The coming Pension Fund Crisis and how it will change the world

The next big thing, after the sovereign debt crisis that is slowly percolating through the financial system, is the pension fund crisis. Basically the problem is that public and private pension funds across the world have long managed their balance sheet as two independent elements - assets and liabilities and the concept of ALM has never been accepted or acknowledged within the industry. Liabilities - the pensions themselves, very much managed as an actuarial portfolio, usually based on the demographics of a particular fund and its covered employees is best thought of as a set of zero coupon bonds with limited optionality, the duration of which reflects the average life expectancy of the average insured individual. This of course varies by pension plan, and no surprise therefore that the asset side, the funding of these liabilities must depend on a detailed analysis of the cash flows associated with these liabilities. In short we need to build a replicating portfolio for the liabilities (just like in Bank ALM) and use that to define the performance expectations of the asset portfolio. This is rarely done - instead pension funds use fund of funds to "divide and conquer" the asset portfolio and evaluate that performance on existing standard market benchmarks for bonds, equities and other assets. But of course, performance for a pension fund means the ability to fund the liabilities, it does not mean the ability to outperform a bond index like the Barclays Capital Aggregate Bond Index - which is typically industry practice. Analysing risk for a pension fund means analysing the risks to achieving performance, in other words, how likely is it that our asset portfolio will underperform the liability portfolio. With a liability replicating portfolio, we can build var and shortfall models that allow us to monitor and manage the net asset position over time. The lack of this capability is not merely a problem for a few pension funds. The mismatch of mark to market values of asset and liabilities in corporate pension funds is of the order of trillions (yes - trillions) of dollars in the US alone (UK, Russia, Italy also big problems). If there is continued fall in the value of equities this is likely to get worse, and be a drain on corporate performance for years to come.