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By AllAboutAlpha

Hedge funds have been riding the gold bandwagon for years now like we noted back in January, but those who most need inflation protection seem almost indifferent to the yellow metal. Pension funds’ growing commodity allocations, including gold, still only account for 2% of investments, according to the Watson Wyatt survey cited here in a July 2010 AAA post.

While all investors want to keep pace with rising prices, many pension funds are contractually required to do so – and many still have signally failed to keep their covenant to their members. Just consider the underfunding, as mentioned in this recent post, and years of closures that have left defined benefit pension schemes virtually extinct outside the public sector. Even the survivors are vulnerable: Basing benefits on career-average rather than final salaries and uprating benefits in line with meaner measures of inflation are two UK reforms already applied to some pensions that may well be extended to all.

Part of the problem has been the "lost decade" for large cap, developed market equities that dominate many pension funds. Whereas more esoteric equities sought out by hedge funds – such as small and mid cap indices (e.g. the S&P 400, not 500) and some emerging markets (e.g. Indonesia) – have made new all-time highs recently, the broad benchmarks that overwhelm big pension fund portfolios have travelled sideways for ten years.

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In contrast, the value of gold has more than quadrupled over that period, so even a single digit percentage allocation could have assisted pension funds in holding onto their purchasing power. State Street’s Head of Alternatives, Ric Thomas, has authored this report advocating that pension funds put between 2% and 4% in gold – apparently twice as much as the average pension fund has in commodities of any kind. Since most commodity indices are market weighted, they are dominated by the largest commodity market – crude oil – with gold may be contributing a tiny percentage. Constructing the widely tracked S&P Goldman Sachs Commodity Index ("GSCI") against world production volumes may, perhaps perversely, mean that if rising prices are caused by declining production, a weighting could drop. Turns out, gold is down to 2.8% for 2011 versus 2.93% for 2010, despite last year’s rally. The chart below shows how gold’s weight is dwarfed by pigs, cows and food. Note how silver is even smaller at 0.36%!

(Click to enlarge)

This means that investors who want gold need to make a conscious decision to go out and buy it. They simply cannot sit back and rely on a passive, index investment in commodities to give them adequate gold exposure. If the GSCI is a typically used by pension funds to obtain commodity exposure, we may be able to infer that the average pension fund 2% commodity weighting translates into just 0.06% or 6 basis points in gold!

However, excessive enthusiasm for gold could run into regulatory obstacles. Even though the giant Dutch pension funds were among the first to allocate to commodities, the Central Bank of the Netherlands recently gave a steelworkers’ fund the red light in relation to its 13% allocation to gold. One argument put forward by the less-than-libertarian Amsterdam-based overseer was that the volatility of gold could increase the risks of a deficit materialising.

The Dutch regulator may have a point. Granted, gold is one of the more efficient ways to deal with inflation risks for pension funds, but it’s far from a complete solution to pension fund deficits. Maintaining the solvency of a defined benefit scheme is like shooting at a moving target, with inflation only one of many dynamically evolving variables. Liabilities rise with salaries – not prices – prior to retirement, with rising life expectancy being another factor. Since JP Morgan did the first longevity swaps only a few years ago, Dutch and UK pension funds are using these instruments to hedge against longer lifespans.

Early retirement is therefore a grave threat to pension funds, both by raising the duration of the liability and reducing the time left to grow assets. If only more people followed the example of two erstwhile New York public servants, septuagenarian Federal Reserve Chairman Alan Greenspan and centenarian District Attorney Robert Morgenthau, then pension payments could be delayed for decades. The United Kingdom has recently emulated the longstanding USA policy and removed mandatory retirement ages, but they remain common, for now, in most European countries. The bottom line is that social and political change have to complement smarter asset allocation – probably by including more gold - to prevent the complete extinction of defined benefit schemes.

Source: Is Gold the Answer for Pension Deficits?