JLT Employee Benefits has modelled the impact on UK pension scheme liabilities of interest rates rising one year behind current market expectations. The analysis is based on the UK pension scheme accounting basis, which sets the liability discount rate with reference to yields on high-grade corporate bonds. The modelling is based on an index of the average UK scheme profile and funding status.
Increase in pension liabilities of “lower, longer” interest rates:
• All UK private sector pension schemes: £62bn
• FTSE 100 companies: £24bn
• FTSE 350 companies: £27bn
John Breedon, Head of Investment Consulting at JLT Employee Benefits, says: “There is an expectation that interest rates in developed economies will rise and when they do, pension deficits will improve. However, the critical point is not just whether the rise occurs, but its relative timing. Simply put, if it happens later than market expectations, pension schemes could be in a worse position.
“If interest rates were to rise a year behind expectations, our modelling shows the liabilities of private sector UK pension schemes, including those of UK PLC, could increase by as much as £62bn. The impact on trustee funding measures and on solvency measures is much greater. Of concern is that almost £35bn of this increase in liabilities will occur in companies that sit outside the FTSE 350. Bigger schemes often have hedging strategies in place to cater for such adverse movements in interest rates and inflation, but smaller schemes remain exposed.
“If we looked at the combined effect of interest rates staying lower for longer and inflation increasing sooner than anticipated by a year, the aggregate increase in liabilities could be as much as £100bn. For a typical £30m pension scheme, this could require an extra £2m of sponsor contribution, or more if the payment is spread over a number of years.
“Much of this risk could be removed by the appropriate use of LDI strategies, which are now much more accessible to smaller pension funds in terms of availability and cost. However, a surprisingly low number of companies and schemes make use of LDI to protect themselves from these massive interest rate and inflation threats to their balance sheets.
“Current market prices build in an expectation for increases in future inflation as well as for increases in interest rates. If interest rates stay lower longer, or if inflation arrives sooner than expected, the impact on pension funds will be bleak.”
Darren Redmayne, Head of Lincoln Pensions, comments: "A number of sponsors cite gilt yield reversion and future expected interest rate rises as reasons to keep contributions lower. JLT EB's research shows the risk of that approach if rates stay low for longer than expected. This is particularly relevant since most economic commentators did not see the current prolonged period of low interest rates as likely and it shows no signs of changing."
"I believe the regulatory regime is providing additional flexibility to sponsors at the wrong point in the economic cycle and this has the potential to build up risk among defined benefit schemes. FTSE 100 deficits are rising but the contributions to repair them have been falling. If you don't fix the roof when the sun is out, or at least when it's not raining, when do you?"
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