From the blog: After its meeting on September 14, the Monetary Policy Committee issued its strongest guidance yet that it expects to raise interest rates from their historic 10-year low.
Gilt yields, which are often used as the basis to measure defined benefit pension liabilities, have been driven lower by loose monetary policy and have caused UK DB pension deficits to swell to around £460bn.
So, will rising interest rates save the day for DB pensions? Sadly, probably not.
Gilt yields, which are often used as the basis to measure defined benefit pension liabilities, have been driven lower by loose monetary policy and have caused UK DB pension deficits to swell to around £460bn.
So, will rising interest rates save the day for DB pensions? Sadly, probably not.
Rate rise impact will be muted
Deficits are not a particularly useful indicator on their own, and we would be better served by assessing the overall risk in pension schemes.
The rate rise has long been expected by the markets and will likely happen in small increments, so its immediate impact on gilt yields and the measurement of pension liabilities will be limited.
In addition, any rate increase tends to be associated with other asset values falling. For example, equity markets tend to respond negatively to rate rises, which will offset the net impact.
Sponsors won't welcome rise
Looking through an ‘integrated risk’ lens, as required by the Pensions Regulator, you need to consider the business standing behind the scheme as well as the fund itself. How will these work in tandem?
A rise in rates will generally not be good news for sponsors – those with material levels of debt will see an increase in their financing costs.
Source: Pension Protection Fund
Rate rises could also act as a brake on economic activity and choke the UK’s already pedestrian level of growth, while a resulting appreciation of sterling would make British business less competitive for exports.
These effects combined could further constrain the ability of UK sponsors to afford their pensions promises, not to mention the impact of Brexit.
Deficits don't give a full picture
Finally, and perhaps most importantly, interest rate rises will not materially affect the investment and demographic risks hidden beneath the surface of DB schemes.
This is a point often missed by market commentators discussing the latest deficit figures. It is more than 10 years since the last financial crisis began, and there are a few indicators which suggest another market event could be on the horizon.
Unless trustees act to ensure that the risks in their scheme can be supported by their sponsor, the impact of a correction could prove to be terminal for many schemes and their sponsors. The time to make contingency plans is when you think you do not need them.
Darren Redmayne is chief executive of covenant advisory Lincoln Pensions
