Awareness of the impact of low interest rates and volatile markets on pension funds is nothing new, but the results of the first stress test on these investors by a European supervisory authority has made clear how acute the problem is.
The low-interest-rate environment has continued to take its toll on the liabilities side of pension fund balance sheets, and sources with knowledge of these institutional investors said no amount of investment would bring the assets up to a level necessary to tackle existing deficits.
The European Insurance and Occupational Pensions Authority's stress test looked at a number of different scenarios for pension funds in European Union countries. But even before applying these stresses, it found that in the 17 tested countries, total liabilities outweigh assets by e428 billion ($477.8 billion) under its common methodology. With a severe stress — an abrupt drop in interest rates and an increase in inflation rates — this shortfall would hit e773 billion under EIOPA's model.
It's a problem evident across the globe: The latest report from Wilshire Consulting showed the aggregate funded status of U.S. corporate pension plans fell to 78.3% at the end of February, down 1.1 percentage points. That was largely driven by an increase in liabilities coupled with flat asset growth.
Falling gilt and equity markets have also hit U.K. pension funds, although the situation improved in February. The latest update from JLT Employee Benefits showed the total deficit of all U.K. corporate defined benefit funds fell 17.1% to £209 billion ($301 billion) in February, and fell 17.4% in the year ended Feb. 29. As of the same date, the funded ratio of these funds was 85%, vs. 83% at the end of January.
But the problem is particularly acute in the Netherlands. Aon Hewitt said the average funding ratio of Dutch pension funds in January decreased five percentage points, to 97%. Pension funds in the Netherlands are considered solvent only at a 105% funded level.
The stress test covered 140 defined benefit or hybrid institutions for occupational retirement plans, across 17 countries in the European Union. Dutch pension funds accounted for 44% of the total defined benefit funds sample analyzed by EIOPA in its stress test, which applied certain financial shocks to test the effect on funded shortfalls. It investigated the shock resistance of pension funds, and the systemic risk that they might pose for the stability of financial markets. While the conclusion was that the links were limited — which sources in the industry accepted — EIOPA's stress test was criticized for its narrow sample and its failure to reflect the impact of a crisis on member benefits.
The EIOPA concluded: “The results of the severe stress scenarios applied show a significant increase in the deficits of assets over liabilities, revealing a number of risks and vulnerabilities that deserve proper attention from IORPS and supervisors. At the same time it is important to realize that the absorption of these shocks depends heavily on the time element for realizing liabilities and the mitigation and recovery mechanisms in place.” The authority added that further work is needed to gain deeper understanding on the effects of stress scenarios, “especially concerning the consequences of the extra pressure put on sponsors to increase their future contributions.”
Nevertheless, the test did highlight one important issue: the Dutch central bank, De Nederlandsche Bank, issued a statement in January on the topic detailing its concern that the Dutch pensions sector is “vulnerable to financial market shocks, as pension funds have hardly any buffers left to absorb shocks amid the current low-interest environment.”