Could the U.S. pensions behemoth be hit by the kind of crisis that just swept across the U. K.?
Don’t bet on it, says ratings agency Fitch. This kind of turmoil is “unlikely,” it says.
We can only add: We had better hope they are right.
Naturally, as we remember that the ratings agencies totally missed the subprime fiasco that brought down the global economy 14 years ago, we are saying this with our fingers crossed.
The “defined benefit” pensions system in the U.S.A. is nearly 10 times the size of the one in Britain that just plunged the global financial system into turmoil and the British government into crisis.
So a similar problem in the U.S. would be on a vastly bigger scale. Think: 2008.
“U.S. state and local pensions are unlikely to face the sudden liquidity crisis that U.K. corporate pensions are confronting,” Fitch Ratings says in a statement. The reason? U.S. pension plans use “different approaches to valuing liabilities,” and as a result different investment strategies, it says.
But it adds: “While they do not appear to employ derivatives on the scale seen in U.K. pensions, U.S. state and local plan assets often have direct derivatives exposure, typically used for hedging foreign currency and interest rate risks and reported at fair value. While plans disclosure of asset allocations, derivatives exposure and related risks has improved in recent years, details on allocations vary widely.”
The crisis that has suddenly enveloped the British pensions system was partly caused by complex technical issues which caused a short-term cash crunch.
All “defined-benefit” pension plans, meaning traditional, old-fashioned pension plans that promise to pay retirees a certain income for the rest of their lives, are faced with the same set of problems: Namely, how do the plan operators calculate today’s value of liabilities that will not come due for years or decades, and how do they match them to their investment plans?
Fitch explains the U.K. crisis in this way: “State and local government pensions discount their liabilities using the same fixed long-term investment return rate that they assume for their assets, whereas U.K. corporate pensions discount their liabilities using variable, market-based rates. To avoid having market rate variability affect U.K. pension liabilities, and thus their parent corporations’ balance sheets, U.K. pensions engage in liability-driven investing (LDI) strategies that use leverage, an approach not commonly used by U.S. plans. LDI strategies typically rely on interest rate derivatives that involve long-dated U.K. bonds to match their long-term obligations.”
British pensions expert Tony Nangle has a good, more technical explainer for those who are really interested.
In a nutshell: Sudden turmoil in the market for British government bonds, known as gilts, meant that British pension funds had to raise cash very quickly to post as collateral for margin calls on their derivatives. The turmoil in government bonds did not necessarily threaten the long-term solvency of the funds, but did threaten their short-term liquidity. They were effectively in danger of being “stopped out” of long term positions.
To meet the margin call, they sold the assets that were easiest to sell: Namely, British government bonds. That caused further turmoil in the market and made the liquidity crisis even worse. In other words, the market was caught in a vicious spiral or “doom loop.” The Bank of England stepped in to backstop the market and end the spiral.
This, at least, is the bull case.
A quite different argument is offered by independent British pensions expert John Ralfe. He says many pensions have been using derivatives irresponsibly, to gamble.
Astonishingly, Britain’s own pension regulator admitted in 2019 that some pensions were levered up to 700%, meaning debts were as much as 7 times assets. This is a bit like owning a home with a mortgage worth 87.5% of the value.
But where does this leave U.S. pensions?
According to the Federal Reserve, U.S. defined-benefit pension plans have (and owe) in total about $17 trillion. About half of that lies in state and local pension plans. The rest is evenly divided between corporate and federal plans.
Even if Fitch is right, and the levels of leverage and speculation in U.S. systems is low, it doesn’t avoid other problems.
One is that U.S. pension plans are still balancing their books only by using ambitious forecasts of future investment returns. A year ago they were expecting about 7% on average, an especially heroic assumption given that 10-Year U.S. Treasury notes, the benchmark risk-free interest rate, were paying interest rates of just 1.6%.
Since then a balanced portfolio of 60% U.S. stocks and 40% U.S. Treasury bonds has plunged by 18%, and so far this year has suffered the worst performance in a century according to Bank of America. It takes a 22% investment return to recover from an 18% loss. Those relying on 7% annual returns a year ago must be counting on much higher returns now.
A second issue is the growing U.S. pension fund reliance on so-called “alternative” investments such as private equity and hedge funds to square the circle by producing supernormal returns. But not everyone cannot earn supernormal returns, by definition. These vehicles charge such ridiculously high fees that it is hard to be bullish about them. Oh, and many of these vehicles have depended for their returns over the past 40 years on the long-term collapse in interest rates—a collapse that seems at best to have stalled and which may have now gone into reverse.
Fitch warns, “The investment return assumption used by U.S. state and local government pensions is a fixed rate, but this presents its own set of risks, most notably incentivizing the search for higher yield, exposing assets to higher volatility. Fitch views this as a central concern for state and local pensions, particularly as investment return assumptions remained unrealistically high, despite incremental decreases during a decade of low inflation and variable returns.”
Meanwhile, we aren’t even getting into the No. 1 crisis of U.S. defined-benefit pension plans, which involves the mother of them all: Social Security. This already has a hole in the accounts valued at $20 trillion, which will either require higher taxes or lower benefits or both.
To put that accounting hole in context: It is bigger than the entire assets of all the other U.S. defined-benefit plans put together. And that’s not the size of Social Security, just the size of the accounting deficit.
In other words, even if the U.S. isn’t facing the kind of immediate pension panic that just rocked the U.K., our long-term pension crisis is much bigger.