Pensions and bonds: the problem explained

Bond mathematics and the scale of pension deficits

Bond yields have fallen globally since the UK vote on leaving the EU on June 23. This has made even more acute a problem for financing pensions, which has been growing for many years. The problem is greatest for “defined benefit” plans, which have made guarantees to their members about the retirement income they can expect.

For more than three decades, bond yields — which follow interest rates — around the world have decreased. The ten-year US Treasury yield — which was as high as 16 per cent in 1981 — is now just about 1.5 per cent.

Source: Thomson Reuters Datastream

These yields are treated as a “risk-free rate,” which underpins the pricing of all other bonds and many other financial transactions. They also critically affect the price that pension funds must pay to meet their guarantees to their employees.

For example, when US long-term interest rates were nearly 16 per cent, a pension fund wanting an annual payout of $16m would need only to buy $100m worth of bonds. But now with an interest rate of 1.5 per cent, a pension fund would only receive an annual payout of $1.5m from a $100m bond.

This is particularly bad for pension funds, which rely on bonds to fund yearly payouts. To make up for lower interest rates, they have to spend more to get the same annual return.

To continue the simplified example, you would need to invest as much as $1.1bn at 1.5 per cent interest rates to make the same amount you would have made with 16 per cent interest rates and $100m, all other things equal.

Add to that the fact that people are living longer. That means that pension funds must be prepared to pay out for longer and hence their liabilities grow.

Source: UN

A further problem for pension funds is that their assets have not grown as fast in recent years, thanks to problems in the stock market. As their liabilities have grown much faster than assets, so their deficits — the gap between the money they have and the money it will take to pay their pensioners — have deepened.

Average results US public and private DB pension funds.
Source: Ryan ALM, Inc

Let’s look at some real numbers. The US public pension deficit is $3.4tn. That’s 6 times the size of Apple. Pension deficits sponsored by S&P 1500 companies are lower at $638bn, but still higher than the GDP of many countries, such as Peru or Belgium. The UK public and private pension deficits are smaller, but follow the same pattern.

Interactive: How big is the pension deficit?

The scale of pension shortfalls is difficult to conceive, and requires many complicated assumptions.* This tool helps put the problem in rough context. Use the text box below to search for a country (GDP — how much it produces in a year) or company (market cap — how much it is worth on the stock market) or use the random generator, and compare them with different pension deficits.

The public private pension deficit in the US UK is
(market cap)
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* Pension deficits are based on latest numbers as of publication, and market caps are as of August 18. UK public pension deficit includes only Local Government Pension Scheme members. UK private pension deficit includes defined benefit pension schemes for the UK's 350 largest listed companies. US public pension deficit includes 564 state and local services systems in the US. It uses Hoover's estimate for pricing liabilities. It does not include the pay-as-you-go social security fund. US private pension deficit includes pension plans sponsored by the largest 1,500 companies by market cap (S&P).

Sources: World Bank, Bloomberg, Local Government Pension Scheme, Mercer, Hoover Institution

Although defined benefit plans are steadily being phased out, they still account for more than half of retirement funds in the developed world. Millions of relatively low-paid public sector workers, typically including teachers, police officers and firefighters — rely on defined benefit pensions for the bulk of their retirement income. So do some of some the largest and longest established corporations on both sides of the Atlantic.

Pensioners’ payouts are guaranteed by law. Companies can only escape them in bankruptcy. But somehow these gaps must be filled. Either workers must be persuaded to accept lower benefits than they have been promised, or funds to fill the gap must come from other sources, meaning less money for companies, for investment, or for public services.