You never know where the next crisis will arise but last week it came from a particularly unlikely place: defined-benefit pensions. The U.K. government bond market (gilts) went wild as rates spiked and pension funds failed to meet their margin calls. It created so much turmoil that the Bank of England had to step in. Does this mean that U.S. pensions could create similar turmoil? Not to be coy about it, but yes and no. The good news is U.S. pension funds are not so exposed to rate changes because they hold less fixed-income assets. But that is also the bad news.

Interest rates are rising and will stay high for the first time in years. This means anyone exposed to fixed income is due for some disruption. U.S. plans hold less debt than U.K. pensions because they do less risk hedging, so spiking rates probably won’t cause immediate damage. But that also means they are more exposed to market risk, and as rising rates unearth all sorts of financial vulnerabilities, U.S. plans may eventually find themselves in even worse shape than U.K. plans were last week.

The smaller subset of U.S. corporate defined-benefit plans invest about half of their $3.7 trillion in assets in bonds (similar to the U.K. plans), according to a report from the Milliman Corporate Pension Funding Study. It’s worth noting American pensions are not so vulnerable to margin calls because they do Liability Driven Investment the old-fashioned way: by mainly just owning bonds instead of adding in leverage. This means as rates rise their assets and liabilities move together, keeping their funding fairly stable.

Corporate plans are in relatively good shape, but they are not the big source of risk. A much bigger worry are state and local government pensions, which have more than $9 trillion in assets, and (as of 2021) only 22% of those assets are in fixed income.

A low fixed-income allocation was typically considered nothing to brag about for pensions. But public pension plans have been moving out of fixed income and public equity over the last 20 years because rates dropped so low.

Unlike U.K. and U.S. corporate plans, public plans in the U.S. value their liabilities using the expected rate of return on their assets instead of the market interest rate; a convention that makes financial economists’ heads explode. This way of accounting may mean less direct exposure to interest rates, but it also rewards more risk taking because the higher “expected” return pensions choose, the smaller their liabilities appear to be.

As interest rates fell pension plans had an incentive to move into opaque, illiquid and risky assets, like private equity and hedge funds because they could claim a higher rate of return. In addition to high fees this meant more risk. U.S. government plans are also underfunded. In 2019, using comparable accounting methods, the public pensions have only enough assets to cover 50% of their liabilities, compared with U.K. plans, which went into the pandemic able to cover more than 90% of their liabilities.

The U.K. pension dustup is only the first buried body higher rates uncovered. U.S. plans are less directly exposed to a sudden large rate increase, but over time they have an equally troubling vulnerability: They are underfunded and dependent on risky assets paying off. Now, with falling markets, their assets are shrinking and their expected returns are harder to justify. A higher interest-rate environment is also bad for private equity and may mean fewer profitable exits. This could mean that over the next few years pension funds will learn that the 12% to 15% returns they thought they were getting from their alternative investments were an illusion and they have less money than they thought.

Pensions may be just the beginning, as the U.S. economy has become dependent on low rates. And that means the new source of vulnerability may come from parts of the economy once thought of as boring and safe, like mortgages and now pensions. Central banks have painted themselves into a corner. The Bank of England attempted to reduce inflation with higher rates and quantitative tightening. But they discovered that fighting inflation and financial stability may be at odds with each other.

Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.

This article was provided by Bloomberg News.