Pension Funds and Systemic Risks

Systemic risks received a lot of media attention after the 2008 financial crisis. The world realized that the failure of one financial institution may not remain restricted to the same financial institution. Instead, such a failure can potentially spiral out of control and impact the entire financial system.

Up until now, the idea of systemic risks has been thought of only in the context of banks. However, over the recent years, the idea that pension funds can default and jeopardize the economic future of a large group of people has also received some attention.

In this article, we will have a closer look at the relationship between pension funds and systemic risks. The details have been mentioned below.

What is Systemic Risk?

Systemic risk is the risk that a single shock or a combination of economic shocks can threaten the entire financial system. It is important to understand that this shock doesn’t necessarily have to be endogenous i.e. it does not have to arise outside the system. The mismanagement of a financial organization can also possibly trigger a domino effect which could lead to catastrophic consequences for the entire system.

It is important to realize that any organization which controls large sums of money has the potential to trigger systemic risks. Since the pension funds control portfolios worth trillions of dollars worldwide, they too are theoretically capable of causing a systemic collapse.

Why do Pension Funds Have Lower Systemic Risks?

Theoretically, pension funds do have the possibility to expose the economy to systemic risk. However, the possibility of such an event actually materializing is quite low. This is because of the fact that pension funds have a much lower systemic risk. Some of the factors that lead to lower systemic risk have been mentioned below:

1. Higher Investment Horizon: Firstly, people who invest in pension funds have a very large investment horizon. This means that the investors are unlikely to simply withdraw money from the markets if it witnesses a downturn.

   Since the pension funds do not face the pressure of immediately returning money to the investors, they can afford to take the bigger mark to market losses. They can also afford to take bigger haircuts on their investments. As such, the failure of one pension fund, even if a large one does not necessarily have to trigger panic in other pension funds.

2. Limits on Leverage: Leverage is an important component of the idea of systemic risk. For a systemic risk to be present, one institution has to be levered so much that its investors cannot absorb the losses and the effects spill over to the system. This is not only possible but also highly probable in the banking system.

   However, pension funds are tightly regulated all across the globe. Hence, it is unlikely that any single pension fund will be allowed by the regulator to jeopardize its own financial health, let alone the health of the entire system.

3. Limits on the Use of Derivatives: The use of derivatives is another way in which systemic risk is created. In the case of pension funds, their usage of derivative instruments is highly restricted. They are only allowed to use derivatives for hedging and not for making speculative bets. Hence, it is unlikely that a pension fund will incur a huge loss in the derivative market and trigger a systemic risk.

4. Limits on International Exposure: Similarly, pension funds have a lot of restrictions when it comes to international investments. Since pension funds cannot deploy money in risky assets abroad, it is very unlikely that they may end up importing a financial crisis that is happening in another country. This also makes it unlikely for pension funds to be involved in any kind of systemic shock.

Pension Funds and Systemic Risk

Even though pension funds are largely shielded from systemic risks by the strict regulatory framework, it would be incorrect to say that pension funds don’t create any systemic risk at all. The risks created by the funds are milder and do not threaten the existence of the system. The details of some of these risks have been mentioned below.

1. Sell-Off of Asset Classes: Pension funds have internal guidelines about the asset allocation which they need to maintain. These guidelines make it mandatory for pension funds to rebalance their portfolios periodically. Hence, if the value of debt markets goes down, all pension funds may have to simultaneously sell off their equity investments just to maintain the ratio between the two asset classes.

   Since pension funds hold large equity investments, this can end up triggering a downward spiral in the equity markets. This could affect other institutions such as banks negatively which could cause a potential systemic risk.

2. Inflation of Blue-Chip Stocks: Since pension funds are actively encouraged by the regulators to invest in blue-chip stocks, they end up causing overvaluation in these stocks.

   Trillions of dollars’ worth of investment flow into these specific stocks which cause misallocation of capital from a macroeconomic standpoint. The drastic overvaluation of a handful of blue-chip stocks makes them more vulnerable to an economic meltdown. Once again, this has the potential to trigger a crisis in the equity markets.

To sum it up, it would be incorrect to completely rule out the possibility of a systemic shock caused by pension funds. However, due to higher regulation and a more conservative approach, pension funds are much less likely to cause a systemic collapse as compared to banks and other financial institutions.