Time for pension funds to get a reprieve from their gilt-edged crisis

​Their accounting has leaped forward. Regulation has improved. Liability calculations are anchored on risk-free gilt yields. Wiser schemes have learnt how to use swaps to protect their funding position. And the Pension Protection Fund plays a valuable role as a lifeboat.

But scandal is never far from the surface, as this year’s British Home Stores pension scandal illustrates. Scheme deficits remain a key issue.

Much of the problem with deficits has been amplified by central banks across the world cutting interest rates to unprecedented levels to dig us out of an economic mess. They are also printing money through quantitative easing to buy bonds and get their yields down.

Time will tell whether this policy succeeds in making people spend and boosting the underlying economy. In the meantime, because they are using rock-bottom gilt yields as a discounting mechanism when doing their calculations, pension scheme liabilities have shot up. Underlying scheme assets have not risen by anything like the same extent.

As the Bank of England has acknowledged, UK pension scheme deficits of 28% in June were nudging a record. In the wake of the referendum result, they have probably broken it. When the UK cut interest rates from 50 to 25 basis points on August 4 and bond yields fell, it was estimated a further £40 billion was added to liabilities at a stroke.

And commentators including Schroders are forecasting another cut in UK interest rates to 10 basis points by November. Axa Investment Managers and Deutsche Bank do not expect an end to QE any time soon. Deutsche Bank strategy chief Jim Reid said in a circular published on August 5: “It’d be stunning if major central banks were not still buying government bonds well into the 2020s.”

You can forgive pension schemes for feeling bruised, given that they are forced to base their funding on nominal yields that are fully pricing in deflation, real yields that are pricing in inflation, and assets that are discounting future growth.

Although the UK has voted to leave, perhaps its schemes can still learn from Europe, where an interesting precedent has been set allowing insurers to limit their liabilities through Solvency II’s Ultimate Forward Rate of 4.2%.

In the UK, schemes can use a so-called gilts-plus approach that takes into account higher-yielding instruments, offsetting the gilts-based calculations.

Alan Baker, partner at investment consultant Mercer, says his firm has put together credit portfolios which add 75 or 100 basis points to the yield used for liability calculations, after making an allowance for possible defaults. Weetabix pension scheme, one of its clients, is using a liability benchmark that matches its income-producing assets.

Consultant Punter Southall says schemes should make full use of regulations that allow them to benchmark their liabilities on the assets they own, including equities. Redington is happy with a gilts-plus approach, but stresses the importance of reviewing the data to ensure assets and liabilities do not drift apart.

Regulators are also aware of the problem. In its latest inflation report, the Bank of England points out that there is some flexibility in the way that schemes report because deficit recovery plans only need to be updated every three years. This gives schemes time to make changes to address unwelcome deficits.

But the Bank is less willing and able to help on the problem it has created through low yields. It is a little ironic that the risk-free liability measure favoured by the authorities following the Maxwell affair could end up being destroyed by the actions of the authorities themselves.​

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