“UK pension funds remain in urgent need of life support. In September, a faint pulse was found as the PPF 7800’s aggregate funding ratio halted its downward spiral, rising from 76.1% to 77.5%. Contracting liability values compensated for weak returns from growth assets, resulting in an overall positive impact on funding levels. A sell-off in UK government bonds, causing yields to rise and liability values to fall, was linked to an announcement at the end of the month that a UK parliamentary committee is to investigate proposals allowing UK private sector pension schemes to temporarily amend or suspend inflation-linked pension increases. Though no details have been confirmed, it is assumed that this so-called “conditional indexation” would help challenged defined benefit schemes by decreasing the value of liabilities, strengthening funding status, and reducing insolvency risk.
“We would caution clients against any changes in portfolio allocation due to these developments. Not only would this consultation likely be advisory only (i.e. with no requirement for the government to follow its recommendations), it is likely to be highly political, with strong voices on either side of the debate, and it is not clear what changes, if any, will result. Consultations around the UK pension scheme landscape have surprised markets in the past. In late 2012, market expectations around the Consumer Prices Advisory Committee (“CPAC”) consultation into changes to the methodology for calculating the RPI measure of inflation, which could have materially lowered UK pension scheme liabilities, were strongly pricing in a prospective change - only for none to subsequently occur.
“It remains the responsibility of schemes and their sponsors to eliminate deficits, rather than hoping for a regulatory silver bullet. We maintain our long-held position that most pension funds should be hedging more interest rate and inflation than their current levels, given our expectation that yields will be low for the foreseeable future. Though we anticipate some additional fiscal stimulus from the Chancellor in the forthcoming Autumn statement, opening the possibility of additional gilt supply, we do not expect this to significantly impact yields – the structural supply and demand imbalance created by pension funds far exceeds the likely scale of stimulus. Indeed, the second quarter of 2016 was the largest on record for government bond buying from UK pension schemes – showing insatiable demand even as yields plummeted. In this ultra-low yield environment, additional returns to out-perform liabilities can be found through well sourced private market assets, which can benefit from attractive illiquidity premia. Newspaper reports at the weekend hinted at the UK government looking to facilitate pension fund investment in such long-dated assets, so opportunities could increase in this space in future.”
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