How a Recession Will Impact Pension Funds?

The post-pandemic economic environment across the world has bearish undertones. During the pandemic, many countries had lowered their interest rates to unsustainable levels. As a result, they are now witnessing record inflation numbers.

The central bankers across the world have started tightening the monetary policy. This means that the risk-free interest rates are likely to see a significant hike. As a result, the entire global economy seems precariously poised on the verge of a recession.

Since pension funds are such an important part of the overall economy as well as financial markets, it is obvious that a recession will have a significant impact on them.

In this article, we will provide details about some of the ways in which pension funds are likely to be impacted by the recession.

1. Lower Contributions: Pension fund contributions are very sensitive to the economic environment. This is because people pay their pension fund contributions from their disposable income. Hence, if the disposable income of a person reduces, their pension fund contributions are likely to take a hit.

   In the event of a recession, job losses and pay cuts are common. Also, since recessions occur in a high-interest rate environment, the monthly expenses also tend to go up.

   The dual pressure of falling incomes and rising expenses make it difficult for people to continue paying pension contributions. The end result is that pensions receive lower contributions and invest fewer dollars in the market. This ends up exacerbating the recession in the long run.

2. Lower Rates of Return: Recessions typically occur when the interest rates begin to rise. As a result of the shaky fundamentals of the economy, investors tend to make a flight towards safety during such periods. This means that the risk appetite of investors is significantly reduced.

   Now, if a pension fund tries to reduce its risk levels, it will inevitably end up reducing the returns as well. It is for this reason that pension funds have offered historically lower returns during periods of recession.

3. De-Risking of Portfolios: As mentioned above, recessions tend to trigger a flight towards safety amongst investors. As a result, recessions also significantly change the asset classes in which pension funds commonly invest.

   During periods of economic boom, the interest rates are low. Hence, investors are forced to take risks. This causes them to invest heavily in publicly listed companies as well as in private placements. During an economic boom, a significant portion of the pension fund's assets is tied to equity, derivatives, and other risky assets.

   Interest rates tend to rise just before a recession. Hence, now fixed income instruments offer a better rate of return as compared to other instruments. In such scenarios pension funds find excessive risk-taking to be futile. As a result, they significantly de-risk their portfolios.

   Since pension funds sell equities in large amounts, the value of equity shares also tends to go down which triggers a recursive selling action. The bottom line is that pension funds are forced to rebalance their portfolios during an economic downturn. Such rebalancing has a huge impact on the people holding pension funds as well as the overall market.

4. Return to Domestic Markets: Pension funds tend to venture into overseas markets only if they are unable to obtain the desired returns in domestic markets. During an economic downturn, pension funds receive fewer contributions. Hence, the amount of money that is available to invest is lowered. At the same time, the interest rates in the domestic economy start to go up as well. Therefore, there is a chance of making a decent return without taking excessive risks.

   Hence, keeping in line with the prudent person rule, pension funds tend to liquidate their overseas holdings and repatriate the money back to their domestic economy.

   If a good return can be made while investing in relatively risk-free assets within the local economy, there is no reason why pension funds should invest in risky assets which bear market risks, liquidity risks as well as currency risks.

   It is for this reason that pension funds generally end up having a largely local portfolio in the midst of a recession. Often this leads to spill over recessions in the emerging markets as well.

5. Lower Pay-outs: Lastly, the value of the corpus of funds held by retirees is linked to the financial markets. During a recession, the financial markets take a downturn. Hence, the value of the retirement corpus of retirees also takes a nosedive.

   If the retirees are not actively withdrawing money from the corpus, they can postpone realizing the loss. Generally, recessions last for a couple of years and the markets start recovering soon.

   However, if the recession lasts for a longer period of time, the retirees may not get the time to let their portfolios recover. The end result would be that they would be left with an inadequate sum of money to manage their retirement expenses.

   Apart from being a personal problem for them, this could also become a problem for the economy as a whole. Retirees with inadequate income need to be supported by government pay-outs which could lead to higher taxation and could end up exacerbating the recessionary trend.

The fact of the matter is that recessions are huge economic events that have a significant impact on the valuation and even the day-to-day functioning of pension funds. Since pension funds are held over long periods of time, investors should factor in the impact of recessions when they invest in pension funds.