As concerns grow over pension fund deficits, too much emphasis is being placed on equities and not enough on bond yields, writes Pat Woods

Minimum pension funding standards required by Irish legislation mean that approximately half of Irish pension schemes operated by major corporates are technically insolvent.

The fact that such shortfalls have to be made up over a maximum of 10 years may mean that companies will move to reduce pensions benefits at a time when the Government is keen that consumers maximise pensions benefits.

The problem of funding shortfalls in retirement schemes refuses to be pensioned off, with headlines in the UK screaming warnings such as "FTSE must top 6,000 to clear pensions black hole".

Meanwhile, on the other side of the Atlantic, the US Congress is debating complex legislation to help schemes in trouble.

Such simple headlines are understandably a concern to investors. But, in practice, the causes and solutions of the difficulties facing pension funds are complex.

Demographics, relative movements in bond and equity markets, wages growth and legislation are all factors.

Too much emphasis has been placed on measuring assets, especially equities, and too little on measuring liabilities, where bond yields are critical.

A recent announcement by General Motors in the US served to highlight the problem of falling interest rates. The company warned it would face an increase of between $6 billion (€4.7 billion) and $8 billion in its pension liabilities if bond yields remained at their end of June levels.

Similarly in Britain, a recent survey by a leading firm of actuaries and consultants estimated that the pension deficit was £55 billion (€79.5 billion) for the FTSE 100 companies as a whole and the stock market would need to rise by 50 per cent to fill the gap. This, however, is only part of the story.

The international accounting standard IAS19 takes a snapshot of a pension scheme's assets and liabilities using several factors. Equities are valued at market prices, so the three-year equity bear market has affected pension fund deficits.

However, too many commentators ignore the fact that the movements in bond yields have been just as important.

The liabilities in a pension scheme are valued using a discount rate, which IAS19 rules stipulate should be a high quality AA corporate bond. Yields on these have fallen by more than 2 per cent over the past three years, which have thereby boosted estimates of pension deficits.

Other issues include the assumptions made by companies under IAS19 rules. Some use more optimistic figures than others, and calculate future returns on different assets or use an alternative figure for wage inflation.

But what is the extent of the Irish problem and what would it take to restore pension schemes to a state of equilibrium?

The 19 per cent rise in the Irish equity market last year is helpful but not sufficient. The performance of overseas markets is also crucial.

It is essential to bear in mind that pension funds have been increasing their exposure to foreign equities, at the expense of the Irish market, over the past decade.

Consequently, it is important to also look at overseas indices, some of which have substantially underperformed the Irish market in the past year.

Clearly, rising equity markets are part of the solution. However, a further rise in bond yields would be more beneficial.

Estimates from credit rating agencies such as Moody's or stockbrokers such as UBS estimate that each 1 per cent rise in yields reduces pension liabilities by 7-16 per cent .

Consequently, a 20 per cent increase in the global equity markets over, say, the next two years combined with a 1 per cent increase in corporate bond yields would eliminate the pension deficit as an investment concern.

Pat Woods is investment director for the UK & Ireland at Standard Life Investments