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Equity Premium Gone – Pension Shortfalls Grow

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Pension Funds In New Crisis As Deficit Hole Grows

By Natsuko Waki LONDON, Sep. 5, 2011 (Reuters) — Pension funds in developed economies are facing a new crisis as falling equities and tumbling bond yields widen their deficits, threatening the incomes and retirement dates of future retirees.

  • At the heart of their problems is a steady move by pension plans in the United States, euro zone, Japan and the UK to cut exposure to risk after the financial crisis.
  • But this “de-risking” may end up depressing their long-term returns from stock market investment and challenge the conventional wisdom that shares generate higher returns than bonds.
  • With weaker holdings and increased liabilities, companies will find it more difficult to fund existing pension schemes. They may cut new business investments as they use more cash to pay pensions.
  • For future pensioners, it means they will potentially face a lower retirement income and a longer working life — or both.

This year has been a nightmare for many in the industry — which controls $35 trillion, or a third of global financial assets — and funding deficits are posting double-digit rises.

“We had a credit crisis and government bond crisis, and the third one we have is the pension crisis. This is the one where everything is going wrong and there’s no obvious way out,” said Kevin Wesbroom, UK head of global risk services at consultancy Aon Hewitt.

The sharp retreat in stocks through the summer has hurt them again by weakening their asset positions and threatening to erode stock market recoveries seen since the equity collapse surrounding the 2007-2009 credit crisis.

Even lower bond yields are proving to be a new headache.

“The real killer is liabilities are going up because in the flight to quality everyone gets out of equities and runs for cover in safe assets like government bonds, and yields are falling,” said Wesbroom.

Many defined benefit(DB) pension plans — where benefits are pre-determined — pay a fixed stream of income to retirees.

The low-yielding environment makes it harder for the funds to meet these bond-like liabilities, forcing them to accumulate even more fixed income instruments to try to meet their obligations, creating a vicious circle.

FALLING YIELDS
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.”

EQUITY PREMIUM PUZZLE
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.

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Written by Rich and Co.

September 5, 2011 at 4:33 pm

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  2. Withdrawals from equity by Pension funds, with corresponding increase in equity related yields will be beneficial to long term investors who are on the other side of the transaction. The opportunity cost lost to Pension funds, will become the unrealized gain for long term value investors like us.
    We are poised to pounce.
    Indira Amladi MS MBA CFA, Managing Member, Princeton Ivy Management LLC

    Indira Amladi MS MBA CFA

    September 7, 2011 at 1:54 pm

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