The Bank of England's anticipated move to raise rates could fuel huge savings for defined benefit schemes, although the inflationary outlook has deteriorated as the cost of living crisis continues to bite.
At its May meeting, the central bank’s Monetary Policy Committee voted by six to three to increase the base rate by 0.25 percentage points to 1 per cent.
The three who voted against the increase had preferred to raise the bank rate by 0.5 per cent instead. The MPC expects the base rate to increase to around 2.5 per cent by mid-2023.
There was also a new forecast for consumer price index inflation, which the committee expects to rise to just over 9 per cent during the second quarter, lifting to more than 10 per cent at its peak in the fourth quarter of 2022. The deteriorating inflation outlook has been driven by higher household energy prices, as represented by the Ofgem price cap.
Pension schemes which are not fully hedged will be better funded than they were at this time last year
Tom Birkin, XPS
Silvia Dall’Angelo, senior economist at Federated Hermes, said that while the interest rate hike was expected, “the overall tone of the meeting was more dovish than anticipated, due to the downbeat updated forecasts”.
She said: “The bank now expects a sharper, short-term trade-off between slow growth and elevated inflation, due to the war in Ukraine and its impact on energy prices, with inflation reaching double-digit territory later this year and [gross domestic product] contracting next year.
“That poses a policy dilemma for the Bank of England, which was reflected in a three-way split in the meeting.”
Dall’Angelo added: “The bank will have to walk a tightrope amid extreme uncertainty and will probably have to adjust as needed along the way.”
Good news for schemes
There could be good news on the way for schemes, however, as Tom Birkin, actuary at XPS Pensions Group, said the rise in the base rate could translate into an additional £100bn in savings for schemes if long-term gilt yields also rise.
He explained: “Despite the UK currently experiencing the highest levels of inflation for over 30 years, with interest rates rising and long-term expectations of inflation now stabilising, pension schemes which are not fully hedged will be better funded than they were at this time last year.
“Given the cost of living crisis facing pensioners and with caps on pension increases already limiting pension income, pension scheme trustees may come under increasing pressure to pass on some of these funding improvements to their members by providing discretionary increases to members’ pensions above inflation caps.”
David Brooks, technical director at consultancy Broadstone, observed that gilt yields have increased significantly in recent months, which could have a material impact on DB schemes’ funding positions depending on their level of hedging in place.
Indeed, the Pension Protection Fund’s PPF 7800 Index — which tracks the performance of all 5,318 DB schemes eligible for inclusion in the pension rescue fund — shows that schemes were already in a healthy position.
The funding ratio for DB schemes, which shows assets as a percentage of their liabilities, stood at a surplus 111.4 per cent at the end of April
“All else being equal, schemes that are not fully hedged will have seen their funding positions improve over recent months,” Brooks said.
“While any under-hedged position may be proving a positive contributor, this is not something for trustees to be complacent about and should be a position taken consciously.”
Brooks added that higher-than-forecast inflation will be concerning for many, but could provide an opportunity for some schemes to derisk their positions now that they are better funded.
“At the very least they should be reassessing whether their liability hedging programmes remain in line with their intended targets, given the significant moves in both interest rates and inflation,” he said.
Inflation strains LDI
Higher inflation should be a concern as it puts a strain on liability-driven investment collateral pools, said Elaine Torry, co-head of DB investment at Hymans Robertson, ahead of the BoE’s decision.
She encouraged trustees to do much more to stress-test their pool, especially as further interest rate rises remain likely over the remainder of this year.
FTSE 350 DB deficit reaches two-year low amid bond yield rise
The accounting deficit of the defined benefit schemes of the UK’s 350 biggest public companies fell to £45bn at the end of last month — a level last seen in April 2020.
Torry said: “If interest rates continue to rise and inflation stabilises, this should be a ray of hope for scheme funding and an opportunity for trustees to take steps to further secure members’ benefits.
“Action now will enable a full assessment to take place and ensure gaps are identified before funding gains are eroded by forced asset sales leading to a collateral headache.”
She added: “Schemes must review their LDI and supporting arrangements as a matter of priority, ensure they fully understand the proximity to critical leverage levels, and have plans in place to replenish the collateral pool in a controlled, cost-effective way.”
