Twisted pensions

Pensions funds in the US and Europe have raised concern over some unintended consequences of

the Federal Reserve’s Operation Twist, which consists of the swapping of short-dated debt for a basket of longer dated debt. The main goal of Operation Twist is to lower the yield on long-term debt.

The rationale behind the move is that lower yields for long-term debt will move investments into riskier and higher yielding short-term assets such as equities and corporate bonds. In addition the Fed would like to lower the cost of mortgages. Both results, it is hoped, will stimulate the US economy.

Pension funds point out that the real issue in the US mortgage market is not interest rates but negative equity. Their other argument is that companies may be constrained by their increased pension liabilities.

Pension funds note that lower long-term yields will disproportionately increase their long-term liabilities. Today’s cost of future pension payments is determined by discounting the liabilities to the present value. The discount rates used should follow long-term yields, which is what Operation Twist aims to drive down. The yield on 30 year Treasury bonds for instance fell to a record low in September of this year.

The key question, pension funds raise, is whether uncertain short-term increases in asset values will offset the negative effect on the long-term liabilities of their pension schemes.