Defined benefit (DB) pension funds across the world may be forced to cut benefits “significantly” in the long term because of ultra-low interest rates, the International Monetary Fund (IMF) has warned.

Shifting asset allocations to meet required returns “appears feasible only by taking potentially unacceptable levels of risk”, the fund said in a new report.

The comments came as part of an analysis of the effects of low growth and interest rates on the global financial system, written by Gaston Gelos and Jay Surti for the IMF’s Global Financial Stability Report. They build on previous IMF statements about the pressures on pension funds’ business models.

Under pressure from low rates, the authors said, “life insurers and pension funds would face a long-lasting transitional challenge to profitability and solvency, which is likely to require additional capital”.

The authors added: “In the low-for-long scenario, life insurers and sponsors of defined benefit pension plans may have no choice but to significantly reduce benefits to policyholders and plan participants over the long term. With permanently low growth and interest rates, guaranteed rates of return are possible only if they are reset significantly lower.”

Gelos and Surti ran a scenario analysis for an underfunded DB fund. The simulation indicated that such pension funds – and life insurers, which often have similar liabilities – would require a “very high” level of volatility risk to meet their funding goals.

A combination of risk aversion and regulatory constraints was likely to deter the vast majority from taking this path, the authors said.

“The analysis makes clear that asset allocation changes alone cannot adequately address the solvency challenge posed by negative cash flows on the current portfolio of liabilities,” Gelos and Surti wrote. “This means that, in the medium term, insurers and sponsors of defined benefit pensions must find a way to capitalise their losses… It seems likely that these institutions will have to make a fresh investment of equity capital to cover part of the loss.”

However, the authors suggested the situation might work to the benefit of insurers backing buy-ins and buyouts. With investors increasingly scrutinising the size of DB obligations and the effects on company share prices, profits, and dividends, the IMF said offloading these liabilities to insurers “is an attractive option” and “may represent a market-efficient arrangement”.

“Regulation could play an important role in this area by facilitating such transactions,” the IMF said.

Elsewhere in their report, the authors said such pressures would reinforce the global trend away from DB towards defined contribution (DC) pension models. The flexibility of DC pensions was also an important aspect, the IMF said, particularly for younger people who generally change jobs more often than older generations.

However, the IMF pointed out that large, hybrid, industry-wide schemes such as those in the Netherlands “will be more resilient” within the context of the DB to DC shift, as “they offer built-in portability to beneficiaries within industries”.

The full analysis, which forms the second chapter of the IMF’s Global Financial Stability Report, is available here.

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