If interest rates rise next year, Stephanie Baxter finds it will not be the answer to schemes' funding troubles.
At a glance
- Rise in short-term rates is unlikely to have a big impact on deficits
- But there could be an upside surprise on gilt yields in the longer term
- Despite the market volatility, schemes must still plan for a rate rise
Persistently low interest rates have been a nightmare for pension schemes with many seeing their liabilities and subsequent deficits soar. The past few years have been dogged by the interminable question: when rates will rise again, and what will the new normal be?
The Bank of England (BoE) is getting closer to raising short-term rates, with its Super Thursday in August leading the market to predict the first rise around Spring next year. However the impact of China's economic slowdown on developed economies and subsequent low inflation pushed expectations to October 2016, and this could change further. Regardless of the current market volatility, schemes must still brace themselves for a rate rise.
A rate rise is often thought to be the nirvana for deficit-ridden schemes, but the reality is far more complex. All things being equal, higher yields and higher discount rates will mathematically lower deficits. But even when short-term rates rise, they are unlikely to have a big immediate impact on deficits.
This is partly because liabilities are discounted using long-term rates rather than the BoE's base rate; schemes are particularly sensitive to 30-year gilt yields and index-linked yields. The yield curve is sloping upwards, meaning long term rates are higher than short term rates, which indicates the market already expects rates to rise gradually in the future. With inflation so low, there is little pressure on the BoE to increase short-term rates anything other than gradually, according to Cartwright Group investment consultant Ashlin Noonan.
Expected rate rises are already priced into the market, and many scheme valuations use a mean reversion model that takes into account future rather than current gilt rates. So any schemes hoping for rate rises to dramatically reduce deficits are likely to be disappointed, although the impact will be scheme-specific.
Noonan says schemes should not get carried away by a rate rise: "If actual rate rises are in line with market expectations, then it won't impact on deficits. Schemes will benefit from an unhedged position if rate rises occur more quickly or are higher than the market expects."
There could be a significant rise in base rates without the rest of the longer end yield curve moving very much at all, effectively flattening the yield curve.
Redington co-chief executive Rob Gardner says: "A rise in base rates may have a small impact on 30-year gilts but it's unlikely to have a one to one impact in terms of higher gilt yields. If base rates rise from 0.5% to 0.75% or to 1%, it doesn't necessarily translate to 30-year gilts going up by 50 or 100 bps."
For example a 0.2% rise in 30-year gilts between January and June only decreased liabilities of the Pension Protection Fund 7800 index by £35bn to £1.5trn.
A muted impact on the long end of the curve will make little difference to deficits.
There is a possibility of an upside surprise on gilt yields if the markets have forecast too low a yield, although in one or two years' time rather than the immediate future.
"This could be beneficial to pension scheme liabilities but will be a fairly long-term and slowly evolving process rather than anything that will surprise us in early months of next year for example," according to Buck Consultants chief economist Simon Hill.
What could happen?
How inflation pans out will also be a pivotal factor.
"The most beneficial [scenario] for schemes would be for yields to rise but expected inflation rates to stay very low," he says. "Less beneficial is if a yield rise goes hand in hand with rises in inflation expectations - even if small changes because they keep real rates negative. This makes financing any kind of pension promise an extremely difficult thing to do."
It is also possible that long-term rates fall in spite of a rise in base rates, or that they rise less than what the market expects. This would be bad news for pension liabilities if the scheme had bought 30-year gilts, and deficits would subsequently increase.
Gardner says this problem is further magnified by the use of mean reversion in valuations, which form the basis for recovery plans.
"The danger is if the mean reversion doesn't occur, then pension schemes in three years' time will be in a worse position than they expected to be," he warns.
This could happen if rates rise later than the markets predicted before the Black Monday stock market crash.
Standard Life Investments Andrew Milligan says the impact of a rate rise on schemes will also largely depend on whether it is seen to be a good or bad thing by the markets: "If there's a view that the MPC is making a policy error, and the UK economy starts to slow quite quickly, then we could see 30-year yields begin to come down."
The response of the equity markets to a rate rise will also play a part, as deficits are also driven by lower asset returns.
Milligan says the "best of all worlds" would be the FTSE rising to 8,000 in addition to an increased discount rate which would mean deficits would start to disappear. This is only one possible scenario, however, as it could well be the case that equities respond negatively.
Schemes must also consider that the BoE may continue to delay raising rates much later than the markets expect because of deflationary pressures driven by China's shock currency devaluation. The danger is that funding levels could fall if rates stay the same for longer than expected.
Noonan says: "A lot of schemes think there is no cost to staying as they are; that the only risk is from rates going down. That's not the case because of carry - where you assume rates will rise but if they don't then you miss out on that gap of what you expect and where they actually are."
Given the high volatility in the markets and renewed doubt over when the central banks will raise rates, it is a very uncertain time for schemes which have seen their deficits balloon after stock markets fell.
Gardner says: "Our view has always been to design something so you don't get caught out by market expectations."
Noonan says recent developments should not change trustees' approach to managing interest rate risk: "They should continue to review their exposure to interest rate risk in the context of employer covenant and the overall risk budget, and look to reduce it where possible."
The risk management approach taken will be scheme-specific, but schemes should at the very least be thinking about what they will do when rates rise if they haven't already.
Schemes should ask their fund managers some sensible questions about how well-placed they are to deal with this likely outcome. "What scenario risk analysis have they put in place and can they cope with the market volatility that will be seen at the time of a rate rise?" says Milligan.
Those that do a lot of investing in-house will need to ask questions about their fixed income exposure. Milligan says: "What is the shape of their fixed income assets at present - are they holding them to maturity and how sensitive is that? How much has been put into corporate bonds possibly for the higher yields but will that yield come under pressure as capital values come under pressure as government bond yield moves higher?"
Schemes could also start doing risk scenario analysis based on the central view of a gradual increase in rates. Two obvious scenarios to consider are: what if the BoE gets it wrong and inflation picks up rather sharply; or central banks push a rate rise back even further and markets have to adjust to a low growth environment.
"That thinking may help schemes to look at how their fixed income portfolio should be positioned," he says.
A typical scheme that has not hedged its liabilities faces a huge proportion of rate and inflation risk.
Hill says: "We've been saying to clients for some time that although yields are relatively low, that is no reason to not think about risk reduction in schemes, to wait for rates to rise before instituting LDI or at least planning what to do when rates rise. There's really no real excuse - you have to think about these things even when yields very low, partly because higher yields won't necessarily solve schemes' problems."
Even if schemes expect the deficit to reduce significantly following a rate rise, there is an argument that it may not be worth delaying hedging until then if rates stay the same for longer.
"If that's the case then by not being hedged, schemes are missing out on an opportunity which builds up and up and they have a way to catch-up just to stand still," according to Gardner.
This is because schemes then may end up having to hedge a larger amount of liabilities if rates stay low for longer than they expect.
A number of schemes have already taken steps to protect themselves, whether through liability-driven investment (LDI), liability management or buy-ins. "They're the ones with really high asset performance and on the way to full funding," says Gardner. "Going forward, unless we do have a miracle rate rise of 100 bps and an equity rally that bails everyone out, then we will see more of these activities."
Unfortunately for schemes there is no clear cut answer in the face of the current market turmoil. How the emerging markets crisis plays out in the global context over the next few months will determine how central banks act in 2016.
But given that a rate rise will not be a panacea for beleaguered pension funds, which now also face a risk that rates will stay low for longer, preparation will be crucial.
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