponsor doesn’t know how much it will need to ‘top up’ the pension fund. We account for both of these uncertain factors.
Our model finds that most pension funds will seek to ‘de-risk’ and move into bonds as yields fall (Chart 1). This is especially true of pension funds with financially weaker corporate sponsors. Only those pension funds with stronger corporate sponsors and small deficits would seek to move out of bonds. This is just one model, but it provides some insights into the incentives pension funds can have to increase allocation to bonds as yields fall. And such buying of bonds could push further down on yields, amplifying initial falls.
Chart 1: Model-implied change in pension funds’ bond holdings for given basis points falls in risk-free rates
Source: Douglas and Roberts-Sklar (2018)
Matt Roberts-Sklar works in the Bank’s Capital Markets Division.
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