We all wish for a comfortable retirement and a well-performing pension fund for that purpose, but pension funds cannot escape the risk-return paradigm.
In the last few weeks, the news came out about various pension funds being affected by the banking crisis in the US and Europe. The Swedish Financial Supervisory Authority initiated an investigation into Alecta, one of the main pension funds in Sweden, after the fund lost almost USD 2bn from its stakes in SVB Financial Group, First Republic Bank, and Signature Bank. For context, the fund oversees around USD 116bn. Several US public pension funds also had limited exposure to these banks. In Switzerland, Migros Pensionkasse is among the investors suing FINMA for the treatment of the Credit Suisse AT1 bonds in the UBS-CS deal. The pension fund lost about CHF 100m when the AT1 bonds were written down completely, in addition to about CHF 10m that were invested in Credit Suisse stocks.
It has been a challenging decade for pension funds. Near-zero interest rates on the asset side and increasing longevity on the liability side translated into soaring unfunded benefits. Pension funds traditionally have a model portfolio invested 60% into Fixed Income securities, with the remainder split between Equities and Alternative Investments. As expected returns in the Fixed Income space have become more and more depressed during the 2010s, pension funds increased the percentage of their books allocated to Equities and Alternative Investments and were also forced to take more risk in the Fixed Income part of their books. These investments made some sense, especially in the easy environment that characterized the market until the end of 2021, and they were the only way to achieve the targeted 6-8% annualized returns. The alternative for funding, for defined benefits funds, would have been to ask for increased contributions either from workers or from governments, which is equally challenging.
However, the market environment has changed: interest rates have increased substantially, and equities have undergone significant adjustments. These movements are weighing on pension funds’ balance sheets, and many executives are now responding to the losses generated in the last year. The yield-seeking nature of pension funds in a low-yield environment led to excessive risk-taking. Furthermore, losses stemming from excessive risks can be detrimental to this type of fund: defined benefit funds have little loss absorption capacity, defined contribution funds are mark-to-market products, but upset workers have the option to transfer their money elsewhere, thereby reducing the assets under management. Pension fund managers must rely on an effective risk management framework to assess the risk of extreme events and consider the impact of losses on the capital they must guarantee. The pension savings accumulated in these funds play a crucial role in the welfare of the future generation of retirees.
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