Eurozone Pensions Count the Cost of Falling Rates

The funding ratios of German pension funds have declined sharply following falling market interest rates, in many cases wiping out portfolio gains for 2014.

Liabilities of pensions linked to DAX-listed companies hit €353 billion ($442 billion) this year, an all-time high, according to a survey by Mercer in Frankfurt. This figure is 86% higher than the €190 billion recorded in 2008.

German funds have had a strong 2014, with investment returns averaging roughly 6.7% between the start of the year and the end of October. Mercer estimated that returns could average 7.5% for the whole of 2014, putting overall assets at roughly €213 billion.

But the effect of these returns has been all but wiped out by the knock-on effects of the European Central Bank’s record low base interest rate. This has led to a downward trend in actuarial interest rates, which have declined from 3.7% at the start of 2014 to 2.3% at the end of October.

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As a result, the combined liabilities of the 30 companies’ pensions have risen to a record level. Mercer estimated that the average funding ratio for DAX company pensions had fallen from 66% at the end of 2013 to 60% at the end of October 2014. This ranges from Deutsche Bank’s 99% funding ratio to Deutsche Telekom’s 22%.

German pension funds' liabilities

However, Thomas Hagemann, chief actuary at Mercer, said 60% was still “a good rate” for these pension funds. The majority of pension funds covered by the study are contractual trust arrangements, a non-regulated pension model that allows greater flexibility for investments. There is no requirement to keep these plans fully funded as pension payments are insured by the country’s Pensions-Sicherungs-Verein in case of company insolvency.

Pension funds in the Netherlands have suffered a similar fate this year. Bernard Walschots, CIO of the Rabobank Pension Fund, writes in next month’s issue of Chief Investment Officer Europe that the volume of Dutch pensions’ liabilities has “increased significantly, exerting strong downward pressure on coverage ratios, despite positive returns from most asset classes”.

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Related Content:Germany Versus the Regulator

Bond funds have not increased cash holdings despite growing fears of illiquidity in fixed income markets, according to Fitch Ratings.

The credit ratings agency said bond fund managers were too averse to the effects of “cash drag” on performance. Between 2007 and the end of June 2014, the average amount of cash and treasury securities held by US corporate and municipal bond funds increased only slightly from 10% to 13%, according to data from Lipper.

“Limiting cash drag may allow some fund managers to avoid underperforming their benchmarks for 2014, but it can eventually expose funds to bouts of market illiquidity and exacerbate fund losses during market shocks,” Fitch said.

Data from the US Federal Reserve, collated by Fitch, shows (below) that the value of corporate and foreign bonds held by mutual funds and exchange-traded funds has almost doubled in the past five years, while brokers and dealers hold roughly the same amount.

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Fitch said more intermediary platforms were needed to alleviate this discrepancy.

Corporate & Foreign Bonds (US)

“The unfortunate side effect of holding higher fund liquidity is fund underperformance, which could lead to net outflows,” Fitch said. “Neither situation—holding excess cash now or being exposed to illiquidity risk later—is optimal, but the dynamic represents a headwind.”

The agency said larger portfolios were most likely to feel the effects of falling liquidity—echoing the concerns of some smaller players in the fixed income market.