The BoE’s aggressive stimulus package has sent gilt yields to record lows and scheme deficits to record highs, finds Jack Jones
The stimulus package announced by the Bank of England today went beyond the expectations of many pundits. The bank’s Monetary Policy Committee cut its base rate of interest from 0.5% to 0.25%, initiated a programme worth up to £100bn to encourage banks to pass the low rates onto borrowers, and voted to extend its quantitative easing project by creating £60bn to buy gilts and a further £10bn to buy corporate bonds.
The unanimous decision to cut the cost of borrowing was widely predicted, but is momentous nonetheless. It is the first movement since March 2009 when the bank slashed the base rate to a record low 0.5%. Today’s announcement takes us further into unknown territory for the UK economy.
Why has the BoE cut rates?
The raft of measures was a response to sharp drops in business and consumer confidence following the June vote to leave the EU. The bank said the outlook for growth in the short to medium term had “weakened markedly” since the vote, which its governor Mark Carney described as a “very large identifiable supply shock”. It has cut it’s growth expectations for 2016 by two-thirds.
The measures are designed to mitigate this expected slowdown, and lessen the chances of a recession in the coming months. This was balanced by concerns that the substantial fall in the value of the pound since the vote could push inflation above the bank’s 2% target. But the committee has placed more weight on the impact of an economic slowdown or contraction.
How will this affect pension schemes?
Low yields mean big liabilities
Today’s package is bad news for schemes. Liabilities had already been swollen by low yields, with data released by Mercer earlier this week showing deficits at FTSE350 schemes had increased by 40% since May.
Why do falling gilt yields increase deficits?
Returns on gilts or high quality corporate debt are used to determine a scheme’s expected risk-free return in the future. Schemes then add a fixed value for the investment risk they take and use this to discount these future liabilities. If yields, and therefore discount rates, fall then in theory a scheme needs more assets today to generate sufficient investment returns to pay a projected amount of benefits in the future.
A fall in gilt yields of 1% will increase liabilities by between 15% and 25% for most schemes, and will reduce annuity rates for retirees by 10-15%.
And although markets had already priced in some of today’s measures, both 10- and 20-year gilts hit record lows when the package was announced. This grief for funding levels is tempered by low inflation expectations, but Hymans Robertson partner Patrick Bloomfield has estimated that £70bn was added to UK scheme liabilities at a stroke, pushing deficits to a record high of £945bn.
The gap between pension schemes which hedged their risks and those that haven’t is starker than ever before”
“Pension schemes are being hit hard by recent events, but we need to remember that the impact will not be felt equally by all,” he said. “Headlines have been dominated by cases where scheme liabilities are putting companies at risk of insolvency and the security of members’ benefits at risk.
“However, there are schemes with robust funding plans that don’t take more risk than they need to who will be able to weather this. The gap between pension schemes which hedged their risks and those that haven’t is starker than ever before.”
With just 30-40% of liabilities in mature schemes hedged according to estimates from Aon Hewitt, many will see funding levels hit by the ultra-low yields.
Lower for longer
The cut in rates also sets back expectations for the when they will begin to rise. Schemes have long been warned that they cannot pin their funding hopes on rates returning to pre-2009 levels. Two years ago Carney said investors should prepare for a new normal of 2.5% rather than 5%, while earlier this year PPF chief executive Alan Rubenstein called for schemes to “face up to [this] reality”.
And in spite of the inflated price of gilts, consultants are still advising schemes to consider increasing hedging. Aon Hewitt head of asset allocation Tapan Datta said: “Funding risks… remain uncomfortably large, even at today’s ultra-low yields. The potential reward from under-hedging this risk remains slim.”
Another blow for annuities
In the DC world, the record low gilt yields are yet another blow for retirees who want to annuitise. Intelligent Pensions head of pathways Andrew Pennie said:” Annuity rates are already at record lows, having fallen 12% since the start of the year – one wonders how much further they can actually fall.”
“It’s no surprise that many are choosing not to buy an annuity under the new pension freedoms in the hope that future rates might improve or a belief better returns can be generated elsewhere. But for some people, annuities are the right retirement solution and there is no advantage in deferring for several months – or years – in the hope that rates rise again.”
What happens next?
The bank forecasts that its measures will be sufficient to avoid a recession, but has revised down its cumulative growth expectations for the next two years by 2.5% - the biggest ever downgrade between quarterly inflation reports. If the bank is correct, it’s actions will have will softened the blow for many businesses, but scheme sponsors could still come under serious strain.
Schemes also need to prepare themselves for more stimulus measures and a further erosion of funding levels. Carney revealed that MPC members are willing to cut the base rate to 0.1% if their inflation expectations are borne out.
Most schemes should be preparing for things to get worse before they get better”
The governor said he was no fan of negative rates though, and suggested that the other three elements of the stimulus package would be boosted before the committee would consider resorting to this extreme resort.
There is also the question of what government will do to stimulate the economy. Carney said the Treasury had identified several areas where it could act, including increasing productivity, and the government seems keen to match the bank’s aggressive actions.
In an open letter to the governor, Chancellor of the Exchequer Philip Hammond said: “Alongside the actions the bank is taking, I am prepared to take any necessary steps to support the economy and promote confidence.”
We will have to wait until the Autumn Statement to find out just what this means, but for now most schemes, and indeed most savers, should be preparing for things to get worse before they get better.