DB scheme funding is in dire straits but there are actions trustees can take to help, finds Jenna Gadhavi

Brexit, and the perfect storm of heightened volatility and collapsing bond yields that followed has shone a light on the hazardous state of UK pension scheme funding.

The latest Pension Protection Fund (PPF) 7800 Index estimates that aggregate deficits in defined benefit schemes totalled a record £384 billion at the end of June 2016, up from £295 billion in May.

deficit-index

There is evidence that the Brexit vote itself may have worsened the situation for some schemes. Graham McLean, head of pension scheme funding at Willis Towers Watson, said: “The market reaction to Brexit has kicked another big hole in pension schemes’ funding levels. Assets have grown – at least when measured in sterling – but not quickly enough to keep pace with the increased cost of paying promised benefits in a world where interest rates and expected returns on assets are lower.”

The medium- to longer-term view has not changed substantially”

However, Andrew Sentance, senior economic adviser at PwC, believes that the impact on long-term pensions outlooks will be minimal. He said: “Interest rates are not expected to rise much before the 2020s, and looking even further ahead, long-term gilt yields are likely to be low. Brexit may have impacted the short-term, with rates staying lower for longer. However, the medium- to longer-term view has not changed substantially.”

Schemes no better off than a decade ago

But it’s not all good news. While it’s possible Brexit fears are overblown, (at least from a pension scheme perspective) - that doesn’t mean there’s no reasons for DB trustees to worry. The reality is that UK economy has been feeling the negative effects of low interest rates for some time - leaving many schemes in dire straits.

In fact, findings by PwC show that DB pension schemes are no better off than a decade ago. And while Brexit may have exacerbated the problem, it is the long-term DB funding woes that should be top of trustees’ list of concerns.

Long-term DB funding woes should be top of trustees’ list of concerns

PwC’s Pension Support Index tracks the relationship between the financial strength of FTSE350 companies and their defined benefit pension obligations. It shows that despite a gradual recovery in corporate performance since the global financial crisis, billions paid into schemes and extensive protections being put in place by the Pensions Regulator, there has been no overall improvement in the FTSE 350 companies’ ability to support their DB pension obligations.

Continued low gilt yields, have prevented an improvement in the index in recent years. Meanwhile the question of support for pension schemes has become increasingly important in light of changing market conditions.

Hedge your bets

Projections of continued low gilt rates mean that unhedged schemes need to seriously consider their positions or run the risk of seeing funding levels fall even further.

The volatility after the Brexit vote clearly demonstrates where hedging can add value for schemes.

Pension schemes that protected themselves against falls in gilt yields by investing in leveraged liability driven investment (LDI) are likely to have fared better than most because the value of the scheme’s assets will have increased in line with liability values. Some pension schemes have even seen their funding levels improve as a result of the referendum outcome.

Delaying a decision to hedge liability risk is less rewarding”

Ben Gold, head of Xafinity’s Investment Team in Leeds commented: “LDI will have provided pension schemes with some protection against the falls in gilt yields that we have seen since the Brexit vote. Indeed, because LDI assets have performed so well, many pension schemes with LDI will imminently be receiving cash payments from their LDI managers.”

And while many schemes have put off hedging in a low rate environment, there are no guarantees that rates won’t fall even further. The Bank of England may have has just surprised markets by keeping interest rates unchanged, but for now, this is a stay of execution for unhedged schemes reprieve

Andy Tunningley, head of UK strategic clients at BlackRock said: “Delaying a decision to hedge liability risk is less rewarding — because we do not expect rates to rise in the current uncertain environment — and more risky — as Japan and Europe have shown there could be much further yet to fall.”

Getting to grips with covenant

The PWC index also shows twice as many companies as in 2006 supported by a weak covenant. Those schemes that have hedged out much of their risk and therefore have not been impacted to the same degree by market shocks are faring best over that period.

Time is running out for trustees and sponsors that have been waiting for gilt yields to rise”

Experts agree that strong covenant is key. Jonathon Land, pensions credit advisory leader at PwC, said: “There is the option to take a longer term view and you may well benefit if rates revert to long-term averages. However, if your covenant is weaker, de-risking and/or using a contingent asset would appear to be a better approach. Our analysis of the FTSE 350 over the last ten years would certainly support this view.

“Time is running out for trustees and sponsors that have been waiting for gilt yields to rise. The key question for those who have kept their interest rate exposure is whether the sponsor covenant can withstand the downside if gilts fall further.”

Amid all the uncertainty only one thing is sure, trustees should be focusing on what they can do now to ensure that risks are managed and market opportunities are captured. Hedging and assessing covenant strength have to be top of the agenda.