If You Think US Pensions Are Safe, Just Wait

You never know where the next crisis will arise but last week it came from a particularly unlikely place: defined-benefit pensions. The UK government bond market (gilts) went wild as rates spiked and pension funds failed to meet their margin calls. It created so much turmoil that the Bank of England had to step in. Does this mean that US pensions could create similar turmoil? Not to be coy about it, but yes and no. The good news is US pension funds are not so exposed to rate changes because they hold less fixed-income assets. But that is also the bad news.

Interest rates are rising and will stay high for the first time in years. This means anyone exposed to fixed income is due for some disruption. US plans hold less debt than UK pensions because they do less risk hedging, so spiking rates probably won’t cause immediate damage. But that also means they are more exposed to market risk, and as rising rates unearth all sorts of financial vulnerabilities, US plans may eventually find themselves in even worse shape than UK plans were last week.

The smaller subset of US corporate defined-benefit plans invest about half of their $3.7 trillion in assets in bonds (similar to the UK plans), according to a report from the Milliman Corporate Pension Funding Study. It’s worth noting American pensions are not so vulnerable to margin calls because they do Liability Driven Investment the old-fashioned way: by mainly just owning bonds instead of adding in leverage. This means as rates rise their assets and liabilities move together, keeping their funding fairly stable.

Corporate plans are in relatively good shape, but they are not the big source of risk. A much bigger worry are state and local government pensions, which have more than $9 trillion in assets, and (as of 2021) only 22% of those assets are in fixed income.

A low fixed-income allocation was typically considered nothing to brag about for pensions. But public pension plans have been moving out of fixed income and public equity over the last 20 years because rates dropped so low.