Interest rates and the PPF

In particular, consistently low interest rates and falling gilt yields have led to an increase in the value of scheme liabilities, which ultimately affects funding ratios.

Since the end of 2013 there has been a marked worsening in scheme funding on the basis used in the Pension Protection Fund 7800 index for the PPF’s universe of schemes. Mainly driven by lower gilt yields, scheme funding has fallen back to the lows seen in 2012.

The aggregate deficit of schemes in deficit has increased from £88bn in December 2013 to £287bn at the end of February.

Pension scheme liabilities in the PPF 7800 index are calculated with reference to gilt yields. As these fall, liabilities will increase. Since the end of 2013, we have seen yields fall substantially, causing liabilities to grow faster than assets.

For example, a 0.3 percentage point fall in gilt yields increases scheme liabilities by 6 per cent, while increasing scheme assets by about 1.5 per cent. Although the flip side of lower gilt yields is higher gilt prices, the impact on assets is smaller than the impact on liabilities.

If gilt yields remain this low and this becomes the new 'normal', the pension promises, expected by millions, will stay in deficit and companies will need to take steps to remedy this situation.

The aggregate deficit of schemes in deficit has increased from £88bn in December 2013 to £287bn at the end of February

A depressing scenario, perhaps. But the millions of members of DB schemes in the UK should take comfort in the protection the PPF provides in case their employer, or former employer, fails and the scheme cannot afford to pay its promised pension.  

Nevertheless, as we look ahead to the prospect of interest rate rises, it is crucial to understand how the changes in rates could impact scheme funding.

An increase in interest rates would probably lead to higher gilt yields and raise scheme funding, lower liabilities more than offsetting the impact of lower assets – the reverse of the first point.      

It is abundantly clear from our 7800 index figures that there are many schemes out there currently in deficit, and some may not be able to meet the promises they’ve made. And there is perhaps 10 per cent, maybe more, where the chances of the shortfall ever being repaired, no matter what happens to interest rates, look decidedly bleak.

Of course, interest rates are not the only factor affecting scheme funding: equity markets, longevity and deficit reduction contributions (under the Pensions Regulator's scheme funding regime), all have an impact.

Any rise in interest rates will see winners and losers. But, whether we see interest rates rising in the short term or not, it’s clear to us that companies need to take a close interest in them and the impact on the funding of their schemes if they are to be able to pay their members what they’ve been promised. 

Gwyn Hacche is risk principal, economic research, at the Pension Protection Fund