We've frequently discussed the many problems faced by pension funds. Public and private pension funds around the globe are massively underfunded yet they continue to pay out current claims in full despite insufficient funding to cover future liabilities...also referred to as a ponzi scheme. In fact, we recently noted that the Central States Pension Fund pays out $3.46 in pension funds for every $1 it receives from employers (see our post entitled "407,000 Workers Stunned As Pension Fund Proposes 60% Cuts, Treasury Says "Not Enough"").
The pension problem is often attributed to low returns on assets. As Bill Gross frequently points out, low interest rates are the enemy of savers and pension funds have some of the biggest savings accounts around.
That said, the impact of declining interest rates on the asset side of a pension's net funded status is dwarfed by the much more devastating impact of declining discount rates used to value future benefit obligations. The problem is one of duration. By definition, pension liabilities represent the present value of future benefit payments owed to retirees which is a virtually perpetual cash flow stream. Obviously, the longer the duration of a cash flow stream the larger the impact of interest rate swings on the present value of that stream.
We created the chart below as a simplistic illustration of the pension "duration dilemma." The chart graphs how a pension liability grows in a declining interest rate environment versus the value of 5-year and 30-year treasury bonds. As you can see, a $1BN pension that is fully funded at prevailing interest rates would be nearly $700mm underfunded if interest rates declined 300bps and all of their assets were invested in 30-year treasury bonds. The result is obviously even worse if the fund's assets are invested in shorter duration 5-year treasuries.
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