IMF: U.S. public pension funds increasing risk to dangerous levels in search of yield

U.S. pension funds, especially poorly funded plans, are increasing their risk exposure to dangerous levels in the current low-interest-rate environment, according to a report from the International Monetary Fund.

The Global Financial Stability Report states that vulnerabilities are growing in the U.S. credit markets while pension funds and insurance companies are moving into more risky assets.

“Reduced market liquidity could amplify the effects of any future increase in risk-free rates,” the report states.

Public DB plans have gone from fully funded in 2001 to a 28% shortfall at the end of 2012. In that same time period, weaker funded plans have increased their allocations to alternatives to 25% from virtually zero, which exposes plans to more volatility and liquidity risks, according to the report. Low interest rates have led plans to search for higher yields elsewhere.

“Low yielding assets may induce excessive risk taking in a search for yield, which may manifest itself in asset price bubbles,” the report states.

The IMF recommends pension plans engage in active liability management operations immediately, including restructuring benefits, extending working years and gradually increasing contributions to close funding gaps.

“An undesired buildup of excesses in broader asset markets is a potential risk over the medium term,” according to the report. “Asset reallocations of institutional investors to alternative asset managers, excess cash holdings by those asset managers, the decline in underwriting standards, and the sharp rise in bond valuations are all intertwined. Constraining those potential excesses is a financial stability imperative.”