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Transition problems

The travails of defined benefit pension schemes and insurers are well known as they seek to meet liabilities made in previous decades in today’s ultra-low-rate environment. As the International Monetary Fund (IMF) points out in its April 2017 Global Financial Stability Report, higher rates are by no means guaranteed in the short or even the medium term. Japan is a case in point.

As the IMF also notes, lower population growth affects economic growth, and may pull down real interest rates; increasing longevity also lowers rates as households save more for retirement. Defined benefit pension funds may not be able to meet their liabilities without further capital. Weaker insurers, including some in Germany with legacy fixed-guarantee liabilities on their balance sheets, are at more of a disadvantage than pension funds with a strong sponsor backing their obligations.

The answer for some authorities has been to impose higher solvency or capital requirements on pensions and life insurers. But there is an increased awareness that this extra capital is likely to come at the expense of corporate investment in jobs and the real economy.

As pension funds have adjusted to lower rates, they have diversified away from equities, but also away from traditional domestic fixed-income instruments, like government and high-grade corporate bonds.

A beneficiary has been alternative credit, including infrastructure debt, which seems like a win-win solution: pension funds benefit from higher yields and sometimes floating rates, while the real economy can benefit strongly from new sources of capital, particularly when loans and even direct lending are considered. 

A Preqin survey of 2016 found that more than half of investors were expecting to invest in private debt in the coming year, while the EU’s Capital Markets Union project is seeking to channel long-term investment into the economy.

Yet for pension funds and insurers there can be unanticipated risks as a wall of capital seeks a limited opportunity set and asset managers pile into areas like leveraged loans, where a buoyant market may be leading to lower covenant quality. Regulators can also find themselves behind the curve as financial innovation outpaces their own resources to apply risk assessments.

This market is ripe for misunderstanding and prejudice against ‘shadow banking’ is real. The Times of London recently highlighted the possible role of hedge funds in UK health service infrastructure funding; in fact, pension funds and insurers, from the UK and elsewhere, are likely to supply the capital. Such facts can easily get lost. Regulators would now do well to ensure they fully understand the expanding credit market to achieve a win-win by ensuring informed investors are encouraged to make investments in the right areas.

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