There are many factors that could have a direct effect on a defined benefit pension plan; geopolitical risk is one of these. This risk has become more pronounced recently with the growing concerns regarding the possible development by Iran of nuclear weapons. Talks have started on April 13th between Iran’s chief nuclear negotiator and representatives from the US, Russia, China, UK, France and Germany. A previous meeting held a year ago ended in failure. The goal of this meeting is to defuse building tension over Iran’s nuclear enrichment program and to hopefully start laying the groundwork for the dismantlement of this program.
The possibility that Iran is developing a weapons-grade plutonium with the intent of arming a nuclear bomb poses a major threat to an area critical to the world economy. Iran is strategically located next to most of the world’s oil exporting nations and is a mere 600 kilometers from Israel. Israel has repeatedly threatened to act unilaterally and attack Iran should diplomatic efforts fail.
Effect on oil prices
Oil prices have already increased significantly due to concerns about the risks in the region. The price is now close to the previous high that occurred in 2007.
Oil exports from OPEC constitute 40% of the World’s oil supply while the Gulf State countries account for 18 million of the 24 million barrels of oil exported daily. A disruption of the exports from the Middle East would have immediate repercussions worldwide. Oil prices would increase sharply and there would most probably be gasoline rationing in many countries. The United States would be particularly vulnerable as it imports half of its daily oil needs.
The effect of a sharp rise in oil prices would be the equivalent of an increase in taxes. The immediate effect would be a slowdown in the world economy as consumers would be forced to cut spending to pay for higher energy prices. This would be a very difficult scenario for policy makers to resolve. Interest rates are currently near historical lows, and developed countries are carrying very high levels of sovereign debt leaving very few options available.
For pension plans with the typical asset mix (60% Equities, 40% Bonds) this would be a highly negative outcome. The most probable outcome would be a flight to quality with risk assets being sold and the funds invested in the government bond market. Interest rates would fall increasing the value of Plan liabilities while asset returns would be low or negative. The net effect would be a decrease in the funding ratios for most plans with this asset mix. The effect would be less for Plans that have already de-risked and have a closer match between their assets and liabilities.