International regulators must monitor pension funds in their ‘search for yield’ as they try to secure benefit promises by investing in increasingly risky assets, the Organisation for Economic Co-operation and Development (OECD) has warned.
The Paris-based think tank published a paper looking at whether pension funds and insurance companies would be able to maintain promises made in higher-interest-rate times, given the current low-yield environment.
In a stark warning, it said regulators should be more lenient on forcing solvency requirements in times of market stress while ensuring pension funds were not taking excessive investment risks that could lead to insolvency.
It said there was a serious concern for the financial longevity of pension funds should they become embroiled in an “excessive search for yield” to cover promises made when interest rates were higher.
In its Business and Finance Outlook 2015 report, the OECD said pension funds, by increasing the risk profiles, could be “seriously compromising their solvency situation” if a financial shock such as a liquidity freeze took place.
Its data showed that, while the overall investment in alternatives had increased, this could be down to overall larger portfolios, with the exception of the UK.
The OECD’s UK data showed pension funds clearly engaging in the search for yield, with an upward trend in private equity and structured products.
Given the prolonged effect of low interest rates on pension funds, the OECD highlighted duration-matching assets, renegotiating promises, increasing contributions and easing regulation as solutions to alleviate concerns.
It echoed calls for regulatory requirements to fund solvency shortfalls to be counter-cyclical, meaning additional funding should be made when pension fund liabilities are not being exacerbated by falling rates.
The OECD’s call for leniency in solvency, and focus on investment risk, goes against the rhetoric seen from Europe’s government and regulators.
Solvency requirements were discussed under the previous European Commission, while work on a risk-focused solvency framework – which may require additional funding in riskier times – is being worked on by the European Insurance and Occupational Pensions Authority (EIOPA).
The OECD said: “The outlook is troubling for pension funds, as solvency positions will deteriorate unless they actively adopt risk-management strategies.
“However, the lack of good quality, very long-term financial assets in sufficient quantities poses serious problems to these risk-management strategies.”
It said pension funds should look to close the duration gap between assets and liabilities, while policymakers should avoid excessive pressure on pension funds to correct solvency in times of weak markets.
“The regulatory framework and policymakers have an important role to play in [ensuring pension funds do not take excessive risk] and need to remain vigilant to prevent excessive ‘search for yield’,” it added.
However, Charles Cowling, director at UK consultancy JLT, sounded a note of caution on the OECD’s proposals.
He said: “If [regulators] responded to concerns from the OECD on the poor level of funding of pension schemes and increased pressure on employers to take less risk and fund their pension schemes better, this could force some of the weaker employers into bankruptcy and put downward pressure on equity prices and make matters worse – as deficits widen as a result.”