Low interest rates and the threat to pension funds

A new study from the OECD suggests that the low interest rate environment poses a threat to pension and life insurance companies. This not a threat, but a reality. There is no way that pension funds will be able to meet their obligations given their unrealistic expected returns and current interest rates. Most pensions have cut their bond exposures, but that only changes the risk profile of their portfolios. Of course, they could make this all work by massively increasing the amount of new money inflows to offset the lower returns, but that is not a solution that most would like to consider.

Pensions have been adjusting to this new world but it not clear that it will be enough to help. The math works against the pensions when rates are low.

If you don't think rates are going to be a problem, you can look at the funding levels to see whether the pensions will be able to meet their obligations. The numbers do not look good, but there are countries such as Netherlands and Switzerland that have been effective with meeting their potential obligations through having funding ratios that are at or above 100 percent. The US has some work to do to get pensions at the 100% funding level.

There are no simple solutions because adding risk for higher return shift the problem. Certainly, being deep into a bull market is not the time to add more equity risk. Hedge funds are a potential solution, but they have to generate higher returns at lower risk than other major asset classes to be a true alternative. Hedge funds have to provide more return for the same level of risk than the current stock/bond allocation. It may be the only valid alternative, but it requires a careful analysis of the diversification being generated.