The Bank for International Settlements warned that pension funds face growing funding problems which could lead to repercussions in the broader economy.

The BIS said in its latest annual report that persistently low interest rates and demographic changes have put a heavy strain on pension funds. However lowering discount rates raises the present value of funds’ liabilities more sharply than that of their assets, which are typically of much shorter duration. For example, a 400 basis point reduction in the discount rate would increase the value of the liabilities of a typical US pension fund by more than 80%.

The report said: “This widens pension fund deficits and may ultimately affect the economy at large.”

Funding ratios at the end of last year were below pre-crisis levels in both the US and Europe and are likely to get worse if interest rates continue to remain low.

In the case of defined benefit plans, the fund’s liabilities are a contractual obligation of the fund’s sponsor so deficits could eventually hurt companies’ profits and possibly undermine their solvency. A drop in the value of a defined contribution  plan’s assets leads to  a decline in the future income stream of its members and a fall in aggregate demand.

Pension funds have responded to declining asset returns by increasing their exposure to alternative investments including real estate, hedge funds, private equity and commodities.

“Industry estimates reveal that the share of such investments in pension fund asset portfolios has risen – from 5% in 2001 to 15% in 2007 and 25% in 2014 – mirrored by a 20% point drop in the equity share,” added the BIS. “UK pension funds are important drivers of this shift, as are US funds, whose disposal of equities has reportedly been masked by strong valuation gains.”

A report from PwC this week, Alternative Asset Management in 2020: Fast Forward to Centre Stage, forecasts that global alternative assets will increase to $15.3tn by 2020 with the biggest rise in allocations to  private equity, real estate and infrastructure. This will be driven by sovereign and public pension funds.

In April this year the $1.1 trillion Government Pension Investment Fund of Japan announced a new strategic mix which included a 5% allocation to alternatives. Three smaller Japanese funds managing $250bn have since said they plan to adopt a similar strategy to GPIF.

PwC said: “By 2020, it is expected that global pension fund assets will have reached $56.6 trillion, with alternative assets expected to play a considerably larger role in their asset allocation mix.”

Assets under management in South America, Asia, Africa and the Middle East are expected to grow faster than the developed world due to the rise in sovereign assets and the emergence of 21 new sovereign investors.

PwC expects alternative asset managers to continue to move into areas traditionally dominated by banks, such as lending, securitization and financing and to invest in technology.

The report said: “By 2020, the shift to data-informed decision-making will lead to improved organisational designs that can make more effective use of third-party administrators, other business process outsourcing firms, and other vendors to achieve operational and cost efficiency.”

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