While pension funds hold bonds as their asset, they also have obligations as liability. Lower interest rate, namely a lower discount rate, on one hand, increases bonds’ return, on the other hand, it also increase pension funds’ liabilities, which is the discounted value of future obligations. Moreover, bonds in asset side are usually in shorter term than long-term liabilities, and therefore are less sensitive to interest rate change. As a result, the increase in liability exceeds the value increase in assets. The net position of pension funds would be worse off. In addition, a protracted low interest rate also means low reinvestment rate, not only for bond investment but also for equity and real estate. We can see from GM pension, that, pension funds hold equity and real estate as their investment as well. If reinvestment return from these assets deteriorate, it is extremely difficult for pension funds to realize an expected return and thus these pension funds would become underfunded.
To determine whether a pension fund is underfunded or overfunded, the asset and liability of this pension should be compared. Pension fund with higher liability than its asset is underfunded, and that with higher asset than liability is overfunded. If a pension fund holds stock as its asset, it is reasonable to take risk premium on stock into consideration, when calculating its value of asset. This approach generally increases the volatility of pension fund’s asset. When the stock market suffers, the pension fund may also become underfunded, due to a decrease in its asset value. In reality, as pension funds usually hold stock as asset, lose in stock market is one of the most common reasons accounting for underfunded pensions. In other cases when pension funds are already underfunded, they would like to hold more stocks as assets, attempting to increase assets value, since the risk premium of stock is generally considered higher than bonds.
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