Saturday, July 15, 2006

Amplifying pension funds [UK]

(Via IPE) In the latest issue of its Financial Stability Report, the Bank of England refers to pension funds as amplifiers of financial market shocks in two instances: It quotes anecdotal evidence of a feedback loop between the prices of long term UK government bonds and of similarly long term liabilities of pension funds. The continuing duration mismatch between pension fund assets and liabilities leads to demand for long term bonds, driving down their yields, which in turn drives down the discount rate with which fund liabilities are valued, thus increasing that position.

The second, and novel, feedback mechanism referred to is described in Working Paper Nr. 289. This paper demonstrates a statistically relevant amplification mechanism of DB pension schemes in the UK stock market. The transmission works via a) the additional leverage provided by pension schemes to their sponsors' balance sheets, if those schemes' underfunded status is considered to be ordinary debt, and b) the substantial cross-holdings of equity of other UK corporations in pension funds. Very interesting!

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