Gilt yields have fallen on the back of January's market jitters and rate rise expectations have been pushed back again. This coupled with lower returns does not bode well for DB schemes, finds Stephanie Baxter
At a glance
- DB funding levels have fallen since the end of 2015
- Schemes will have to cope with low yields and lower equity returns
- 2016 valuations will be challenging and sponsors may have to pay up
It has not been a good start to the year for defined benefit (DB) pension scheme funding levels. Not only have equity markets fallen on the back of concerns about China and subdued global growth, but bonds have also been affected with gilt yields falling around 20 basis points (bps).
This is bad news for DB trustees, who have already seen pension liabilities balloon under the historically low interest rate environment. Although many schemes have been de-risking away from equities, they have still had exposure to the markets and therefore been able to reap the benefits of decent equity returns over the past few years.
Funding levels down
Schemes face a difficult future as funding levels are hit with a double whammy of lower equity returns amid higher volatility, and lower for longer gilt yields.
The 20bps fall in the discount rate since the start of the year to 27 January has added approximately £25bn to total pension liabilities of the FTSE 350 companies, according to Lincoln Pensions chief executive officer Darren Redmayne.
The firm has applied this to the most recent full dataset it has for the FTSE 350 at the end of June 2015 when total liabilities were around £689bn. It is likely that pension asset values will have fallen given that equities have declined by around 6% over the same period to 27 January, says Redmayne.
"This combination of changing market factors, uncertainty around rate rises in the UK and the ensuing Brexit vote does not bode well for DB scheme funding levels," he adds.
Hymans Robertson head of investments John Walbaum calls the recent market falls and subdued growth a "perfect storm of bad news for pension schemes".
He says an average scheme with an average liability profile and fairly average asset allocation would have seen its funding level fall from around 83% at the end of December by around 5% even 6%.
"It means schemes are well behind their funding targets. It's not been great, and the difficulty is for schemes that have been waiting for yields to rise. Schemes that have been diversifying asset exposure and hedging their liability risks will be protected to an extent but those that haven't will suffer quite badly."
The situation is particularly worrying for schemes that are preparing for their 2016 triennial valuations. Independent Trustee Services client director Janine Wood says there will be some challenging valuations this year and will likely result in some sponsors having to raise contributions.
The big difficulties will occur where liabilities are material in proportion to the size of the company, or where there is correlation between the performance of the business and performance of the pension assets. Redmayne says the more challenging situations are likely to be in retail companies or in a business that has a lot of both operating risk and pension risk.
While it is hoped that what is happening in the markets will be short lived, the expected future outlook is lower asset returns with a lot of volatility.
BlackRock head of intermediated institutional clients Andrew Stephens says: "The 30-year average beta return is just over 7%, and if you look over the past five years, just under 12% is the total realised return on an annual basis. But our forward-looking five-year expectations are around 4.5% – so that's quite a change."
Clearly, schemes will not be able to rely on investment returns to get out of deficits.
On top of this, the prospect of a UK rate rise continues to be pushed further away into the future, with little rationale for the central bank to act when there is so little inflation. The latest market prediction for the first UK rise is in the second half of 2017.
"This is an environment that pension schemes will have to get used to living with," says Walbaum. "I expect what that means for many is that if the horse has bolted, they have to think about any opportunity on the upside to capture some risk reduction."
Betting on a rate rise
Although hedging has become very popular in recent years, a lot of schemes have avoided it on the belief they will be bailed out by a gilt yield reversion. They do not want to lock into hedging at a time when bonds are so pricey and they believe a rate rise is not far away.
But Walbaum says: "If schemes have been saying we'll trigger into an interest rate rise – those triggers haven't been hit, they're just moving further away. And if they're triggering into funding level de-risking, those triggers have moved farther away as well. So everything has moved against them."
Schemes are being warned they are taking too much of a bet on long-dated rates rising more than the markets anticipate – which is the only way they will win. "As soon as you get a rate rise, there will be a load of demand for bonds that just push rates back down again. I can't see it going up quicker than markets anticipate," explains Wood.
Trustees and companies will need to be much more focused on managing their liabilities this year, and not assume they will be bailed out by gilt yield reversion or by stellar asset performance.
Redmayne says there is still a lot of denial, however: "The argument that ‘we have a good covenant and invest every penny of cash flow in the business and let the investment strategy fund the returns to get the scheme out of deficit' is too binary and needs to shift to something much more pragmatic."
Instead, schemes and sponsors need to say: "'We need to manage our liabilities carefully, look at hedging our risks, and ensure we've got the right balance between looking for investments to get us out of a hole and cash contributions from the company, which may need to be taken over time'."
It is clear that trustees and sponsors cannot hide their heads in the sand anymore. If some schemes were already unaffordable, it is likely they will become even more unaffordable unless action is taken.
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