Why you shouldn't sit on your hands waiting for a rate rise

For pension funds the ongoing uncertainty over when interest rates will rise continues to bring significant risks to funding levels and complexity for stakeholders regarding what to do about it and when.

Schemes face two key risks from interest rates. First, an equity market correction, as economic wobbles mean rates stay low for even longer. For example, the increasingly Japan-like trajectory of the eurozone may bring further monetary stimulus from the European Central Bank next month and potentially lead to increased demand for UK over European assets.

The second risk is that rates do rise but by less than is already priced in by the market. For funds considering delaying their liability hedging, the question should be whether rates rise more than the forward curve rather than just from current levels.

At the moment, 30-year gilts yield around 3.4 per cent, and the market expects them to rise to 3.9 per cent in the next three years and up to 4 per cent in 10 years’ time. If in 2017 gilt rates are still at 3.4 per cent this means the liabilities will be 10 per cent greater than expected. 

Bond markets have a habit of waiting for higher rates. In 2009 markets expected base rates to rise to 4 per cent in three years’ time, and then in 2012 the rate was priced to rise to 2 per cent in 2016. Currently, the bond markets expect base rates to rise to 3.5 per cent in three years’ time. 

If you are looking after a pension fund and are concerned about the funding level then interest rate risk is a big risk. Here is a checklist that can be used to monitor and manage your interest rate risk:

• Do you have a liability benchmark and do you measure and monitor your investment risk against it? 

• Do you use liability-driven investment? In this context, LDI is not about selling equities to buy gilts, it is about thinking the way your diversified growth fund manager thinks about risks, ie bringing a holistic focus to risk management. 

• If you use LDI, what is your hedge ratio? What is your decision framework for increasing it? Have you thought about what happens if rates do not rise in line with forward rates? 

• Has your funding level benefited from the recent strong equity and credit market performance? Have you locked in these gains?

If you are still waiting for Godot, now is an opportune time to zoom out and answer some of these questions.

Widen your options, challenge your assumptions, and prepare to be wrong. Good luck.

Rob Gardner is co-founder and co-CEO at consultancy Redington