State and Federal pension funds are plagued by extravagant promises to pensioners and low yields on pension assets caused, in part, by Central Banks, like the European Central Bank and Federal Reserve.
(Bloomberg) Back in 2012, the world’s best-managed pension market was thrown a lifeline by the Danish government to help contain liabilities. That was when interest rates were still positive.
Seven years later, with rates now well below zero, even Denmark’s $440 billion pension system says the environment has become so punishing that it may be time for a change in European rules.
Henrik Munck, a senior consultant at Insurance & Pension Denmark, an umbrella organization, says the way liabilities are currently calculated “could cause a negative spiral” that forces funds to keep buying low-risk assets, drive yields lower and the value of liabilities even higher.
The warning comes as pension firms across Europe struggle to generate the returns they need to cover their growing obligations. In Denmark, some funds saddled with legacy policies guaranteeing returns as high as 4.5% have had to use equity to meet their obligations.
To calculate liabilities, pension firms use a complex mathematical formula constructed by the European Insurance and Occupational Pensions Authority (EIOPA). The formula is intended to shield funds from erratic market swings that artificially inflate or hollow out balance sheets. But with negative rates more entrenched, there are signs the EIOPA curve, as it’s called, may not be working as intended.
“When pension funds across Europe de-risk simultaneously, it may actually become pro-cyclical: it increases the price movements, and it could result in yet more downward pressure on the EIOPA yield curve, exacerbating the problem,” Munck said.
The curve is comprised of several elements. Its backbone — the euro interest-rate swap curve — has sunk since its implementation about four years ago, driving up the value of liabilities.
PFA, like many Danish pension funds, started scaling back guaranteed products for retirees many years ago. That’s given it a buffer to help absorb some of the shock of growing liabilities. But not everyone’s as well prepared. “If the discount curve is more volatile and you can’t hedge it, you can — if you don’t have enough capital — be forced to lower risk on the more hedgeable space, to compensate,” Damgaard said.
Low volatility assets like sovereign debt?? Pretty soon, government pensions will have to deliver cheaper payments to pensioners.