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.
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.
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.