Bond yields have been falling since 1982. Many sovereign bonds have ultra-low yields today. Ultra-low yields generate ultra-high liability values since the time value of money does not apply when there is too much debt in the system. Pension schemes that were comfortably funded a few years ago at 5% now have huge deficits. 

For as long as anyone can remember, pension schemes have been valued using bond yields.  Bond yields have been falling since 1982. Many sovereign bonds have ultra-low yields today. Ultra-low yields generate ultra-high liability values since the time value of money does not apply when there is too much debt in the system. Pension schemes that were comfortably funded a few years ago at 5% now have huge deficits. 

Pensions do not work at zero interest-rate policy (ZIRP). Ultra-low interest rates can double and even triple the cost of pensions. The pensions model needs to be reconsidered until interest rates return to their long-term average. 

Pension funds are unavoidably exposed to central bank risk, the risk that central banks are not in control and that asset values fall as a result. The Bank for International Settlements (BIS) has repeatedly indicated its concern that central bankers are trapped in a cycle of asymmetric policymaking that restricts the financial system to an ongoing procession of bubbles, busts, and bailouts which do not bring the economy back to equilibrium.  This points to another decade in which monetary policy normalization may prove very difficult.

Pension funds are particularly vulnerable to asset write-downs during the loss allocation phases of the busts which will occur. Extreme care is required. This by definition implies the need to be exceptionally vigilant with market consistent valuation since the system itself is highly unstable, meaning that market values will consequently be volatile and uncertain. 

How to address this in real-life Pension schemes?

We can consider different potential steps as follow:

1. The first step is to reconsider how to value the liabilities. 
2. The second is to reconsider how to manage the tail risk on the assets. Ultra-low interest rates drive a huge speculative bubble in bonds and equities and mean reversion may be very costly without hedges planned in advance to such event.
3. The third step considers integrating a Minsky type model into asset valuation. Such a framework considers a move away from market consistency in anticipation of the switch from stability to instability, given that stability eventually morphs into instability. Further, volatility can be suppressed but not indefinitely. In real life, unlike in many of current models, crises are not an instant event, but a time period; a process. This time dimension creates ample opportunity for all sort of strategic decisions within a crisis, and thereafter.
4. The fourth step contemplates short-term tactical asset reallocations, which can make the Minsky moment a profitable once given that the rest of the market is operating on the basis of business-as-usual (BaU). During the time period of the crisis, several iterations of short-term tactical asset reallocation may be required as the system moves in the direction of break down.

Aspects to consider:

• One of the most important aspects is to note that each reallocation is independent of the previous one. Furthermore, the key is to measure the level of instability risk continuously; or as a kind of continuous process that flows, where randomness is high. Once the system goes beyond the point of no return, interest rates will return to normal; except if dimensions are disproportionate, in which case past experiences can only provide some signals, but not firm predictions.
• Most pension modeling professionals currently bootstrap low-interest rates well into the future on the back of flat sovereign yield curves. This implies that low-interest rates will be a feature of the next 2 generations and that the system can maintain stability. This is implausible and stands in the face of the evidence from economic history. In this case, the key is to focus on safety. There is a strong likelihood that debt will be written down. 

In summary, Pension Funds should seriously consider detaching themselves from central bank risk. When a crisis happens, not everyone suffers. Smart money can escape the violent market moves. The approach mixes real-world interest rate insight with tactical asset reallocation to steer the fund to safety.

As some People say: "In Finance, the first objective is not to lose, and only thereafter it comes to the second goal, which is to make a profit."

Authors:   Cathal Rabbitte and Fernando Walter Lolo

www.DirectionalAlpha.com