Analysis by Aon Hewitt shows that UK pension schemes lack protection against movements in long term interest rates to the tune of over £400bn.
Pension scheme liabilities are highly sensitive to movements in long term interest rates - one of the biggest financial risks schemes face. Aon Hewitt's analysis suggests that on average, closed and frozen schemes should be protecting against at least 70% of their interest rate risk. Instead, the average amount hedged is thought to be nearer 30% to 40%.
John Belgrove, senior partner at Aon Hewitt, said:
“Of course, any decision to change current levels of hedging needs to be made in relation to a scheme’s specific situation. However, our analysis suggests that on average UK pension schemes are leaving themselves over-exposed to long term rate changes when compared to many other risks. Why take such unbalanced risks? Even where pension schemes have taken action, the level of hedge taken is often still sub-optimal, and does not adequately address the issue.
“When a pension scheme hedges out some of its fixed interest-rate liabilities, it effectively locks in a certain future rate. Many pension schemes have been holding off implementing this kind of protection until rates rise. While it is true that short term rates haven’t moved, long term rates have moved up more than many expected, so now may be a good time to start taking more of this risk off the table.”
Over the course of 2013, there was a significant rise in gilt yields and more importantly a significant rise in future interest rate expectations
“Most schemes saw liabilities fall in 2013 in response to rising long term interest rates. This provided some welcome respite, but interest rates will not generate a return commensurate to the risk being taken in the longer term. A pension scheme of any size can access solutions to remove the risk and find the right support and training to overcome the apparent complexities.
"Short term interest rates are clearly set to rise, but schemes should avoid falling into the trap that this means they should remain exposed to interest rate risk.”
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