Matt Roberts-Sklar
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.
If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.
Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.
A very good subject and one that is going to be very interesting going forward.
Pension Funds are trapped, no easy answers as respects to their holdings and performance. Many decided to reach for yield or risker returns, ( investing in equities/ETF’s).
Now is not the time to reach for yield or high returns via equities or commodities. Now is the time to review and understand Risk and Liquidity. Its better to settle for lower yield and high quality low Risk Bonds, such as US Treasuries, avoid commodities which are for the most part are in a long term Bear MKT. Also, make sure their portfolios are Liquid vs investments in Illiquid. We have seen major funds Gate their funds due to Illiquid portfolios.
Unfortunately, many Pension Funds are under funded.
This decade 2020 to 2030 are going to be very interesting for Pension Funds, Investors and Central Banks.
I think the various U.S. states responded to the ‘crisis’ by reducing the shares of both bond and equity holdings in their pension funds, moving into so-called ‘alternative investments’ (at least as of 2016). The sum of the shares held by equities and alternative investments together was little changed. Are you aware of any research to explain these moves?
One advantage DB pension funds have over investment funds is that they will have a clear idea as to how much liquidity they need. There is no reason to ensure 30-day or 90-day liquidity for all their fund, if the duration of the liabilities is 10-15 years. The optimum solution from the point of the fund, and therefore the pensioner, would seem to be:
adequate tranches of highly-liquid zero-yield assets (cash and cash-like) to cover all reasonable short-term cash needs;
low-volatility low-yield assets (e.g. government and high-rated commercial bonds) to cover 5-10 years of market slumps;
the remaining assets in higher-yielding assets (e.g. equities, private equity) that will often be illiquid and volatile.
In this way, the issues of investment liquidity and volatility are mitigated, and yet there is still some yield-enhancing investments to reduce the cost of satisfying the long-term liabilities. In the long run, improved yields means higher fund asset value, and thus is the most fundamental of risk reduction for the pensioners.
Many pension funds that were not cowed by simplistic accounting understood the advantages they had over normal investment funds from having well-defined requirements for cash. They were therefore able to invest some of the portfolio in assets that were not liquid and so of only limited interest to investment funds – hence the move into private equity and alternative investments. Less demand for these assets should mean lower prices, and so higher yields.
The key reason that this approach has not been taken is the risk to the sponsor company of accounting deficits caused by equity price volatility and discount rate moves. These require the sponsor company to inject more cash if this drives an actuarial deficit. To avoid this, the sponsors encourage investment in short-term government bonds whose values are closely correlated to the present value of pension liabilities as interest rates and equity markets move. This reduces significantly the risk of sponsors having to top up the pension fund in the short term.
The risk to the sponsor is real, short-term, one-sided, and very different (and should be clearly separated from) the risk to the fund, the trustees, or the pensioners. Articles often make the mistake of calling this risk to the sponsors “pension risk”, which is easily mistaken for a risk to the pensioners.