Why Your Pension Plan Has
Sovereign Debt In It
Pension funds are a type of retirement plan that “contracts” with the employee
to pay a certain amount per year based on several factors after the employee
retires. To meet the contractual obligations, pension plans invest in a
variety of assets to ensure they meet their hurdle rate. This is the rate of return determined
by an actuary necessary to meet all the future obligations, i.e., the return
needed to be able to pay the employee the “promised” amount after the employee
retires. Pension plans usually employ a diversification strategy when investing
so that they reduce market risk as well as stratify the securities to match
their obligations or liabilities.
One
type of security pensions tend to invest in is sovereign debt, or the debt issued by a government in that
country’s currency. For example, the U.S. government issues debt, such as U.S.
Treasuries or T-bills, in U.S. dollars. These types of securities are attractive
to pension plans for several reasons, but understanding how these securities work is helpful in discussing why
pension funds invest in them.
Sovereign vs. Corporate Debt - Sovereign debt is one type of a fixed
income security. Fixed income refers to any security where the issuer
borrows money from the investor, and in return the issuer pays the investor a
fixed level of interest at predetermined intervals until the bond’s end date or
“maturity”, at which point the issuer pays the investor the face value of the bond.
Another
type of fixed income security is corporate debt. Sovereign debt differs
from corporate debt in a few ways. Corporate debt is issued by
companies. These bonds tend to be more risky than sovereign debt because
the ability to repay the loan depends on the company’s ability to execute its
business, which is influenced by the company and its products, services,
competitors, overall market conditions and extraneous forces such as regulations. As a result, corporate bonds
typically pay higher yields or returns than sovereign bonds to compensate
investors for the increased risk.
In
contrast, sovereign debt is considered a safer security since it is issued by
governments. Historically, it is rare for governments to fail to meet debt
obligations since they control their revenues (in the form of taxes), and
because of this these assets are deemed risk-free by investors.
Although
sovereign debt tends to be safe, there have been instances where countries have
failed to meet their obligations and defaulted on the bonds. Several
examples include Russia in the Ruble Crisis in 1998, Germany after World War
II, the U.K. in the 1930s, and most recently Greece in 2012. Even the
U.S. has defaulted on its bonds five times before. In fact, most countries have
at one point or another defaulted on their obligations, and some have done it
many times over. Despite these historical facts, the “safe” assumption attached
to sovereign bonds persists because although most countries going back to the
1800s have defaulted, it is still quite a rare occurrence.
Matching Liabilities - In addition to the safety, another reason that pension
plans find investing in sovereign bonds desirable is because pensions need to
be able to meet their contractual obligation to pay retiree benefits. Investing
in sovereign bonds of the same currency helps pensions “avoid mismatches”
between their assets (how much money they currently have to pay retirees)
and liabilities (how much money they need to
pay retirees). In theory, pension funds need to determine how big the liability
is and when they will need to pay it, and buy government bonds (because they
are safe) in quantities that match the size of the liability with maturities,
or end dates, that match when the liabilities are due to be paid out. One
problem with this approach is that although it is a low probability, the risk
of default for these bonds may impact the sensitivity of the bonds to changes
in interest rates. Thus the expected return may differ from the actual
return. For example, a bond with a sensitivity to changes in interest
rates of three years means that the price of the bond is expected to rise 3%
for every 1% decrease in yield. But because the default risk may be higher than expected, the
sensitivity may be less than three years, so the matching principle fails
and the pension fund’s assets come up lower than the liabilities. This is
one of the risks with investing in sovereign debt.
Pension
plans have investment guidelines set up to establish controls over the types of
securities the plans can invest in. As a result, plans are often limited to the
specific percentage of the total plan they can buy in any one asset class,
investment type and geographic region. As a result of these limitations, plans
have very little diversification in sovereigns that they buy. Although plans
will often ladder or stagger the maturities, they infrequently purchase
securities denominated in a broad diversified range of
currencies. Therefore, one way pension funds can reduce exposure to
default risk is to diversify the currency of sovereigns. However, this strategy
is limited by the plan’s investment guidelines.
Bottom Line-
The use of sovereign debt in pension plans makes sense, because the benefits of
“risk-free” investing where the default risk is extremely low and matching
assets with liabilities can be accomplished with minimal “tweaking” of the
sensitivity calculations. While these are the benefits, they can also be
the risks! Without a clear understanding of the default risks, plans may
overstate their assets and fall short of meeting their liabilities. Some of
these risks can be diversified away by investing in a broad cache of sovereigns
- broad enough to not only invest in different countries but also make sure that they
invest in different regions. Then if one country fails, the regions are so
diversified that they will not all fail together. By employing this strategy,
the pension plan will accomplish its goal of meeting its obligations
(without making unanticipated contributions) because the assets exceed the
liabilities.
Comments
Correction. These
Pension Plans are investing in treasury bills to support the federal spending
spree. Pension Plan Trustees think they are doing a great job if they break
even.
Norb Leahy, Dunwoody
GA Tea Party Leader
No comments:
Post a Comment