Home Fixed interest If you think US pensions are safe, wait

If you think US pensions are safe, wait


You never know where the next crisis will come from, but last week it came from a particularly unlikely place: defined-benefit pensions. The UK government bond market (gilts) went wild as rates soared and pension funds failed to meet their margin calls. This created so much trouble that the Bank of England had to intervene. Does this mean that US pensions could create similar troubles? Don’t be shy about it, but yes and no. The good news is that US pension funds are not as exposed to rate changes because they hold fewer fixed income assets. But that’s also the bad news.

Interest rates are rising and will remain high for the first time in years. This means that anyone exposed to fixed income securities is due for disruption. US schemes are less leveraged than UK pension schemes because they cover less risk, so soaring rates are unlikely to cause immediate damage. But it also means they are more exposed to market risk, and with rising rates revealing all sorts of financial vulnerabilities, US plans could eventually find themselves in even worse shape than UK plans last week.

According to a report by the Milliman Corporate Pension Funding Study, the smallest subset of US corporate defined benefit plans invest about half of their $3.7 trillion in assets in bonds (similar to UK plans). It’s worth noting that US repos aren’t that vulnerable to margin calls because they’re doing old-fashioned liability-driven investing: holding mostly bonds instead of adding leverage. This means that when rates rise, their assets and liabilities move together, keeping their funding relatively stable.

Company plans are doing relatively well, but they are not the main source of risk. State and local government pensions, which hold more than $9 trillion in assets, and (in 2021) only 22% of those assets are fixed income, are a far bigger concern.

A fixed low-income allowance was generally considered a nothing to brag about for pensions. But public pension plans have ditched fixed income and public stocks over the past 20 years because rates have fallen so low.

Unlike UK and US company schemes, public schemes in the US value their liabilities using the expected rate of return on their assets instead of the market interest rate; a convention that blows the heads of financial economists. This way of accounting may mean less direct exposure to interest rates, but it also rewards greater risk taking, because the higher the pensions choose a higher “expected” return, the lower their liabilities appear to be.

When interest rates fell, pension plans were encouraged to turn to opaque, illiquid and risky assets, such as private equity and hedge funds, because they could claim a higher rate of return. In addition to high fees, this meant more risk. US government plans are also underfunded. In 2019, using comparable accounting methods, public pensions only have enough assets to cover 50% of their liabilities, compared to UK schemes, which entered the pandemic able to cover over 90% of their commitments.

The UK pensions case is just the first buried body to uncover higher rates. US plans are less directly exposed to a sudden and large rate increase, but over time they have an equally troubling vulnerability: they are underfunded and dependent on risky assets that pay off. Today, with the markets falling, their assets are shrinking and their expected returns are harder to justify. A higher interest rate environment is also bad for private equity and can mean fewer profitable exits. This could mean that over the next few years, pension funds will learn that the 12-15% returns they thought they were getting from their alternative investments were an illusion and that they have less money than they thought. thought.

Repo may be just the start, as the US economy has become dependent on low rates. And that means the new source of vulnerability may come from parts of the economy once considered boring and safe, like mortgages and now pensions. Central banks have painted themselves into a corner. The Bank of England tried to reduce inflation with higher rates and quantitative tightening. But they discovered that the fight against inflation and financial stability could be incompatible.

More other writers at Bloomberg Opinion:

A European crisis is coming. What kind will it be? : Tyler Cowen

Don’t let Lehman’s ghost throw Pall at Credit Suisse: Paul Davies

How to Uncover the Hidden Leverage of Pensions: Chris Hughes

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Allison Schrager is a Bloomberg Opinion columnist covering the economy. A senior fellow at the Manhattan Institute, she is the author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk”.

More stories like this are available at bloomberg.com/opinion