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LONDON (Reuters) - This year's surge in equities and other risky assets has been a relief for investors under pressure to boost returns after a dire 2011, but pension funds seem trapped in a low-yield world, aggravating their battle with demographic trends.
Despite equities enjoying one of the best annual starts in 30 years, the giant $35 trillion (22 trillion pound) pension funds industry has seen its chronic funding gap widen this year - reflecting portfolios still laden with the low-return bonds whose yields they use to calculate their future liabilities.
Pension funds are already struggling to meet ever-growing future payments as populations age. Life expectancy in the developed world has jumped by 10 years, to 76 for men and 82 for women, in the past 50 years.
This demographic time-bomb, which is most pronounced in Japan and other developed economies, is potentially so problematic it could make recent financial crises such as that in the euro zone pale in comparison.
New data from consultancy Mercer shows funding deficits of pension plans of FTSE350 top British companies rose 9 billion pounds in February alone to 92 billion pounds, their highest since at least 2008.
In the United States, funding deficits of the 100 largest defined benefit plans, promising pensioners an annual income equivalent to a percentage of their final salaries, stood at $413 billion in February, more than double the amount seen in mid-2011, according to the Milliman Pension Fund Index.
While stronger equities do benefit pension asset positions, it is the level of bond yields that counts when it comes to assessing liabilities, which are calculated using benchmark yields such as those on top-rated corporate bonds.
Low yields lead to bigger liabilities, hence more deficits, because pension funds will need more assets to pay sufficient income to pensioners in the future and companies may need to pay more into the pot.
Bond yields in general have remained low due to large-scale money printing by developed central banks and a growing shortage of the triple-A-rated paper craved by pension funds.
"The key problem of pension funds globally is they tend to target very low-risk type portfolios like fixed income. They haven't been quick enough to take advantage of a rally in equity markets," said Norbert Fullerton, director of consulting EMEA at Russell Investments.
"Even if some of the assets are rising, liabilities are rising faster because quantitative easing has driven down bond yields. Pension funds are running a very large deficit. So in order for assets to keep paying liabilities, they have to work at least twice as hard."
The general rule of thumb is that a 50-basis-point fall in the discount bond rate roughly results in a 10 percent increase in liabilities.
The benchmark U.S. discount rate used to calculate pension liabilities fell to 4.77 percent in February, down from 4.84 percent in January and from 5.79 percent a year ago, according to Mercer. In Britain, regulators use double-A-rated corporate bond yields as a benchmark, for which spreads over risk-free rates have fallen more than 30 basis points since January 1.
Japan, the world's most rapidly ageing society, expects two out of every five of its population will be 65 or older by 2060, reflecting low birthrates and long life expectancy, with nearly 35 million pensioners but just 8 million children aged 14 or under.
Demographic trends are similar in other major economies.
HSBC projects Germany's working population will shrivel by 29 percent by 2050 while the European Union warned in 2010 that without reforms, the number of people in work for every retired person in the bloc would drop from four to just two by 2060.
Against this backdrop, pension funds around the world are under pressure to boost returns, but their bond-heavy portfolios are making things difficult.
Japan's $1.3 trillion public pension fund - the world's largest, with a portfolio nearly as big as Spain's economy - lost 2.5 percent in the nine months to December 2011, although returns were positive in the final quarter.
The fund puts two-thirds of its assets in Japanese government bonds, for which the benchmark 10-year yield languishes below 1 percent. Within its portfolio, foreign equities generated the biggest investment return, of around 8.8 percent, in the final three months of last year.
The California Public Employees' Retirement System (Calpers) lost 2.7 percent in the same nine-month period, while the Canada Pension Plan Investment Board made a 2.2 percent return.
In Europe, pension funds slashed their weightings for equities to an average of 31.6 percent in 2011 from 43.8 percent in 2006, while fixed income holdings rose to 54 percent from 47.8 percent in the same period, according to Mercer.
"They need to start focusing more on how much juice they can get from their portfolio, by investing more in equities or a more diversified return-type portfolio, infrastructure, commodities, and alternative type assets," Fullerton said.
"They are trying to match assets and liabilities but given high government bond prices, it's not the way to do it because all of their bond portfolio will start to fall in value."
One solution to the persistent funding problem may be to tweak accounting standards.
The U.S. Congress is debating whether to allow companies to use a longer 10-year average of bond yields instead of the current 24-month average to determine the amount of annual contribution by firms. This would lead to higher benchmark yields used to estimate future payments, thus lower liabilities.
Another way, is simply to increase contributions by sponsoring companies, whose balance sheets in general have improved considerably after the financial crisis.
Ford Motor (F.N) is pouring $3.8 billion into its global pension plan this year, more than double its 2011 contribution, to minimise pension risks.
"The majority of plans which are in deficit have a choice: either take investment risks or commit to pay additional contribution to close the gap. Most companies are trying to strike the balance," said Adrian Hartshorn, partner at Mercer's financial strategy group.
Editing by Catherine Evans