Pension funds struggling with low yields have held back from selling long-dated government bonds, causing the Bank of England to miss its gilt buying target on Tuesday.
When the BoE, which recently cut the base rate to a historic low of 0.25 per cent in an attempt to boost the economy, tried to purchase £1.17bn worth of long-dated gilts as part of the first stage of its latest quantitative easing operation, it only received offers of around £1.12bn – despite offering prices above market rate.
Pension funds and other institutional investors with long-dated liabilities were reluctant to sell because of the need to use gilts as protection against further drops in government bond yields.
The prevailing conditions have meant convention is being ripped up
Chris Roberts, Dalriada Trustees
The news came as data recently published by the Pension Protection Fund revealed that the aggregate deficit of all schemes in deficit at the end of July is estimated to have increased to £440.4bn, from £416.3bn at the end of June.
Many schemes have consulted on closure over the past few years; the Royal Mail pension scheme is the latest high-profile fund set to close to accrual.
Plunging gilt yields have increased pension fund liabilities, but the extent to which this has affected schemes depends on individual funds’ investment strategies and hedging.
Covenant important for hedging decision
Schemes that have already taken action to hedge against interest rate risk will have suffered less from the effects of rate cuts and the drops in gilt yields.
“But for most pension schemes, it’s more pain at a time when they are already feeling pretty low,” said James Fermont, partner at consultancy LCP.
Ultimately, a lot depends on a scheme’s reliance on its sponsor, he noted. Pension funds can either generate higher returns or “go cap in hand to the employer and ask for more money”.
He added it is likely that schemes that have not hedged will now expect to have to opt for the latter option when it comes to the next actuarial valuation.
For schemes that think they may not be able to rely on the sponsor in the long term, he said: “They should definitely be taking action to derisk, even though that probably feels like a very painful decision to take, given that gilt yields continue to be hitting record lows.”
Schemes with a strong sponsor on the other hand, “may be able to ride out the storm here”.
If a scheme has a strong employer covenant and additional contributions from the sponsor are available if needed, then trustees may decide that “these rates are too expensive” and look to invest in assets that will achieve higher long-term returns, said Andy Green, chief investment officer at consultancy Hymans Robertson.
However, he noted that when an employer cannot support further funding deterioration and increase in cost, if the situation gets worse, “trustees have got to start protecting themselves, even though it may feel like the worst time to be doing that”.
Richard Butcher, managing director at professional trustee company PTL, said schemes should “continually monitor the strength of the employer covenant”, although the extent to which it is monitored varies.
“If you’ve got a weak employer and they owe you a large amount of money then you’re going to spend more time monitoring their covenant.”
Unusual times demand unusual measures
Chris Roberts, trustee representative at professional trustee company Dalriada Trustees, also noted that schemes that find themselves exposed more fully to the gilt yield movements will be expecting significant increases in their liabilities.
“These trustees must consider if the covenant can support the depleted funding level and if they must now consider locking down the interest rate risk, however unpalatable they may find the current yields,” he said.
Roberts pointed out that when looking at economic modelling, trustees should take into account that “the parameters have been recalibrated for a post-Brexit world”.
“Normal convention would dictate that the lowering of the UK credit rating would not result in a rush of people buying UK gilts at increasingly lower yield rates. However, the prevailing conditions have meant convention is being ripped up,” he said.
The worsening of the funding crisis comes with new ways of solving the problem. At a recent trustee meeting, “we discussed the potential for looking at a valuation measured on an alternative to gilts”, Roberts said; and while this defies convention, “it is not impossible”.
