"The Pension Protection Fund published its latest health check for defined benefit pension funds yesterday and its conclusions provide bad news for finance directors. The aggregate deficit of the 6,533 schemes in the PPF7800 index increased sharply from £8.3bn at the end of June to £67.3bn at the end of July. This lowered the funding ratio from 99.2% to 93.7%. Moreover, there were 4,684 schemes in deficit and just 1,849 schemes in surplus. The chart below shows that these pension deficits are experiencing a double dip having briefly moved back into aggregate surplus at the start of 2010 and 2011. However, the close relationship between the number of funds in surplus and the aggregate deficit shows that pension funds failed to take advantage of these two periods of relief to close the substantial asset-liability mismatch in their funds exposing their balance sheets to massive volatility.
"The section 179 assumptions represent the premium that would have to be paid to an insurance company to assume the payments of mandated Pension Protection Fund levels of compensation. The monthly estimates are produced by the PPF using a complex pricing model and include complete actuarial data as of April 2011 but does not include derivative hedges. The PPF has developed a number of rules of thumb to estimate the impact of asset price movements on scheme assets and section 179 liabilities. A 7.5% rise in equity prices boosts assets by around 4%, while a 0.3% rise in gilt yields reduces scheme assets by 1%. Meanwhile a 0.3% rise in gilt yields reduces scheme liabilities by 5.0%.
"However, we have dimensionally reduced the PPF's complex model into a two factor model, consisting of the 15y gilt yield 5yr forward and the FTSE 100 index. As the chart below shows, this has a 70% correlation with the PPF index. The movement in both of these factors since the start of the month suggests that the aggregate deficit has fallen by more than £80bn over this period, taking the aggregate deficit back to the depths of the second quarter of 2009.
"Hope is not a viable investment strategy. The chart of the 15yr5yr forward shows the importance of pension fund hedging activity for structural demand of for the long end of the gilt market. This shows the panic in the fourth quarter of 2005 and into January 2006 after the Labour government fixed the defined benefit pension promise. The yield rose steadily from this date as economic activity accelerated during the great moderation but the curve inverted as pension funds continued to hedge their liabilities. This hedging activity ended abruptly in September 2008 as the Lehman's crash turned these pension fund surpluses into deficits. The resulting rise in long dated forward gilts was a crucial trigger for the Bank of England to initiate its first round of quantitative easing. The resulting recovery in pension fund deficits provided a perfect opportunity for pension funds to de-risk, but the uncertainty over the shift from retail prices to consumer prices provided an excuse to wait and hope for better levels.
"Hope is no longer an option. In the second quarter of 2009, the global economy was recovering from rock bottom and companies could hope that financial markets were recovering and that the enormous government and central bank stimulus could provide the catalyst for strong self-sustaining growth that would allow companies to escape their deficits. Three years since this date and governments have reached the limit of their balance sheet expansion. The UK economy is embarking upon the longest and most substantial fiscal austerity since the twenties. The resulting deleveraging of government, consumer and financial sectors will lead to the paradox of thrift and very weak growth. This is turn is expected to result in a lost decade of low growth. Indeed, we expect UK economy to experience annual average growth of just 1.0-1.25% over the remainder of the decade. Financial markets are expected to remain extremely volatile over this decade.
"The Bank of England has a rosier view of the economic outlook, believing that growth will return to trend by 2014, but acknowledged that both growth and inflation were likely to be subdued during 2012 and 2013. Moreover, it believes that the risks to growth are on the downside, whilst the Quarterly Inflation Report highlighted the fact that 5y5y forward gilt yields are as high as the late nineties. The low growth, low inflation environment over the next few years clearly highlights the risks of significantly lower forward rates as the yield curve compresses. Corporate pension funds should not bury their heads in the sand."
Stuart Thomson
Chief Market Economist
Ignis Asset Management
Issued by Ignis Investment Services Ltd. Authorised and regulated by the Financial Services Authority.
This article contains the personal views of the author and do not necessarily reflect those of Ignis Asset Management - Chart source Ignis Rates ClearCurve, Bloomberg
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