Pension funds are a type of retirement plan that “contracts” with the employee to pay a certain amount per year based on several factors after the employee retires. To meet the contractual obligations, pension plans invest in a variety of assets to ensure they meet their hurdle rate. This is the rate of return determined by an actuary necessary to meet all the future obligations, i.e., the return needed to be able to pay the employee the “promised” amount after the employee retires. Pension plans usually employ a diversification strategy when investing so that they reduce market risk as well as stratify the securities to match their obligations or liabilities.

One type of security pensions tend to invest in is sovereign debt, or the debt issued by a government in that country’s currency. For example, the U.S. government issues debt, such as U.S. Treasuries or T-bills, in U.S. dollars. These types of securities are attractive to pension plans for several reasons, but understanding how these securities work is helpful in discussing why pension funds invest in them.

Sovereign vs. Corporate Debt
Sovereign debt is one type of a fixed income security. Fixed income refers to any security where the issuer borrows money from the investor, and in return the issuer pays the investor a fixed level of interest at predetermined intervals until the bond’s end date or “maturity”, at which point the issuer pays the investor the face value of the bond.

Another type of fixed income security is corporate debt. Sovereign debt differs from corporate debt in a few ways. Corporate debt is issued by companies. These bonds tend to be more risky than sovereign debt because the ability to repay the loan depends on the company’s ability to execute its business, which is influenced by the company and its products, services, competitors, overall market conditions and extraneous forces such as regulations. As a result, corporate bonds typically pay higher yields or returns than sovereign bonds to compensate investors for the increased risk.

In contrast, sovereign debt is considered a safer security since it is issued by governments. Historically, it is rare for governments to fail to meet debt obligations since they control their revenues (in the form of taxes), and because of this these assets are deemed risk-free by investors.

Although sovereign debt tends to be safe, there have been instances where countries have failed to meet their obligations and defaulted on the bonds. Several examples include Russia in the Ruble Crisis in 1998, Germany after World War II, the U.K. in the 1930s, and most recently Greece in 2012. Even the U.S. has defaulted on its bonds five times before. In fact, most countries have at one point or another defaulted on their obligations, and some have done it many times over. Despite these historical facts, the “safe” assumption attached to sovereign bonds persists because although most countries going back to the 1800s have defaulted, it is still quite a rare occurrence.

Matching Liabilities
In addition to the safety, another reason that pension plans find investing in sovereign bonds desirable is because pensions need to be able to meet their contractual obligation to pay retiree benefits. Investing in sovereign bonds of the same currency helps pensions “avoid mismatches” between their assets (how much money they currently have to pay retirees) and liabilities (how much money they need to pay retirees). In theory, pension funds need to determine how big the liability is and when they will need to pay it, and buy government bonds (because they are safe) in quantities that match the size of the liability with maturities, or end dates, that match when the liabilities are due to be paid out. One problem with this approach is that although it is a low probability, the risk of default for these bonds may impact the sensitivity of the bonds to changes in interest rates. Thus the expected return may differ from the actual return. For example, a bond with a sensitivity to changes in interest rates of three years means that the price of the bond is expected to rise 3% for every 1% decrease in yield. But because the default risk may be higher than expected, the sensitivity may be less than three years, so the matching principle fails and the pension fund’s assets come up lower than the liabilities. This is one of the risks with investing in sovereign debt.

Pension plans have investment guidelines set up to establish controls over the types of securities the plans can invest in. As a result, plans are often limited to the specific percentage of the total plan they can buy in any one asset class, investment type and geographic region. As a result of these limitations, plans have very little diversification in sovereigns that they buy. Although plans will often ladder or stagger the maturities, they infrequently purchase securities denominated in a broad diversified range of currencies. Therefore, one way pension funds can reduce exposure to default risk is to diversify the currency of sovereigns. However, this strategy is limited by the plan’s investment guidelines.

Bottom Line
The use of sovereign debt in pension plans makes sense, because the benefits of “risk-free” investing where the default risk is extremely low and matching assets with liabilities can be accomplished with minimal “tweaking” of the sensitivity calculations. While these are the benefits, they can also be the risks! Without a clear understanding of the default risks, plans may overstate their assets and fall short of meeting their liabilities. Some of these risks can be diversified away by investing in a broad cache of sovereigns - broad enough to not only invest in different countries but also make sure that they invest in different regions. Then if one country fails, the regions are so diversified that they will not all fail together. By employing this strategy, the pension plan will accomplish its goal of meeting its obligations (without making unanticipated contributions) because the assets exceed the liabilities.

Related Articles
  1. Mutual Funds & ETFs

    An Introduction To Sovereign Wealth Funds

    Countries use sovereign wealth funds to stabilize their economies, but these investments can lack transparency.
  2. Bonds & Fixed Income

    Investing In Sovereign Bonds

    Investing in sovereign credit can be a dicey affair. Learn if you should take the risk.
  3. Economics

    7 Things You Didn’t Know About Sovereign Debt Defaults

    Sovereign debt defaults are scary, but should they be? They are actually more common than you think.
  4. Economics

    The History Of Greek Sovereign Debt Defaults

    This isn't the first time Greece has been in financial trouble. Here's a brief history of the country's money woes.
  5. Bonds & Fixed Income

    The Risks Of Sovereign Bonds

    Sovereign debt can play an important role in providing international diversification to individual investors.
  6. Retirement

    7 Signs Your Pension Fund Is In Trouble

    Even if you're lucky enough to have a pension plan, you can't assume it'll pay out.
  7. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  8. Retirement

    Using Your IRA to Invest in Property

    Explain how to use an IRA account to buy investment property.
  9. Retirement

    How a 401(k) Works After Retirement

    Find out how your 401(k) works after you retire, including when you are required to begin taking distributions and the tax impact of your withdrawals.
  10. Retirement

    Read This Before You Retire in the Philippines

    The Philippines has a warm climate, a low cost of living and plenty of people who speak English. What to do next if you think you want to retire there.
  1. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  2. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
  3. Who can make catch-up contributions?

    Most common retirement plans such as 401(k) and 403(b) plans, as well as individual retirement accounts (IRAs) allow you ... Read Full Answer >>
  4. Can you have both a 401(k) and an IRA?

    Investors can have both a 401(k) and an individual retirement account (IRA) at the same time, and it is quite common to have ... Read Full Answer >>
  5. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>
  6. Are 401(k) rollovers taxable?

    401(k) rollovers are generally not taxable as long as the money goes into another qualifying plan, an individual retirement ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  4. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  5. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  6. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
Trading Center