The great capital misallocation

Public policy spurs push for investments with lower yields, making a bad funding situation worse

As government bond yields continue to fall to new lows in several developed market economies, most obviously in the U.S. and the U.K., the impact on pension liabilities has been acute. How regulators are responding and moving to alleviate the effect of ever lower yields on the funded status of pension funds is significant.

Pension assets, particularly in developed economies, make up a large portion of the pool of private investible capital. Regulation surrounding how pension funds account for their assets and liabilities frames the nature of their asset allocation.

As quantitative easing across the globe pushes government bond yields lower, the interest rate used to discount pension liabilities is falling, thereby increasing the present value of those liabilities. If assets are unable to match these increases in liabilities, pension funds might be forced to chase ever lower yields, thus perpetuating the problem while at the same time forgoing other asset classes.

The effect on the economic system is further complicated as corporate entities with ever larger pension obligations are forced to pay in additional capital to stabilize the funding situation of their associated pension funds. That capital contribution may have been diverted from the possibility of making a return-generating investment in that company's operations.

Alleviating conditions

Against this backdrop, regulators in several jurisdictions have sought to alleviate the funding conditions for pension plans by adjusting up or putting a floor under the interest rates used to discount pension liabilities.

In the U.S., for example, the Moving Ahead for Progress in the 21st Century Act, signed into law July 6, modifies the discount rate stipulated under the Pension Protection Act of 2006. Prior to this adjustment, the discount rate was calculated using two-year average corporate yields. The revision looks to introduce a “corridor” around a 25-year smoothed corporate yield. This will begin at the 10% level, on either side of the smoothed 25-year corporate yield, and will incrementally adjust wider by five percentage points each year to 30% by 2016.

This will provide short-term relief, as currently the yield on the 25-year smoothed segment is approximately 7.5%. With a new lower bound of 6.7% and an equivalent two-year rate of 5.9%, this would imply an increase in the discount rate of 80 basis points and is likely to result in lower contributions for U.S. corporations. However, corporations do not need to make changes to the reporting of deficits, as the accounting rules of both U.S. generally accepted accounting principles and International Financial Reporting Standards state that the current AA-rated corporate spread must be used.

While the U.S. has so far gone the furthest in this endeavor, the Netherlands, Sweden and Denmark have made modest moves as well. Sweden has put in a temporary floor on the discount rate, which is the risk-free rate as of May 31. Denmark has looked to adjust long-term rates. The effect of this will be to raise the discount rate by approximately 20 basis points. The Netherlands has made similar adjustments to Denmark, but has only extended this benefit to insurers.

In the U.K., regulators have acknowledged the challenges of ever lower rates, but so far no adjustments have been made. The implications of an increase to the discount rate in the U.K. are difficult to predict, however, it could create some risk around longer-dated gilts, both conventional and those linked to an index.

How have pension funds fared?

According to Aon Hewitt and Citigroup Global Markets, combined pension deficits of companies in the FTSE 350 stock index totaled 71 billion ($111 billion) at the end of the second quarter, compared to 56 billion at the end of the first quarter. The funding ratio fell to 87% from 90% during the same time frame. In Europe, companies in the Stoxx 50 saw deficits increase by e30 billion ($37 billion), with funding ratios falling to 57% from 61%.

Looking at how this splits between assets and liabilities, FTSE 350 liabilities rose around 1% to 563 billion, while assets fell by 1% to 492 billion. The fall in the discount rate from 4.63% to 4.25% in the second quarter was largely offset by a fall in inflation expectations to 2.91% from 3.31%. Inflation expectations are integral in calculating long-term liabilities.

For the Stoxx 50, assets were unable to keep pace with liabilities, which were up by 20% in the first half of 2012. The discount rate has fallen from 4.6% at the start of the year to 3.38% by the end of June.

In terms of the asset allocation of pension funds, allocations to equities in both the U.K. and the Continent have declined relative to bonds. FTSE 350 companies have been holding approximately 36% in equities and 46% in bonds relative to 43% and 41%, respectively, during the last reporting period. In continental Europe, equities have declined to 27% from 32%.

Where does this leave us?

Governments around the world are, in the name of monetary policy, pushing down interest rates across their respective yield curves. Inappropriate interest rates lead to a misallocation of capital and this may be evident by the response of pension funds which, through regulation, have no choice but to try to match their liabilities and manage their deficits.

While it may be attractive for governments to have a captive perpetual buyer of their debt at ever lower rates, they are effectively inducing a great misallocation of some of the biggest pools of capital in the economy. This might be the right decision should we experience lower yields in perpetuity, but given that we know the government is influencing yields, we are skeptical of this outcome.

Corporations across the globe are surely tired of having pension issues in the boardroom. The movement to relieve some of this burden by several nations will free up capital and help use it in more productive corporate undertakings.

While holding bonds helps asset allocators manage volatility, for those who are not bound by these discount rate conventions, this misallocation of capital is likely to present great opportunities in other asset classes that currently suffer as a result of the regulatory environment. When looking at assets on a strategic basis, we certainly keep this in mind.

Shaniel Ramjee is multiasset investment manager at Baring Asset Management, London.

This article originally appeared in the August 20, 2012 print issue as, "The great capital misallocation".